Key lessons from Warren Buffett and Berkshire Hathaway’s annual letters

Warren Buffett published his now famous annual letter to Berkshire Hathaway’s shareholders on Saturday February 22nd 2020. He’s known to communicate openly both good and bad. Buffett uses a rule when writing his annual letter: write as if his auntie, who doesn’t understand complicated terms, would read it and communicate key business numbers as if he’s the investor who would read the letter.

The compound interest that Buffett achieved for Berkshire Hathaway from 1965 to 2019 is remarkably 20.3%. This is the best record that any investor can achieve for the duration of 54 years.

Lesson 1: Power of retained earning

It’s easier for people to see when the company pays dividends. When companies retain earnings, many factors need to be considered.
Buffett wrote about retained earnings and its importance to the company’s growth many times.
This time, he quoted Edgar Lawrence Smith, the author of the popular book Common Stocks as Long-term Investments, and John Maynard Keynes. Smith planned to argue that bond performs better in deflationary period and stock performs better in the inflationary period. He was in a shock.
Keynes captured Smith’s insights: “I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest (Keynes’ italics) operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”
Rockefellers, Carnegie, and Ford amassed mind-boggling wealth by retaining a huge portion of their earnings to fund growth.
Buffett has followed them to retain all Berkshire Hathaway’s earnings. He reinvested $121 billion in the last decade into the company.

Lesson 2: criteria to acquire businesses

Buffett looks for three things in a business:

  • They must earn good return on the net tangible investment required in their operation
  • They are run by able and honest managers
  • They must be available at sensible prices

Those types of businesses are rare. Down markets often offer more opportunities to own such businesses.

Lesson 3: acquiring good businesses
Tom Murphy gave Buffett an advice: “to achieve a reputation as a good manager, just be sure you buy good businesses.”
Reviewing his record which has losers and winners, Buffett concluded: “Acquisitions are similar to marriage. They start, of course, with a joyful wedding – but then reality tends to diverge from pre-nuptial expectations… I’d have to say it is usually the buyer who encounters unpleasant surprises. It’s easy to get dreamy-eyed during corporate courtships.”
Even though Buffett does not sell losers, they became stagnate and required less and less capital from Berkshire. Capital allocation is one of Buffett’s specialty. He allocated like he invested: more to the winners and less or none to the losers.

Lesson 4: Don’t forecast
as the pundits who opine on forecasting reveal far more about themselves than they reveal about the future.

Lesson 5: 5 factors of Buffett’s optimism on Berkshire’s future.

  • Berkshire’s assets are deployed in extraordinary variety of businesses that on average earn attractive return on invested capital.
  • Berkshire’s positioning of its controlled businesses within a single entity with substantial amount of capital endows it with some important and enduring competitive advantages.
  • Berkshire’s financial affairs will unfailingly be managed in a manner allowing the company to withstand external shocks of an extreme nature.
  • We possess skilled and devoted top managers for whom running Berkshire is far more than simply having a high-paying and/or prestigious job.
  • Berkshire’s directors are constantly focused on both the welfare of owners and the nurturing of a culture that is rare among giant corporations. (A new book called Margin of Trust will be published)

Lesson 6: board of directors

When a CEO wants to make an acquisition, he/she hardly brings in consultants or directors that would likely challenge him/her.
If a director’s income is largely tied with directorship fee, the director is not independent. He/she would not challenge the CEO for the fear of losing their directorship. In addition, CEO often looks at a director’s track record and would more likely bring in directors who have not opposed to CEOs.
At Berkshire, directors got paid a tiny fee compared to their net worth. Berkshire’s directors also buy their own shares instead of being granted.

For the full annual letter, please visit https://berkshirehathaway.com/letters/2019ltr.pdf

Warren Buffett series #9 – rational thinking – don’t kid yourself about getting rich quick

It’s dynamite to start with things that can expire and become worthless. For example: buy options of Coke thinking that the stock is attractive.

Borrowed money usually leads to trouble.

Once you start focusing on short-term price behavior, which is nature of buying calls, you are likely to take your eyes off the main ball, which is just valuing businesses.

If you have X and you think you are going to be happier when you’ve got 2X, it’s probably not true.

