Newsletter January 14, 2012
InvestorsFriend Inc. Newsletter January 14, 2012
The Wisdom of Warren Buffett
Warren Buffett is generally acknowledged as one of the best investors in history. He started investing in 1942 at 12 years old and today at 81 he is not done yet.
His annual letters are a treasure trove of investment wisdom and advice.
Here is some of his wisdom:
Way back in his 1961 letter Buffett said the Dow Jones Industrial Average total return over the future years will probably be 5 to 7%. (Which was not as good as recent years had been). Interestingly, he would essentially repeat the 5 to 7% figure some 39 years later in a famous Fortune magazine article written at the tail end of the 1990’s stock boom.
In 1961 he also said his job was to pile up yearly advantages over the Dow. That it was not important that his return be positive, just that it be better than the Dow. (Since the DOW itself would do well over time, he would do well if he could beat the DOW)
In 1963 Buffett noted that he makes no attempt to time the market. He considered attempting to gauge stock market fluctuations to be a very poor business.
In 1964 he said “If a 20% to 30% drop in the market value of your equity holdings is going to produce emotional or financial distress, you should simply avoid common stock type investments.”
In 1965 Buffett described how the partnership he ran had been accumulating shares in Berkshire Hathaway since 1962 on the basis that it was trading significantly below the value to a private owner. The first buys were at a price of $7.60 and the average cost was $14.86 reflecting heavy purchases in 1965 as Buffett (the investment partnership he ran) took control of the company in the Spring of 1965. The 1979 letter reveals that: “The book value per share of Berkshire Hathaway on September 30, 1964 (the fiscal year-end prior to the time that your present management assumed responsibility) was $19.46 per share.”
These are the very same Berkshire Hathaway shares that closed out 2011 at $114,755. This is a gain of 772,000% over his average purchase price of $14.86. What is perhaps most remarkable is that this represents “only” 21.0% per year compounded for the 47 years from 1965 to 2011 inclusive.
In 1975 Buffett also talked about his lack of diversification.
He described a new “ground rule” whereby the fund diversifies much less than other fund managers and might invest up to 40% of the money in a single security if there was both a high probability that our facts and reasoning are correct and a very low probability that anything could drastically change the underlying value of the investment.
Ideally he would put 2% each into 50 un-correlated investments that all had an expectation of beating the Dow by 15%. Then he could have a high certainty of getting near that 15% advantage. But, “it doesn’t work that way”. He worked extremely hard to find just a very few attractive investment situations. Where the expectation by definition is at least 10% higher per year than the Dow. “Our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations.” It is imprecise and emotionally influenced.
“A portfolio that expects to beat the market and yet contains 100 securities is not being operated logically. This is the Noah school of investing – two of everything.”
“The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable”. More securities leads to less variation but lower returns (as you invest less in the securities with the highest expected returns). Buffett was willing to accept quite a bit of variability for higher returns. Therefore he concentrated in the best investments and accepted that there would occasionally be a very sour year.
In 1966 he said: “We don’t buy and sell stocks based upon what other people think the stock market is going to do (I never have an opinion) but rather upon what we think the company is going to do”
In 1975 he said:
“Our equity investments are heavily concentrated in a few companies which are selected based on favorable economic characteristics, competent and honest management, and a purchase price attractive when measured against the yardstick of value to a private owner.”
“With this approach, stock market fluctuations are of little importance to us – except as they may provide buying opportunities – but business performance is of major importance.” Market fluctuations in bond investments held (due to interest rate movements) were also of little importance since the bonds would unlikely be sold other than at times of Buffett’s choice.
In 1979, at a time of high inflation, Buffett made some interesting comments on the future value of money and printing money
“One friendly but sharp-eyed commentator on Berkshire has pointed out that our book value at the end of 1964 would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce. A similar comparison could be drawn with Middle Eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.”
“We have severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day. Those dollars, as well as paper creations of other governments, simply may have too many structural weaknesses to appropriately serve as a unit of long term commercial reference. If so, really long bonds may turn out to be obsolete instruments and insurers who have bought those maturities of 2010 or 2020 could have major and continuing problems on their hands. We, likewise, will be unhappy with our fifteen-year bonds and will annually pay a price in terms of earning power that reflects that mistake.”
