Book notes and lessons learnt: “Berkshire Hathaway Letters to Shareholders, 1965–2018” by Warren Buffet

"Investing" and "risk" definitions

Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date . “ Risk ” is the possibility that this objective won’t be attained.

Choosing a business to own/invest

( 1 ) favorable long — term economic characteristics

( 2 ) competent and honest management

( 3 ) purchase price attractive when measured against the yardstick of value to a private owner

( 4 ) an industry with which we are familiar and whose long — term business characteristics we feel competent to judge .

Focus on long term (5 years minimum)

We never take the one — year figure very seriously . After all , why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off ? Instead , we recommend not less than a five — year test as a rough yardstick of economic performance.

Severe change and exceptional returns usually don’t mix.

Most investors , of course , behave as if just the opposite were true . That is , they usually confer the highest price — earnings ratios on exotic — sounding businesses that hold out the promise of feverish change . That prospect lets investors fantasize about future profitability rather than face today’s business realities . For such investor — dreamers , any blind date is preferable to one with the girl next door , no matter how desirable she may be .

Experience , however , indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago . That is no argument for managerial complacency . Businesses always have opportunities to improve service , product lines , manufacturing techniques , and the like , and obviously these opportunities should be seized . But a business that constantly encounters major change also encounters many chances for major error . Furthermore , economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress — like business franchise . Such a franchise is usually the key to sustained high returns .

Mental models

-> The (short-term) forecasts (of stock or bond prices) may tell you a great deal about the forecaster; they tell you nothing about the future.

-> Should you find yourself in a chronically — leaking boat , energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks .

-> Beware of past — performance “ proofs ” in finance : If history books were the key to riches , the Forbes 400 would consist of librarians.

-> A tolerance for short — term swings improves our long — term prospects .

-> Though “ working ” means nothing to me financially , I love doing it at Berkshire for some simple reasons : It gives me a sense of achievement , a freedom to act as I see fit and an opportunity to interact daily with people I like and trust .

-> stay with simple propositions — that we usually apply in investments as well as operations . If only one variable is key to a decision , and the variable has a 90 % chance of going your way , the chance for a successful outcome is obviously 90 % . But if ten independent variables need to break favorably for a successful result , and each has a 90 % probability of success , the likelihood of having a winner is only 35 % .

-> When a problem exists , whether in personnel or in business operations , the time to act is now .

-> Sir Isaac might well have gone on to discover the Fourth Law of Motion : For investors as a whole , returns decrease as motion increases .

-> Approval , though , is not the goal of investing . In fact , approval is often counter — productive because it sedates the brain and makes it less receptive to new facts or a re — examination of conclusions formed earlier . Beware the investment activity that produces applause ; the great moves are usually greeted by yawns .

-> It’s often useful in testing a theory to push it to extremes.

-> Though practically all days are relatively uneventful , tomorrow is always uncertain .

-> In our view , it is madness to risk losing what you need in pursuing what you simply desire .

-> Noah’s Law : If an ark may be essential for survival , begin building it today , no matter how cloudless the skies appear .

-> Betting on people can sometimes be more certain than betting on physical assets .

Why “be fearful when others are greedy and to be greedy only when others are fearful” is the way to go

What we do know , however , is that occasional outbreaks of those two super — contagious diseases , fear and greed , will forever occur in the investment community . The timing of these epidemics will be unpredictable . And the market aberrations produced by them will be equally unpredictable , both as to duration and degree . Therefore , we never try to anticipate the arrival or departure of either disease . Our goal is more modest : we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful .

Mr. Market analogy

He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr . Market who is your partner in a private business . Without fail , Mr . Market appears daily and names a price at which he will either buy your interest or sell you his . Even though the business that the two of you own may have economic characteristics that are stable , Mr . Market’s quotations will be anything but . For , sad to say , the poor fellow has incurable emotional problems . At times he feels euphoric and can see only the favorable factors affecting the business . When in that mood , he names a very high buy — sell price because he fears that you will snap up his interest and rob him of imminent gains . At other times he is depressed and can see nothing but trouble ahead for both the business and the world . On these occasions he will name a very low price , since he is terrified that you will unload your interest on him . Mr . Market has another endearing characteristic : He doesn’t mind being ignored . If his quotation is uninteresting to you today , he will be back with a new one tomorrow . Transactions are strictly at your option . Under these conditions , the more manic — depressive his behavior , the better for you . But , like Cinderella at the ball , you must heed one warning or everything will turn into pumpkins and mice : Mr . Market is there to serve you , not to guide you . It is his pocketbook , not his wisdom , that you will find useful . If he shows up some day in a particularly foolish mood , you are free to either ignore him or to take advantage of him , but it will be disastrous if you fall under his influence . Indeed , if you aren’t certain that you understand and can value your business far better than Mr . Market , you don’t belong in the game . As they say in poker , “ If you’ve been in the game 30 minutes and you don’t know who the patsy is , you’re the patsy . ” Ben’s Mr . Market allegory may seem out — of — date in today’s investment world , in which most professionals and academicians talk of efficient markets , dynamic hedging and betas . Their interest in such matters is understandable , since techniques shrouded in mystery clearly have value to the purveyor of investment advice . After all , what witch doctor has ever achieved fame and fortune by simply advising “ Take two aspirins ” ?

Is the market efficient?

Observing correctly that the market was frequently efficient , they went on to conclude incorrectly that it was always efficient . The difference between these propositions is night and day .

Calculate and focus on your portfolios look-through earnings

We also believe that investors can benefit by focusing on their own look — through earnings . To calculate these , they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these . The goal of each investor should be to create a portfolio ( in effect , a “ company ” ) that will deliver him or her the highest possible look — through earnings a decade or so from now . An approach of this kind will force the investor to think about long — term business prospects rather than short — term stock market prospects , a perspective likely to improve results . It’s true , of course , that , in the long run , the scoreboard for investment decisions is market price . But prices will be determined by future earnings . In investing , just as in baseball , to put runs on the scoreboard one must watch the playing field , not the scoreboard .

Margin of safety

An investor needs to do very few things right as long as he or she avoids big mistakes . Second , and equally important , we insist on a margin of safety in our purchase price . If we calculate the value of a common stock to be only slightly higher than its price , we’re not interested in buying . We believe this margin — of — safety principle , so strongly emphasized by Ben Graham , to be the cornerstone of investment success .

Avoid paying taxes

…tax — paying investors will realize a far , far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate .

Ignore the beta, calculate risk properly

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 . Employing data bases and statistical skills , these academics compute with precision the “ beta ” of a stock — its relative volatility in the past — and then build arcane investment and capital — allocation theories around this calculation . In their hunger for a single statistic to measure risk , however , they forget a fundamental principle : It is better to be approximately right than precisely wrong . For owners of a business — and that’s the way we think of shareholders — the academics ’ definition of risk is far off the mark , so much so that it produces absurdities . For example , under beta — based theory , a stock that has dropped very sharply compared to the market — as had Washington Post when we bought it in 1973 — becomes “ riskier ” at the lower price than it was at the higher price . Would that description have then made any sense to someone who was offered the entire company at a vastly — reduced price ? In fact , the true investor welcomes volatility .

In assessing risk , a beta purist will disdain examining what a company produces , what its competitors are doing , or how much borrowed money the business employs . He may even prefer not to know the company’s name . What he treasures is the price history of its stock . In contrast , we’ll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company’s business .

The primary factors bearing upon this evaluation are :

1 ) The certainty with which the long — term economic characteristics of the business can be evaluated ;

2 ) 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 ;

3 ) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself ;

4 ) The purchase price of the business ;

5 ) 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 . These factors will probably strike many analysts as unbearably fuzzy , since they cannot be extracted from a data base of any kind . But the difficulty of precisely quantifying these matters does not negate their importance nor is it insuperable .

by confining himself to a relatively few , easy — to — understand cases , a reasonably intelligent , informed and diligent person can judge investment risks with a useful degree of accuracy .

