commentary
authored by
Investing Principals. Keep it Simple and let it Compound.
Investing Principals. Keep it Simple and let it Compound.
Warren Buffett’s first investment principal in a word –simple. Keep it simple. For God’s sake keep it simple. Investing is not like figure skating. You do not get extra points for the degree of difficulty in performing the task at hand. Don’t spend time studying new-fangled technologies. Buffett was always happy to invest in the mundane. As he says, ‘don’t jump 7 foot hurdles just because you can, jump 1 foot hurdles’.
Find simple profitable companies in profitable industries that you can easily understand. Getting the industry right is important. Buffett often cites his mistakes in the textile industry – a dying industry in America. He doubled down in textiles and stuck with them for almost 20 years. But it was a waste of time. He repeated this mistake years later in Airlines (USAir Group, 1988) and in shoes (Dexter et al, 1992). His lesson is that no matter how good the management is, if the tide is going out on that industry, it will be very difficult to prosper. Buffett’s repeated investment mistakes are endearing. He has the integrity to highlight his errors and the humanity to make the same mistakes again. He reminds me of the sage advice I received from an older pit trader, Big George. He said, you will always make the same mistakes, but as you improve you will make them less often.
As you would expect, Warren got it right more often than he got it wrong. Buffalo News was one of his greatest and simplest successes. In the Seventies and Eighties newspapers were in a very strong position. It was a good industry. Typically a single newspaper would dominate a city and thus be able to command better prices for advertising etc. When appraising a business Buffett asks himself, ‘if I had the capital and the skilled personnel, would l like to compete with it?’. Buffalo News was one such business. The product itself was superb, the management was second to none and Buffalo News was the dominant local newspaper.
These simple metrics are applied to all Berkshire Investments, including global publicly listed companies like the Coca-Cola Company. Coca-Cola is the world’s premier soft drinks company. They are profitable and extremely hard to compete against.
His only regret with regard to this investment was how long it took him to wake up to it. Here is how he put it in his own words in the 1989 Shareholder Letter.
SL 1989
"This Coca-Cola investment provides yet another example of the incredible speed with which your Chairman responds to investment opportunities, no matter how obscure or well-disguised they may be. I believe I had my first Coca-Cola in either 1935 or 1936. Of a certainty, it was in 1936 that I started buying Cokes at the rate of six for 25 cents from Buffett & Son, the family grocery store, to sell around the neighborhood for 5 cents each. In this excursion into high-margin retailing, I duly observed the extraordinary consumer attractiveness and commercial possibilities of the product.
I continued to note these qualities for the next 52 years as Coke blanketed the world. During this period, however, I carefully avoided buying even a single share, instead allocating major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses, trading-stamp issuers, and the like. (If you think I'm making this up, I can supply the names.) Only in the summer of 1988 did my brain finally establish contact with my eyes".
Another example of simplicity and perhaps the most revealing of Buffett’s humanity and his genius is his purchase of See’s Candy. See’s is a Candy Store chain. They manufacture and retail chocolates and sweets.
In effect the offering price for See’s was $30m in 1971. Berkshire should have paid the price. They did not. They bid $25m. The seller relented and the deal was done at Berkshires price - $25m. Buffett still twitches in his sleep at night thinking about how he and Charlie almost blew the deal of a lifetime. They didn’t understand at the time how cheap See’s was at $30m.
In the 50 years that Berkshire has owned See’s Candy, it required no further capital investment from Berkshire, and it has produced a net $2Bn of profits for Buffett to invest in other companies. Which leads us onto Buffett’s second major investing principal – compounding.
Early in his career Buffett did a lot of what he called ‘cigar butt investing’. Imagine picking up a cigar off the ground with one good puff left in it. You pay nothing to get a free puff from the cigar – it is the ultimate value investment! Buffett describes buying cheap or undervalued stocks and selling them on for a quick profit as ‘cigar butt investing’. Charlie Munger encouraged Buffett to discard his ‘one night stand’ approach to investing and think about longer term deeper investments.