About me and why this series:
I got a life-changing experience studying Warren Buffett’s annual letters in 2013 after 10 years of speculating, market timing, charting, and forecasting. I started investing in the Vietnamese stock market in 2015 with what I saved from my engineering job. In 2018, I decided to study Warren Buffett’s investing again by going through all of available Berkshire Hathaway’s annual meeting videos. It has been another life-changing experience. Warren Buffett’s teaching is a real germ and yet not many people replicate. Hence, I am committed to share what I learned.

You can subscribe to my blog to follow the series of what Warren Buffett has been teaching in his annual meetings. I attempted to modify but keep as much as possible what he spoke.

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Warren Buffett series #8 – bought National Indemnity in 15 minutes

National Indemnity purchase in 15 minutes

Warren Buffett is known to make a decision to buy a business in very short period of time. The following is his story of how he bought his first insurance business in less than 15 minutes.

Jack Ringwalt, who ran National Indemnity, for every 15 minutes every year would want to sell the company. A friend of mine and I discussed this phenomenon of Jack being in heat once a year for 15 minutes. I asked my friend if he ever caught Jack in this particular phase to let me know. He called and said “Jack is ready.” I asked him to tell Jack to come over. We made a deal in that 15 minutes zone.

It’s a fascinating story because Jack having made the deal really didn’t want to do it. But he wouldn’t have backed out of a deal. 

He said to me after we’d shaken hands: “I suppose you will want audited financial statements.” If I’d say “Yes”, he would have said “Well, that’s too bad then. We can’t have a deal.” So I said “I wouldn’t dream of looking at audited financial statements. They are the worst kind.” Then Jack said “I suppose you will want me to sell my agencies to you as well.” I said “Jack, I wouldn’t buy those agencies under any circumstances.”

If I’d said yes, he would have said “Well, I wouldn’t be able to do it. We must have misunderstood each other.” So we went through about three or four of these.

Finally, Jack gave up and sold me the business.Jack was an honorable guy. When he came to pick up his money, he was about 10 minutes late because he was looking for a parking meter with a few minutes left on it. 

About me and why this series:
I got a life-changing experience studying Warren Buffett’s annual letters in 2013 after 10 years of speculating, market timing, charting, and forecasting. I started investing in the Vietnamese stock market in 2015 with what I saved from my engineering job. In 2018, I decided to study Warren Buffett’s investing again by going through all of available Berkshire Hathaway’s annual meeting videos. It has been another life-changing experience. Warren Buffett’s teaching is a real germ and yet not many people replicate. Hence, I am committed to share what I learned.

You can subscribe to my blog to follow the series of what Warren Buffett has been teaching in his annual meetings. I attempted to modify but keep as much as possible what he spoke.

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Join 4,662 other followers

Warren Buffett series #7 – How to calculate intrinsic value of a business

People always want a formula. They go to the Intelligent Investor and think somewhere they are going to find a little formula.
It really doesn’t work that way.

“A bird in hand is worth two in the bush” – Aesop

Aesop was onto something but he didn’t finish it. There are a couple of other questions that go along: “When are you going to get the two in the bush?”, “How certain is it to get the two in the bush?”, “What’s the interest rate?”

If you know interest rate and the timetable, you know investing. You would trade a bird in hand.

You lay out cash today to get more cash in the future.

It’s an investing decision. You have to decide how many birds are in the bush, when they are going to get out, and when you are going to acquire them. 

If the interest rate is 5% and you will get the two birds in five years, two birds in the bush is much better than one bird in hand. That’s roughly 15% compounded annually. If the interest rate is 20%, you would decline to take two birds in the bush five years from now. 

With growth, people associate with a lot more birds in the bush. You still have to decide when you are going to get them. You have to measure that against interest rates. You have to measure that against other bushes.

It’s a value decision: what it is worth, how many birds are in that bush, when you are going to get them, and what interest rate is.

Every year you wait to take a bird out of the bush, you have to take out more birds. If a company doesn’t pay you a dividend this year or next year, it has to be able to pay you more in perpetuity the year after.

If you buy a company for $500 billion and purchase 10% of that company and want to get a 10 percent return, $50 billion of cash has to come out of that company year after year. If they delay one year of dividend, $55 billion of cash has to come out. To do that, they have to make $80 billion pretax. There are not many companies that earn $80 billion pretax. So it requires a rather extraordinary change in profitability to give you enough birds out of that particular bush to make it worthwhile to give up the one you have in your hand.