Nevertheless, Buffett never wavered in his belief that he could make excellent returns by investing in companies, in the same letter he said: “We continue to feel very good about our insurance equity investments. Over a period of years, we expect to develop very large and growing amounts of underlying earning power attributable to our fractional ownership of these companies. In most cases they are splendid businesses, splendidly managed, purchased at highly attractive prices.”
In his 1984 letter, Buffett spoke about buying attractive bonds at that time but also wrote about the irrationality of investors buying long-term bonds at times of very low interest rates. (This may be very relevant to the situation in 2012 and InvestorsFriend would note that Berkshire Hathaway today has only a very tiny amount invested in long-term bonds).
“Our approach to bond investment – treating it as an unusual sort of business with special advantages and disadvantages – may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessmans perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a business that earned about 1% on book value (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.”
“If an investor had been business-minded enough to think in those terms – and that was the precise reality of the bargain struck – he would have laughed at the proposition and walked away. For, at the same time, businesses with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, or 15% after tax on book. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. Similar, although less extreme, conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards.”
Conventional wisdom is that stocks are riskier than bonds, but here is what Buffett said about stocks versus bonds (this was at a time of relatively high inflation):
“While there is not much to choose between bonds and stocks (as a class) when annual inflation is in the 5%-10% range, runaway inflation is a different story. In that circumstance, a diversified stock portfolio would almost surely suffer an enormous loss in real value. But bonds already outstanding would suffer far more. Thus, we think an all-bond portfolio carries a small but unacceptable wipe out risk, and we require any purchase of long-term bonds to clear a special hurdle. Only when bond purchases appear decidedly superior to other business opportunities will we engage in them. Those occasions are likely to be few and far between.”
(And InvestorsFriend’s opinion is that such occasions right now would only be found in a very few high yield bonds and most certainly would not be found in long-term government or investment grade bonds.)
Buffett also wrote in 1979 about stocks being superior to bonds at that time. He wrote again in 2001 about the 1978 situation and said:
“Back in 1978, as I mentioned, we had the Dow earning 13% on its average book value of $850. The 13% could only be a benchmark, not a guarantee. Still, if you’d been willing then to invest for a period of time in stocks, you were in effect buying a bond–at prices that in 1979 seldom inched above par–with a principal value of $891 and a quite possible 13% coupon on the principal.
“How could that not be better than a 9.5% bond? From that starting point, stocks had to outperform bonds over the long term. That, incidentally, has been true during most of my business lifetime. But as Keynes would remind us, the superiority of stocks isn’t inevitable. They own the advantage only when certain conditions prevail.”
InvestorsFriend would note that today, stocks are earning about 14% on their book values but trade at twice book value and so they are earning 7% on their market prices. We think that this implies that Buffett would once again conclude that stocks will certainly beat all government bonds in the long run given that long-term government bonds yield in the 2 to 3% range.
In a 1999 article Buffett said:
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
InvestorsFriend’s Stock Picks for 2012
At InvestorsFriend, we never make any promises or guarantees about investment results. What we can do is point out that we have a consistent track record of beating the market significantly. We intend to continue to evaluate and rate stocks on the same basis that has been successful in the past.
Check out our Performance here:
Borrow to Invest?
Normally, it is a dangerous idea to borrow to invest in stocks. Only those with very secure jobs and with very little other debt should consider it. Right now may be a good opportunity to borrow to invest for those who are in a position to take that risk.
Bank of Montreal is offering a fiver-year mortage locked in at only 2.99%. Meanwhile there are many preferred shares and dividend stocks that pay more than 3%. This includes bank preferred shares. For centuries banks have operated by taking in money at a low interest rate and lending it out at a higher interest rate. Right now you have the the opportunity to effectively do the same. Imagine borrowing from the bank of Montreal at 3% and simply investing the money in Bank of Montreal preferred or Common shares which are expected to (but not guaranteed to) earn more than 3%.
Shawn Allen, President
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Shawn Allen CFA, CMA, MBA, P.Eng.
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