In my opinion, Warren Buffett’s 1989 shareholder letter is one of his most significant ones as it has his greatest insights buried in there.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
This concept took me a very long time to understand.
Buying $1 bills for less than $1 makes intuitive sense. So when I first started investing, I bought a stock called Jemtec because it was trading below its cash. It was only until later that I realized that Jemtec is a “management employment agency”. Most of these stocks trade at such a low value because there are serious issues with the company. On the other hand, it was hard for me to understand that some companies are worth paying up for. Suppose that there was a chocolate company selling for 3X the market value of its tangible assets. In my mind, here’s what I’m thinking: “But somebody else could copy exactly what they do! And they would create the same business for only 1X the market value of its tangible assets!” Of course, what I miss is that it’s brutally difficult to duplicate businesses like See’s Candies. Oftentimes, competitors have been trying to compete with these wonderful businesses for decades without much success.
“…when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Some industries have bad economics. Some individual businesses have bad economics (e.g. high labour costs from unions, will eventually be wiped out by the #1/#2 player, etc. etc.).
“After some other mistakes, I learned to go into business only with people whom I like, trust, and admire.”
I guess I learned the hard way that integrity matters. The CEO of QXM/XING simply ran off with the money. People who have stolen in the past are likely to steal again in the future. But maybe I am not very good at learning my lesson because I own a very small position in Pinetree Capital.
Putting it together
In general, the best investments have:
- Good economics.
- Smart management.
- Ethical management.
- A fair valuation.
Of course, some of these things are hard to predict. Let’s take a look at good economics. You want to find businesses that will be able to consistently grow its earnings far into the future. One way to look for these businesses is to find ones that have a track record of consistently growing earnings. Unfortunately, the past is not a fool-proof predictor of future earnings. The 1989 letter talks about Warren’s investment in USAir convertible preferred shares. In the 1996 letter, Warren reflects on his mistake:
I liked and admired Ed Colodny, the company’s then-CEO, and I still do. But my analysis of USAir’s business was both superficial and wrong. I was so beguiled by the company’s long history of profitable operations, and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point: USAir’s revenues would increasingly feel the effects of an unregulated, fiercely- competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline’s past record might be. (If history supplied all of the answers, the Forbes 400 would consist of librarians.)
To rationalize its costs, however, USAir needed major improvements in its labor contracts – and that’s something most airlines have found it extraordinarily difficult to get, short of credibly threatening, or actually entering, bankruptcy. USAir was to be no exception. Immediately after we purchased our preferred stock, the imbalance between the company’s costs and revenues began to grow explosively. In the 1990- 1994 period, USAir lost an aggregate of $2.4 billion, a performance that totally wiped out the book equity of its common stock.
Predicting the future is not easy. Commodity industries often have boom/bust cycles so it is dangerous to extrapolate from the past. Insurance companies exhibit profits in most years while sitting on dangerous tail risks. Financial companies often exhibits long stretches of profitable years only to lose everything when the tide washes out. Some industries exhibit steady earnings for decades only to be wiped out by some type of disruptive technology (e.g. what the Internet did to phone directories). I don’t have any easy solutions though I believe that some industries are more predictable than others.
However, Buffett doesn’t always invest in good industries. Sometimes he has made investments in very difficult industries such as retail and insurance. In those two industries, the superstar managers are able to consistently outperform their peers by a large margin. The economics of these businesses are only good because of the management team. Good economics and talented management are often intertwined. Unfortunately, sometimes these managers leave the company and the economics of the business quickly deteriorate in the hands of its successor.
as Peter Lynch once said, “Invest in businesses any idiot could run, because someday one will.”
A last way in which a business can have good economics is if it has some type of special competitive advantage. In theory, these businesses are more “idiot-proof”. For example, Fannie and Freddie Mac have lower borrowing costs than their peers due to the US government’s implicit guarantee of their debt. Unfortunately, buying into these businesses isn’t always a guarantee of success as Fannie/Freddie collapsed with the US housing markets. (Fortunately for Buffett he sold well before their collapse.) Television stations and dominant newspapers are probably better examples of businesses that any idiot can run.
Finally, what is value investing?
Originally, I thought that value investing was about the things that Ben Graham preached:
- Buying companies below the market value of its assets. The “cigar butt” approach to investing.
- Low P/E
- Low P/B
Ben Graham also participated in tender offers and engaged in merger arbitrage.
As I understand Buffett better, I am starting to see the wisdom of buying wonderful businesses over cigar butts. And for whatever reason, there just aren’t that many people who engage in Buffett’s style of value investing.