People always want a formula. They go to the Intelligent Investor and think somewhere they are going to find a little formula.

It really doesn’t work that way. What you do is to look at all cash a business will produce between now and judgement day and discount it back at a rate that’s appropriate (intrinsic value), and then buy it a lot cheaper than that (margin of safety). You really want to look for things you can understand and where you can see out for a good many years as to the cash that can be generated from the business. If you can buy it at a cheap enough price compared to that cash, it doesn’t make any difference what the name attached to the cash is.

The intrinsic value calculation should already factor in the fact that certain businesses are going to earn less in the future than now. It’s that their intrinsic value goes down. 

Intrinsic value is very important and very fuzzy. We do our best to work with the kind of businesses where we think we have the highest possibilities where our predictions are of a fairly highly probable nature. That leaves out all kind of companies. It’s something like the natural gas pipeline. The chance of big surprises in a pipeline should be relatively small. It doesn’t mean they are zero but they are relatively small.

Let’s assume that you have a pipeline which either the supply of gas is going to run down or there are competitive pipelines that may be trying to take away your contracts that you wrote 10 years ago and expire in two years and you will have to cut the price. Two years from now when you have to cut the price, the intrinsic value hasn’t gone down from today if you properly calculate it today and build in the fact that profit margins in the future will be lower than today.

You build in the prediction of decline in the future operating years. You don’t want to wait till you get there to anticipate it. That’s part of predicting in business. Lots of businesses’ earning go down. They are going to go down. You have to analyze businesses and some businesses are going to be subjected to enormous competitive pressures that are not extant today.

We made a mistake with Dexter Shoes which was earning $40 million pretax. We assumed the future would look as good as the past. That’s part of the game to figure out what those future cash flows are likely to be. When you can’t come up with reasonable estimates, you move onto the next one.

About me and why this series:
I got a life-changing experience studying Warren Buffett’s annual letters in 2013 after 10 years of speculating, market timing, charting, and forecasting. I started investing in the Vietnamese stock market in 2015 with what I saved from my engineering job. In 2018, I decided to study Warren Buffett’s investing again by going through all of available Berkshire Hathaway’s annual meeting videos. It has been another life-changing experience. Warren Buffett’s teaching is a real germ and yet not many people replicate. Hence, I am committed to share what I learned.

You can subscribe to my blog to follow the series of what Warren Buffett has been teaching in his annual meetings. I attempted to modify but keep as much as possible what he spoke.

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Warren Buffett series #6 – Advice to start investing

You can’t look around for people to agree with you. You can’t look around for people to even know what you are talking about. You have to think for yourself.

Advice to start investing:

Start young.

The big thing about investing is that we started building this little snowball on top of a very long hill. We started at a very early age rolling the snowball down.

The nature of the compound interest is that it behaves like a snowball of sticky snow. The trick is to have a very long hill.

If I am to start out today with $10,000, I would do exactly the same way. I would start going right through companies. I would focus on smaller companies because that would be working with smaller sums and there’s more chance that something is overlooked in that area. 

You have to buy businesses or a little piece of businesses called stocks and buy them at an attractive price. You can’t expect anybody else to do it for you. You’ve got to know what you know and what you don’t know.

Within the arena of what you know, you have to pursue it very vigorously and act on it when you find it. 

You can’t look around for people to agree with you. You can’t look around for people to even know what you are talking about. You have to think for yourself. 

The hard part of the process is the first $100,000. The people who get there quickly are helped if they are passionate about being rational, very eager, and opportunistic, and steadily underspent their income grossly.

About me and why this series:
I got a life-changing experience studying Warren Buffett’s annual letters in 2013 after 10 years of speculating, market timing, charting, and forecasting. I started investing in the Vietnamese stock market in 2015 with what I saved from my engineering job. In 2018, I decided to study Warren Buffett’s investing again by going through all of available Berkshire Hathaway’s annual meeting videos. It has been another life-changing experience. Warren Buffett’s teaching is a real germ and yet not many people replicate. Hence, I am committed to share what I learned.

You can subscribe to my blog to follow the series of what Warren Buffett has been teaching in his annual meetings. I attempted to modify but keep as much as possible what he spoke.

Enter your email to subscribe to notifications from this site

Join 4,662 other followers