3 Nuggets From Buffett's Annual Letter
More clippings--and a few thoughts--for your 'Oracle of Omaha' file.
Morningstar's stock analysts dug into the firm's earnings in a separate report. Beyond business results, the annual letters also include a broader essay that holds some nuggets of insight on investing from the Oracle of Omaha. The whole thing is well-worth a read, but I plucked out three interesting points to riff on today.
Price Does Not Equal Value
In his letter, Buffett recounts two real estate purchases he made--including a Nebraska farm in 1986--to illustrate some key tenets of his philosophy.
The first has to do with thinking like a business owner, and that means understanding the fundamental value of what you're buying. With respect to the first property, Buffett freely admits he's no farmer (he's visited the farm only twice!), but he was nonetheless able to easily calculate average bushels produced and average costs of production, and hence a normalized return for the farm.
"Focus on the future productivity of the asset you are considering," Buffett writes. "If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on."
A farm is a particularly astute example of how easy it should be to think like a business owner. Even if you only visit the property twice, you can close your eyes and imagine smelling the fertilizer, counting the silos, seeing the rows of corn waving on a warm September day. It's tangible, and when you hear Buffett's rationale for the purchase, it makes all the sense in the world. How else would you think about it?
Well, imagine if the ownership of that farm is divvied up into thousands of small pieces and dispersed among many owners. Imagine those pieces are bought and sold, and continuously "valued" on an exchange, where you can look any time of day and get a current quote. Mind you, it's still the same farm, still the same productivity profile. Nothing about its intrinsic value has changed. Good weather will still be good weather, storms will be storms. The soil is just as fertile. But owners now have something else to latch on to: the price other people are willing to pay for pieces of that farm at any given moment.
If buyers seem increasingly willing to pay more and more, how tempting it becomes to buy more shares for yourself with the hope of enjoying that ride up. If buyers turn sour and the quotes sink, how difficult to stay the course, focus on the fundamentals, and resist jumping ship.
"If you ... focus on the prospective price change of a contemplated purchase, you are speculating," Buffett writes. "There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so."
In addition to the alluring distraction of daily price quotes, it would also seem that the further removed the investment is from the actual business--owning some shares of Monsanto (MON), for instance, as opposed to directly owning a farm--the more difficult it is for investors to think like business owners, which makes Buffett's next piece of advice an interesting one to ponder.
Most People Should Just Buy the Index
Thinking like a business owner naturally requires the investor to know something about the business. Buffett has long preached the virtues of sticking within your circle of competence. If he and his longtime partner Charlie Munger can't understand a business, they are happy to pass it by and move on. And of course, the pair have an outstanding track record of investing in those businesses they do understand.
But what about the rest of us?
"Most investors ... have not made the study of business prospects a priority in their lives," Buffett writes. "If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power ... The goal of the non-professional should not be to pick winners--neither he nor his 'helpers' can do that--but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal."
It's provocative for such an investing giant, a man whom scores and scores of individuals flock to every year for bits of wisdom and insight, to essentially say to would-be stock-pickers, "Don't quit your day job."
But he does have a point. However, perhaps it's not so much about investors' potential skill at understanding businesses as it is about their temperament, something else Buffett has written a lot about over the years.
Again, going back to the price versus value issue: the prices of individual stocks can be a volatile lot. Their value? Yes, that can change too but rarely in such a dramatic and visible fashion. Holding the index helps smooth those returns and diversify the risk of any one company falling out of bed.
At Morningstar, we've seen this effect in our own Investor Return data for mutual funds. The smoother a fund's return pattern, the better investors tend to be at using it (buying it and selling it). For investors who really will be unplugged, we might suggest going one step beyond an S&P 500 Index fund and considering a target-date fund that holds stocks and bonds and automatically adjusts that allocation and rebalances for you. These funds have had among the very best Investor Returns.
Holding index or target-date funds may help lead investors to better results, but I'm not so sure they help investors think like business owners. And with index funds now readily trade-able on exchanges, you can see the same price versus value issues creeping in. After all, it wasn't just individual stocks that investors were fleeing in 2008.
Keep Your Eye on the Horizon
Whether you're an individual stock investor or an index investor, I've always found Buffett's long-term perspective to be among his most compelling planks of wisdom--and potentially the best salve to investors' poor timing and behavioral pitfalls.
Whenever I'm on a turbulent flight, I always look around for a flight crew member. Undoubtedly I find them going about their business with little regard for the bumpiness. It's reassuring to see it from their perspective.
Likewise, when the American economy and stock market hit major turbulence in 2008, how beneficial for investors to hear Buffett essentially say, "Sit tight. We'll get through this." (Buffett was doing more than sitting tight, of course, but having the stomach to be contrarian in a time of tremendous fear is a discussion for another day.)
As a long-term investor, my favorite nugget from Buffett's letter comes from his persistent ability to keep it all in perspective: "In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts)," he writes. "In the 20th century, the Dow Jones industrial index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st century will witness further gains, almost certain to be substantial."
I'll be investing through a lot of that 21st century. I'll be holding both individual stocks and mutual funds. And I know I'll be looking for the flight crew on several occasions during this ride. So I'm just going to keep that last quote in the seat-back pocket.
What nuggets from Buffett's letter will you be adding to your file? Let me know in the comments below.
Operating and Investment Results
As I mentioned above, our analysts will discuss Berkshire's results separately, but I pulled a few interesting notes from the operating and investments sections of the letter that caught my eye:
Jason Stipp does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.