Of course , some investment strategies — for instance , our efforts in arbitrage over the years — require wide diversification . If significant risk exists in a single transaction , overall risk should be reduced by making that purchase one of many mutually — independent commitments . Thus , you may consciously purchase a risky investment — one that indeed has a significant possibility of causing loss or injury — if you believe that your gain , weighted for probabilities , considerably exceeds your loss , comparably weighted , and if you can commit to a number of similar , but unrelated opportunities . Most venture capitalists employ this strategy .

Invest in index funds

By periodically investing in an index fund , for example , the know — nothing investor can actually out — perform most investment professionals . Paradoxically , when “ dumb ” money acknowledges its limitations , it ceases to be dumb .

There are three connected realities that cause investing success to breed failure (talking about investment funds). First , a good record quickly attracts a torrent of money . Second , huge sums invariably act as an anchor on investment performance : What is easy with millions , struggles with billions ( sob ! ) . Third , most managers will nevertheless seek new money because of their personal equation — namely , the more funds they have under management , the more their fees .

Both large and small investors should stick with low — cost index funds .

very low — cost S & P 500 index fund . ( I suggest Vanguard’s . ) (recommended in 2013)

Don’t try to time the market

We try to price , rather than time , purchases . In our view , it is folly to forego buying shares in an outstanding business whose long — term future is predictable , because of short — term worries about an economy or a stock market that we know to be unpredictable . Why scrap an informed decision because of an uninformed guess ?

Don’t rebalance your portfolio

To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team .

Black Swans

Over time , markets will do extraordinary , even bizarre , things . A single , big mistake could wipe out a long string of successes . We therefore need someone genetically programmed to recognize and avoid serious risks , including those never before encountered . (Black Swans)

On barriers of entry

A truly great business must have an enduring “ moat ” that protects excellent returns on invested capital . The dynamics of capitalism guarantee that competitors will repeatedly assault any business “ castle ” that is earning high returns . Therefore a formidable barrier such as a company’s being the low — cost producer ( GEICO , Costco ) or possessing a powerful world — wide brand ( Coca — Cola , Gillette , American Express ) is essential for sustained success . Business history is filled with “ Roman Candles , ” companies whose moats proved illusory and were soon crossed .

Our criterion of “ enduring ” causes us to rule out companies in industries prone to rapid and continuous change . Though capitalism’s “ creative destruction ” is highly beneficial for society , it precludes investment certainty . A moat that must be continuously rebuilt will eventually be no moat at all .

Choose mature markets

Charlie and I avoid businesses whose futures we can’t evaluate , no matter how exciting their products may be . In the past , it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos ( in 1910 ) , aircraft ( in 1930 ) and television sets ( in 1950 ) . But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries . Even the survivors tended to come away bleeding . Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy . At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable . Even then , we will make plenty of mistakes .

Why EBITDA is a poor metric

Indeed , the depreciation charge we record in our railroad business falls far short of the capital outlays needed to merely keep the railroad running properly , a mismatch that leads to GAAP earnings that are higher than true economic earnings . ( This overstatement of earnings exists at all railroads . ) When CEOs or investment bankers tout pre — depreciation figures such as EBITDA as a valuation guide , watch their noses lengthen while they speak .

Book recommendations

The Intelligent Investor (recommended in many letters)

1940 edition of Security Analysis (recommended in many letters)

Bull ! by Maggie Mahar (recommended in 2003)

The Smartest Guys in the Room by Bethany McLean and Peter Elkind (recommended in 2003)

In an Uncertain World by Bob Rubin (recommended in 2003)

Common Stocks and Uncommon Profits (recommended in 2012)

Jack Bogle’s The Little Book of Common Sense Investing (recommended in 2014)

Checkout all my highlights from this book here: Kindle highlights from: “Berkshire Hathaway Letters to Shareholders, 1965–2018” by Warren Buffet