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I am not in the business of predicting general stock market or business fluctuations.
contrarian diversification strategy,
Generals, Workouts, and Controls,
The market can and will at times be completely deranged and irrational in the short term, but over the long term it will price securities in line with their underlying intrinsic values.
Buffett could get a good job elsewhere but other highly qualified Jews, if turned down by Graham, might be otherwise shut out.
“The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen.”
Buffett teaches investors to trust that the market will get it right eventually; he focuses us on finding the right businesses at the right prices, largely ignoring the timing of when to buy or when to expect the investment to work out.
“If you can’t forecast well, forecast often.”
According to Buffett, predictions often tell you more about the forecaster than they do about the future.
Who would sell a farm because they thought there was at least a 65% chance the Fed was going to raise rates next year?
Buffett reminds investors that during such periods even a portfolio of extremely cheap stocks is likely to decline with the general market. He stresses this as an inevitable part of owning securities and that if a 50% decline in the value of your securities portfolio is going to cause you hardship, you need to reduce your exposure to the market.
To be a successful investor, you need to separate your emotional reaction to a plunge from your cognitive ability as a rational appraiser of long-term business value. You can never let the market quote turn from an asset to a liability.
I resurrect this “market-guessing” section only because after the Dow declined from 995 at the peak in February to about 865 in May, I received a few calls from partners suggesting that they thought stocks were going a lot lower. This always raises two questions in my mind: (1) if they knew in February that the Dow was going to 865 in May, why didn’t they let me in on it then; and, (2) if they didn’t know what was going to happen during the ensuing three months back in February, how do they know in May?
We will not sell our interests in businesses (stocks) when they are attractively priced just because some astrologer thinks the quotations may go lower even though such forecasts are obviously going to be right some of the time.
Buffett was convinced by his mid-twenties that the power of compound interest was going to make him rich. Returning to Omaha with a little over $100,000 before starting the partnerships, he already considered himself to be essentially retired. He figured he would read a lot and perhaps attend some university classes.
continued high rates of growth become impossible to sustain. The larger an investment program becomes, the harder it is to grow. This is the law of large numbers at work and Buffett, from the Partnership Letters to today, has always been very candid in this regard. Today Berkshire is simply too big to grow a lot faster than the general economy.
Fees and taxes (not to mention underperformance) have been crushing the long-term investment results of most Americans. In fact, the actual average result of individual investors in this country in the 20 years ending 2011 has been closer to 2%. In real dollars (after inflation) purchasing power has been lost! It’s a scandalous state of affairs relative to the 7.8% delivered by the market index.11 Buffett and others have been sounding this alarm for decades, but these practices continue.
The big question from here, which we’ll explore next, is: Given your interest and capabilities, should you try to pick stocks and follow Buffett’s lead as a stock picker, or should you simply dollar-cost-average your way to prosperity by increasing your share of American business through a low-cost index over a lifetime? Doing nothing else but indexing is a highly attractive option—relative to the little time or effort required, the results, compounded over many years, can actually be remarkably good. For most people, this will be the best choice.
Buffett has been teaching investors for a very long time that you can’t get much more from the market than what you put into it. If you’re uninterested, unable, or unwilling to dedicate the time and effort to your investments, you should buy the index. The only reason to choose an active investment program is a belief that you, or the investment manager you’ve chosen, will outperform the “do-nothing” strategy.
Fees, taxes, and psychology are all working against the active manager,
Ground Rule #4: “Whether we do a good job or a poor job is not to be measured by whether we are plus or minus for the year. It is instead to be measured against the general experience in securities as measured by the Dow Jones Industrial Average, leading investment companies, etc. If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes.”
Ground Rule #5: “While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.”
putting the cart in front of the horse.
His skill as an investor, the advantage of working with relatively smaller sums, a market that was right for his style, and luck were all factors that helped the Partnership achieve such consistently outstanding results,
Investors should not expect too much consistency from any style of investing. Everything will have its seasons.
He taught and reminded investors that even a given year’s relative performance was largely a matter of luck. It relies on the “voting machine” nature of short-term market movements. As you stretch out your evaluation horizon, the test becomes more and more like a “weighing machine.”
Buffett also teaches investors that there is one important caveat to the multiyear test: Underperformance in the late stages of a speculative bull market is highly likely. It’s a caveat that he repeats to this day.
We should only care about trailing 3-year figures (at a minimum) because that is the threshold where markets can be expected to become efficient. Five years is better. A full market cycle is the best period over which to evaluate an active manager (market low to market low, or market high to market high).