The compounding effect of a good company’s retained earnings is one of Berkshires most profound insights. Companies can pay out all or some of their earnings in dividends or via stock buybacks to their owners. The retained earnings are what they do not pay out. Nevertheless, these retained earnings are the property of the stockholders. Good quality companies like See’s or Coca-Cola can do great things with retained earnings like investing in new stores / markets / products etc. This creates a compounding effect of evermore profits being reinvested by great companies to generate more profits and so on.
Buying a cheap stock for $1.00 and selling it on for $1.25 the following year is only profitable in the short term. But you will need to find a continuous supply of cigar butts lying on the ground to make this investing approach work as a long-term strategy. Buying a top-quality company for $1.00 that retains all its earnings is a better and more durable investment. Imagine a company making and retaining 15% per year. In year 2 you would have the original $1.00 investment plus $0.15 retained earnings working for you. By year 10 you would have the original $1.00 investment plus $2.50 of retained earnings invested in the company. It seems simple when you see it written down in black and white, but it is profound. Buffett does not focus on the stock price, he really doesn’t care about it at all. The magic is in the earnings. He can see a continuous stream of ticker tape prices in Coca-Cola and yet he cannot see any stock prices for See’s Candy (a private company). Buffett does not need a stock price to tell him whether See’s Candy is doing well or not.
He uses a farming analogy to illuminate and justify his relentless focus on earnings and more importantly his disregard for stock prices. Imagine owning a very profitable farm. Your neighbour also owns a profitable farm. However, your neighbour is a little bit mad and has an unusual habit of shouting over the fence to you every morning and night. In the morning he shouts out a price that he is willing to pay for your farm. You don’t care, because you know how hard it is to find very profitable businesses and have no intention of selling no matter what crazy price he shouts at you. However, in the evening he shouts out a price that he is willing to sell his profitable farm for. Being a little bit mad your farming neighbour sometimes offers to sell his farm at a ridiculously cheap price. Buffett is interested in that!
Buffett’s preferred method of investing has evolved from buying cheap companies at low prices and selling them on at higher prices. He wants to buy quality companies at fair or low prices and hold them, allowing compounding to do its magic.
You Might Find This a Little Weird.
The reader needs to be prepared for the unusual consequences arising from Berkshires investment philosophy.
An Always Low Stock Market is Better.
In his own words (SL 1978):“We are not concerned with whether the market quickly revalues upward securities that we believe are selling at bargain prices. In fact, we prefer just the opposite since, in most years, we expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up in stock prices to levels at which we are unwilling to continue buying.”
Diversification Is Not Always Very Important.
This is heresy to most professional fund managers. Buffett is certainly not against diversification as such, it just that he does not target it. He prefers to concentrate his investments. Lukewarm investments in middle ranking companies just for the sake of diversification are pointless.
Inactivity Can Be a Good Thing.
Buffett does not want to be a trader. Although he has been quite active, his stated preference is to just sit around and wait for the phone to ring. Investment managers often feel they need to be doing something or at least be seen to be doing something. Not Buffett. In his own words (SL 1990) “Lethargy bordering on sloth remains the cornerstone of our investment style”.
Conclusions
The average investor can draw some lessons from Warren Buffett and Charlie Munger. New industries are more risky than mature stable ones. Look for companies that have a near permanent competitive advantage or a virtual monopoly within a stable industry. Look for honest competent management within those companies. Diversification may become a natural out come of your investments, but it should not be a primary principal of your investment strategy. If you plan to keep adding to your investments, you should prefer low stock prices. Think about how much ‘earnings’ you can buy. Don’t get too fixated on stock price appreciation.
In our next commentary, we will wander somewhat off the investing curriculum and examine some of the performance enhancing activities that Buffett engages in that are outside the ‘investing box’. We will see that Warren Buffett is a good deal more than just a value investor.
