Warren Buffett is widely regarded as the greatest investor of all time. His track record is astounding: since 1965 Berkshire’s compound annualized return has been 20.5% as compared with 9.7% for the S&P 500. In any other business, competitors and amateurs alike would be doing everything they could to get a peek “behind the curtain” to understand how one could be so successful in the hopes of emulating or recreating that success. Unfortunately, companies and management are typically highly protective of their “Caramilk Secret”.
Not so for Warren Buffet. He has been telling the world for decades exactly how he thinks and acts around investing, yet very few professional investors and even fewer individual (or, retail) investors pay him much heed.
The good news is that Warren Buffett’s 2018 Letter to Shareholders could be summarized as his “greatest hits” of themes he has been discussing for decades. So if you have ignored or missed Buffett’s advice over the last 5+ decades, you are in luck. What follows is a summary of the key highlights in his latest quarterly letter.
Hit #1: Buy Great Businesses at Great Prices
“…let me remind you of our prime goal in the deployment of your capital: to buy ably-managed businesses, in whole or part, that possess favorable and durable economic characteristics. We also need to make these purchases at sensible prices.”[1]
This really is Buffett’s #1 Hit but this year he understated his 50+ year message. So let me elaborate for him.
What does “favourable and durable economic characteristics” mean? I define that term to encompass companies with: strong competitive positions, essential service-type products, big competitive moats, strong balance sheets and superb management that operate with integrity.
What does “sensible prices” mean? Buffett is looking for both great businesses trading at great prices. Not just one or the other. Using the FAANGs (Facebook, Amazon, Apple, Netflix, Google) as an example, there is no doubt that all five are great businesses. They are world dominating in some cases. Buffett, however, has only determined that Apple trades at a reasonable or “sensible” valuation and therefore meets both his criteria. For reference, Apple currently trades at a P/E multiple of approximately 14x. Facebook trades at 21x, Google trades at 26x, Amazon trades at 81x, and Netflix trades at 134x[2].
An amazing company trading at an amazingly high valuation requires everything to go right and then some to keep the stock price moving upward. A great company trading at a great (i.e., cheap or discounted) valuation creates a large margin of safety for investors to absorb inevitable hiccups in the business or the economy.
Hit #2 Reprise: Buy Businesses, Not Ticker Symbols
“Charlie and I do not view [Berkshire’s common stock investments] as a collection of ticker symbols – a financial dalliance to be terminated because of downgrades by “the Street,” expected Federal Reserve actions, possible political developments, forecasts by economists or whatever else might be the subject du jour .”
This is a follow-on lesson from the first one – Buffett treats the businesses he invests in as just that – businesses that he understands that possess the fundamental characteristics highlighted in Hit #1 above. If one has truly done a tremendous amount of research and understands the investee company significantly better than the average manager, investor, journalist or other newsmaker, the noise generated from those individuals is generally of no consequence. Tremendous investment conviction comes from serious work that is not swayed by noise. Those that do an average (or less) amount of work have their weak conviction shaken fairly easily.
Hit #3: Focus on Earnings & Cashflow, Not EBITDA or other Adjusted Financial Measures
“When we say “earned”, … , we are describing what remains after all income taxes, interest payments, managerial compensation (whether cash or stock-based), restructuring expenses, depreciation, amortization and home-office overhead. That brand of earnings is a far cry from … “adjusted EBITDA,” a measure that redefines “earnings” to exclude a variety of all-too-real costs.”
Owners of companies are entitled to a share of the earnings of those companies. One step further would be to look at a company’s free cash flow. Cash doesn’t lie. A business is either producing it (hopefully lots of it) or consuming it. Look to own companies doing the former.
Hit #4: Everyone Seems to Love Dividends. We Love Buybacks.
“All of our major holdings enjoy excellent economics, and most use a portion of their retained earnings to repurchase their shares. We very much like that: If Charlie and I think an investee’s stock is underpriced, we rejoice when management employs some of its earnings to increase Berkshire’s ownership percentage.”
Investors have been infatuated with dividend-paying companies over the past decade under an often false belief that dividend stocks are stable, less risky and less volatile than non-dividend paying stocks.
In 2018, the iShares Canadian Select Dividend ETF, a diversified “fund” of Canadian dividend paying stocks, fell over 16% while paying out an approximate 5% dividend yield. So on a total return basis, using this ETF as a proxy, Canadian dividend stocks’ 2018 performance was worse than the S&P/TSX’s overall 8.9% decline.
