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In 2017, my Dad issued a challenge for me to start reading books about investing. After completing 4 books that year, he brought the challenge back for 2018-2019 with a new list of books.
So far I’ve read The Myth of the Rational Market and Value Investing: From Graham to Buffett & Beyond. This is my recap for the third book in the challenge, The Essays of Warren Buffett: Lessons for Corporate America.
It goes without saying that Warren Buffett is the greatest investor of all-time. I’m fascinated by his life and his thoughts on investing, so I was looking forward to reading this book. Buffett serves as the chairman and chief executive of Berkshire Hathaway, an American multinational conglomerate holding company which owns the likes of GEICO, See’s Candies, Duracell, Dairy Queen, among others. The company also holds significant minority shares of American Express, Wells Fargo, Coca-Cola, and Bank of America.
Every year, Buffett writes a letter to Berkshire Hathaway shareholders. The letter helps explain his decision-making, the direction of the business, and the long-term outlook of the company. Berkshire is focused on attracting business-oriented long-term shareholders, and filtering out those focused on market-oriented short-term shareholders, which makes these letters a goldmine of information for the long-term investor.
In The Essays of Warren Buffett: Lessons for Corporate America, author Lawrence A. Cunningham compiles the key learnings from Berkshire Hathaway’s annual letters from 1979 through 2006. What makes the book so impactful is that Cunningham keeps the integrity of Buffett’s words from the letter, but reorders them by theme to make them much easier to learn from. Ordering the book in this way also makes it easier to see how Buffett’s key themes have developed over time. There are close to 50 books that mention Warren Buffett’s name in the title, but he calls this one his favorite.
Here are the key themes that stood out to me in this book:
The three legs of the Warren Buffett and Benjamin Graham stool of intelligent investing
Buffett talks about intelligent investing often, and the three main components he continues to go back to are “Mr. Market,” margin of safety, and circle of competence.
Mr. Market: is a fictional character symbolizing the stock market from Benjamin Graham’s book, The Intelligent Investor. This character comes to his house every day in a different mood. Some days he’s ecstatic and some days he’s depressed. Graham tells readers that it’s better to ignore the market rather than focusing on it on a daily basis. Mr. Market’s mood swings between being overly optimistic and overly pessimistic. Graham advises readers to not let Mr. Market tell you what the value of a particular stock is, do your own research and make your own value assessment.
Stocks represent ownership of businesses. In his letters, Buffett references Mr. Market and discusses the mental attitude that investors need to have during market fluctuations in order to be successful. He talks about how we shouldn’t try to predict market fluctuations, and how we should be “fearful when others are greedy, and greedy when others are fearful.”
Margin of safety: In value investing, the focus is on looking beyond the share price and instead focusing on a company’s intrinsic value. Value investors try to find the intrinsic value of a business through research. They compare this to the share price, and then purchase stock when a gap exists. This gap is called the “margin of safety,” and it helps absorb various risks.
Circle of competence: Only invest in what you know and understand. If an investment is complicated to understand, avoid it. The size of your circle of competence isn’t important, but knowing its boundaries is vital. Buffett explains that knowing the boundaries of his circle of competence has been one of the biggest keys to Berkshire Hathaway’s success.
When looking for good businesses
Buffett defines good businesses as businesses that “can employ large amount of incremental capital at very high rates of return.”
When looking for good businesses an investor should look for a few key characteristics including: moats, economic goodwill, incremental earnings, simplicity, skilled managers.
Economic moats are defined as a unique competitive advantage that a company has over others, for example Coca-Cola’s recipe would be considered a moat because another soda company can’t easily replicate it.
Economic goodwill: “Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill.” (p. 185-186)
He says that we should focuses on strong, well-run businesses with skilled managers and buying stocks at a price that offers a sufficient margin of safety.
When assessing an investment’s risk
Buffett lists 5 factors to consider when assessing an investment’s risk:
- The certainty with which the long-term economic characteristics of the business can be evaluated.
- The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows.
- The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to itself.
- The purchase price of the business.
- The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.
Buffett’s definition of risk
Definition of risk: “We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.” Academics, however, like to define investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks—that is, their volatility as compared to that of a large universe of stocks.”
This is a key distinction to pay attention to. Buffett defines risk as the possibility for loss, while many other investors equate risk to volatility. Buffett disagrees with equating volatility with risk, instead advising investors to embrace volatility as it means more opportunity.
Primary causes for poor investment results
Buffett indicates three primary causes for investors to experience poor investing results:
- high costs (investment fees, etc)
- portfolio decisions made on tips/fads, rather than basic principles
- a start-and-stop approach to the market marked by untimely exits and entries.
Buffett advocates for buying and holding for the long-term, and avoiding jumping in and out of the market.
Growth vs Value
Buffett’s perspective is that both are related, growth is always a component of value, and all investing should be about seeking value. When valuing a business, pick something at a rational price, something understandable, with earnings likely to grow in the long-term. True investing is based on the relationship between price and value. Without considering this relationship, it’s not investing, it’s speculation.
Thinking Long-term
Buffett says to ignore political and economic forecasts, and invest for the long-term. There will always be new headlines talking about gloom and doom, but ignore them and stay the course.
He doesn’t take “all or nothing” type risks to gain a few more percentage points in his investments. For example, he mentions that if he found an investment with a 99% chance of making gains and a 1% chance of Berkshire going under, he would still pass on the investment opportunity.
When investing, he views himself as a business analyst, not a market analyst. Focus on getting rich slowly. Leverage will move things along faster, but also incurs unnecessary risk.
Time is the friend of the wonderful business and the enemy of the mediocre. Focus on businesses you could see yourself owning for 10+ years. Commitment is a key lesson, Buffett and Charlie Munger put their money where their mouth is. 99% of Buffett’s net worth is held in Berkshire Hathaway, along with much of their family and friends’ money. Their personal interests are aligned with the company’s interests.
Acquiring Businesses and Capital Allocation
When Berkshire acquires a new business, Buffett stays out of the day-to-day, trusting the managers to continue to execute with excellence. He is involved in “capital allocation,” the ‘science’ of how to best add shareholder value from the profits, which the business generates.
Two options for capital allocation is to retain the earnings and invest them back into the business, or pay them out as dividends to shareholders. “Earnings retention is justified only when capital retained produces incremental earnings equal to, or above, those generally available to investors.” (p. 15)
This principle of “capital allocation” is a great way to think of our own personal finances. Once you’ve created a gap between your income and expenses, you will have excess capital that you’ll need to evaluate how to allocate in the best way possible. Buffett does this for Berkshire on a much larger scale of course, but it’s an interesting way to think about it.
He talks a lot about business accounting, and explains that there are limitations in accounting in investment analysis. An accountant’s job is to record what is going on in the business, not to evaluate how the business is doing.
Final Thoughts
These are just a few highlights of the many nuggets of wisdom within this book. I’d recommend this book to anyone interested in Warren Buffett and investing. I learned a lot of new information, along with reinforcing key ideas that I had encountered in other books. I could definitely see myself re-reading this book in a couple years, to remind myself of these lessons.
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