Friday, April 27, 2007

What will save us when everything fails?

In the June of 1996, Warren Buffett issued a booklet entitled “An Owner’s Manual” to Berkshire Hathaway’s shareholders. In this manual, he set down 13 business principles, which are the foundation upon which he built Berkshire Hathaway.

These principles are an amazing free gift to all of us, who try to emulate Mr. Buffett. My of my personal favorite is the eleventh principle, which states:

“You should be fully aware of one attitude Charlie [Munger] and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub-par businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.) Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.

We continue to avoid gin rummy behavior. True, we closed our textile business in the mid 1980’s after 20 years of struggling with it, but only because we felt it was doomed to run never-ending operating losses. We have not, however, given thought to selling operations that would command very fancy prices nor have we dumped our laggards, though we focus hard on curing the problems that cause them to lag.”

This principle essentially refers and is applicable to businesses which Berkshire owns outright, not in public listed equities.

Now, what’s so great about this statement?

To answer this question we must remember how Warren Buffett invests. As we all know, he doesn’t buy a stock based on its price. He buys a stock so he can own a share of a great business. GEICO is a case in point.

Then, when we look at Berkshire’s investments, we see companies like Coca Cola, American Express, and The Washington Post Company, all of which Mr. Buffett has held for over 20 years.

In principle one of the owner’s manual, he says the following in regard to the stock he buys:

“In fact, we would not care in the least if several years went by in which there was no trading, or quotation of prices, in the stocks of those companies. If we have good long-term expectations, short-term price changes are meaningless for us except to the extent they offer us an opportunity to increase our ownership at an attractive price."

This is all great for Berkshire Hathaway, but the question we, small-time investors, need to ask is: How can we use Warren Buffett’s insights to become better investors?

First, we must buy stocks of solid businesses with longevity. Meaning, if you are 30 years old, make sure you buy a stock that will be around for the next 50 years, in case you live up to 90.

Second, we must learn to wait. Oh no, I better explain, when I say wait, I mean “forget about waiting.” Warren Buffett will die before he sells his stocks. Can we do this? It’s better to.

Third, we must stock buying stocks based on their price – not to be confused with value. This is such a difficult concept that 99 out of 100 investors can’t do it. Very few people can buy a stock at $50 and still hold it when the price drops to $20. But then, very few of us are billionaires.

Lastly, when we find a company we really like, we must buy its stock in large amount. Imagine if we, or our parents, bought Wal-Mart in August 1972, ok, better be more realistic, in 1982, we would be sitting on a 173-bagger. Meaning for every $1000 invested in 1982, it is worth $173,000 today. If we add the dividends in, we don’t even need to count the capital gain because in dividend alone, we’d be getting 88cents for every original 28cents (after accounting for stock splits) the share was worth in 1982.

So when the charts and the ratios, and the EPS estimates fail us, which they will eventually, these four steps will save us, and more. Amen!

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