While companies paying a dividend may be strong businesses generating significant cashflows (although some use debt to fund dividend payments), investors should make no mistake about what receiving a dividend means: the company and its management cannot find a more attractive use for its excess capital…so it is giving it back to shareholders, along with an almost 40% tax bill for those (Ontarians) in the top tax bracket.
Consider investing in companies that most often use their excess free cash to buy back their own shares. In contrast to dividends, share buybacks typically provide a different message from management: our stock is cheap and therefore the best use of our excess capital is to buy back our shares, thereby increasing each remaining investor’s share of our earnings. For the taxable and long-term investor, share buybacks minimize the distribution of taxable dividend income. They enable each individual investor to decide when to sell units for their specific cash needs, thereby generating a capital gain which will be taxed at approximately 27% (in Ontario) versus almost 40% as noted above.
“When earnings increase and shares outstanding decrease, owners – over time – usually do well.”
Hit #5: When You Find All The Above, Hold On For Dear Life
“Truly good businesses are exceptionally hard to find. Selling any you are lucky enough to own makes no sense at all.”
These two simple sentences are two critical tenets of Buffett’s investment strategy.
First, because truly good businesses (selling at reasonable prices) are exceptionally hard to find, it stands to reason that it is not really possible to build a portfolio of 50 such companies (plus, how could you truly know the companies well at that level?).
Buffett’s letter shows that the top 16 public company holdings (if Kraft Heinz is included), comprise 88% of Berkshire’s public company investments. Put another way, Berkshire holds an investment portfolio with a market value of $164 billion that is 16 stocks in total![3] Oh…and the Top 5 holdings represent almost 63% of the total common stock portfolio[4].
The second sentence highlights Buffett’s long term focus. For those that have been reading Buffett’s letters for years, you will note that Berkshire owns some great businesses and brands (Coke, Amex, Apple, Goldman Sachs, etc.) and in most cases those companies appear over and over each year. In other words, Buffett buys, and rarely sells.
If you think about finding a fabulous business as similar to finding an attractive building selling at a reasonable cap rate, and where the owners can raise rents over time. It would be abnormal to see real estate investors buy and sell buildings even within a few years of their purchase.
Hit #6: Investment Performance Converges with Business Performance
“Charlie and I have no idea as to how stocks will behave next week or next year.”
“Our advice? Focus on operating earnings, paying little attention to gains or losses of any variety…I expect [Berkshire’s equity portfolio] to deliver substantial gains, albeit with highly irregular timing… Over time, … , investment performance converges with business performance.”
Buffett has said over and over again that he does not have a crystal ball to predict what the future holds for the markets in general. Instead, he buys great companies that he can better predict will do well over time from a business performance perspective. Markets, in theory, are efficient. In practice, they are reasonably efficient, but are very good over the longer term at ensuring stock prices ultimately reflect what is going on in the underlying businesses (often with a bit of a lag relative to those who have studied the company thoroughly – like Buffett).
Last Hit: Invest Now. Markets Have Historically Climbed the “Wall of Worry”
“Since 1942 , we have had seven Republican presidents and seven Democrats. In the years they served, the country contended at various times with a long period of viral inflation, a 21% prime rate, several controversial and costly wars, the resignation of a president, a pervasive collapse in home prices, a paralyzing financial panic and a host of other problems. All engendered scary headlines. All are now history.”
Investors (I mean, speculators) seem to be very focused on timing the market just right and getting in or staying out of the market with perfect timing. In December, speculators pulled huge amounts of money out of the market because it was falling (and missed January’s rally) and in February speculators are holding off entering the market because “it just got frothy again”. Trying to time the market has been proven time and time again to be a loser’s game. Similarly, dollar cost averaging (investing similar amounts over regular intervals vs a lump sum up front) has also been proven to be a poor investment approach.
A better approach, for those with long investment time horizons, is to simply get in “now” (whenever “now” is for those reading this paper).
Over the last 100+ years, on the whole, the markets go one way – up.
[1] Unless otherwise indicated, all quotes are from Warren Buffett’s 2018 Shareholder Letter dated February 23, 2018: http://www.berkshirehathaway.com/letters/2018ltr.pdf
[2] All P/Es are approximate and based on trading prices as of February 28, 2019.
[3] Excludes $22.4 billion of “Others” as we are not provided the composition.
[4] Total is $186.8 billion, which includes Kraft Heinz at a market value of $14 billion as at December 31, 2018 according to Buffett.