Our next section looks at the three principal types of stock picking Buffett did for the Partnership. He referred to these three categories as Generals, Workouts, and Controls.
Just because something is cheap does not mean it is not going to go down.
Intrinsic value can be estimated a number of different ways. Most are a derivation of an appraisal of either the value of a company’s (1) assets or (2) earnings power. Each method, asset based or earnings based, can be useful at different times and indeed they are linked; the value of any asset will always be linked to the earnings it is capable of producing.
You can gain great insights about investing from a careful study of Buffett’s Generals. He was constantly appraising the value of as many stocks as he could find, looking for the ones where he felt he had a reasonable ability to understand the business and come up with an estimate for its worth. With a prodigious memory and many years of intense study, he built up an expansive memory bank full of these appraisals and opinions on a huge number of companies. Then, when Mr. Market offered one at a sufficiently attractive discount to its appraised value, he bought it; he often concentrated heavily
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To Buffett, the collective superior performance of this cohort proved the validity of the value investing method and demonstrated a great flaw in the efficient market hypothesis.
The Super Investors of Graham and Doddsville’s tremendous results represented a statistical absurdity under the efficient market framework, which would have predicted that the successful investors were randomly distributed throughout the country.
Buying the securities right after an activist files a 13D, a formal Securities and Exchange Commission document signaling an investor’s intent to attempt influence over corporate decisions, is a strategy that has meaningfully outperformed the market over time.
This is fertile ground for small, enterprising investors. First, familiarize yourself with all the net-nets in the market. While Buffett thumbed through the Moody’s Manual page by page, there are plenty of free stock screeners on the Web these days to help you get started. Then as you go along, cross the ones off the list when you find a disqualifier, such as a hidden liability or a lawsuit that causes the stock to screen as a net-net even when it isn’t.
So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.
It may be due to the exploding ranks of security analysts bringing forth an intensified scrutiny of issues far beyond what existed some years ago. Whatever the cause, the result has been the virtual disappearance of the bargain issue as determined quantitatively—and thereby of our bread and butter. There still may be a few from time to time.
As he continued to gain assets he had no choice but to leave the cigar butt strategy behind; he outgrew it financially.
While this dynamic is the engine of our economic system and the reason behind decades of massive productivity gains for American corporations, it’s also the reason returns on equity have consistently cycled around 12–14%. That was true in the 1950s and it’s true today. Competition tends to drive good returns down with only a few exceptions. Those who choose to find value in highly profitable companies need to find the ones that are going to stay that way.
A private owner was quite willing (and in our opinion quite wise) to pay a price for control of the business which isolated stock buyers were not willing to pay for very small fractions of the business.
In past annual letters I have always utilized three categories to describe investment operations we conduct. I now feel that a four-category division is more appropriate. Partially, the addition of a new section—“Generals–Relatively Undervalued”—reflects my further consideration of essential differences that have always existed to a small extent with our “Generals” group. Partially, it reflects the growing importance of what once was a very small sub-category but is now a much more significant part of our total portfolio. This increasing importance has been accompanied by excellent results to
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“Generals–Relatively Undervalued”—this category consists of securities selling at prices relatively cheap compared to securities of the same general quality.
As mentioned earlier, this new category has been growing and has produced very satisfactory results. We have recently begun to implement a technique, which gives promise of very substantially reducing the risk from an overall change in valuation standards; e.g. If we buy something at 12 times earnings when comparable or poorer quality companies sell at 20 times earnings, but then a major revaluation takes place so the latter only sell at 10 times. This risk has always bothered us enormously because of the helpless position in which we could be left compared to the “Generals–Private Owner” or
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In his commentary on Generals we see Buffett departing from teaching principles and now teaching methods. While principles never change—they are timeless—methods can and often should change according to a given investing environment. We see different methods used by Buffett at various stages of the Partnership, in various stages of the market cycle, in order to best act in accordance with his principles.
While Buffett never explicitly laid out his math, the value of $10 in annual earnings growing at 2% is $125 when discounted back to present value at a 10% rate
“Give a man a fish and you feed him for a day. Teach him how to arbitrage and you feed him forever.”
The spread between the offer price and the stock price reflects the risk that something will happen to scuttle the deal as well as the time value of money between now and the expected closing.
Buffett probably assessed most deals but was highly selective in the ones he participated in.
Buffett outlined the four questions needed to evaluate a Workout in his 1988 letter to shareholders of Berkshire: (1) what chance does the deal have of going through, (2) how long will it take to close, (3) how likely is it that someone else will make an even better offer, and (4) what happens if the deal busts?
