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Summary

  • Warren Buffett's recent letter to shareholders presents several investing principles that most individual investors can use.
  • Some of the most important principles are to see yourself as a capital allocator, look for wonderful companies, and always consider the price compared to value.
  • Run your investing like a business, because that is what it is.

Warren Buffett can do lots of things that you or I cannot do. Most of us cannot offer $5 Billion cash to Goldman Sachs in their hour of need.

But lots of us can apply many of Buffett's basic principles for stock investing. I am writing this from the perspective of a dividend growth investor, which is what I am, but these principles can be applied by anyone who takes a value approach to investing and tries to be businesslike about it.

Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) recently sent out its 2013 Shareholder Letter, which is Buffett speaking. I was struck this year by how several passages are directly applicable to individual self-directed investors. Here they are, with each passage followed by my "translation" from what Buffett does to what individual investors can do.

Berkshire Hathaway Inc. is a holding company owning subsidiaries that engage in a number of diverse business activities…. Operating decisions for the various Berkshire businesses are made by managers of the business units.

As an individual investor, you too are a holding company with stakes in a number of diverse businesses.

One of the things that makes Berkshire unique is that Buffett makes no effort to integrate his businesses. Usually when there are mergers and acquisitions, the mother company combines operations, seeks synergies, eliminates duplication, and the like.

Buffett does not do this. This gives him several advantages that are also available to small investors.

  • Buffett does not invest on wishful thinking. He analyzes businesses as they are, projects earnings for the foreseeable future, values each company, and decides whether its future earnings power is a good deal for what he can buy the stock for. Small investors can do this too.
  • He never tries to identify back-room synergies. Small investors are forced to be in the same situation: You will never be able to impose synergies or operational efficiencies on your companies. He doesn't try to, and you cannot.
  • He prefers to buy companies that have managers that will come with the business. Obviously, when you buy shares in a company, you are also taking the management team along with your stake.

I look at my portfolio exactly as if I were a holding company with interests in diverse businesses. I am a conglomerate.

Investment decisions and all other capital allocation decisions are made for Berkshire and its subsidiaries by Warren E. Buffett, in consultation with Charles T. Munger.

With Your Investment Company, you make all capital allocation decisions. That's what investing is: Deciding where to allocate capital, whether it be to shares of stock, bonds, investment property, cash, or any of the other myriad investment instruments that are available.

Obviously, you do not make capital allocation decisions for the companies that you hold. You depend on their managers to do that. But you make the most important capital allocation decisions, which involve what stocks to own, what prices to pay, and when to sell them.

Berkshire increased its ownership interest last year in each of its "Big Four" investments - American Express, Coca-Cola, IBM and Wells Fargo….The earnings that these four companies retain are often used for repurchases of their own stock - a move that enhances our share of future earnings - as well as for funding business opportunities that usually turn out to be advantageous. All that leads us to expect that the per-share earnings of these four investees will grow substantially over time. If they do, dividends to Berkshire will increase and, even more important, our unrealized capital gains will, too. (For the four, unrealized gains already totaled $39 billion at yearend.)

As an individual investor, everything in the above quote applies to you except the scale of the operation.

  • Since you are the capital allocator for your investing business, you can decide whether and when to increase or decrease your stakes in any of the businesses you own. This is called portfolio management, and it is one of the most important things that you do as an investor.
  • The earnings of your companies inure to your benefit, in the same proportion as your ownership percentage. The decisions the companies make on "funding business opportunities" will, if you have chosen your investments well, "usually turn out to be advantageous."
  • If your companies repurchase shares of their own stock, and retire those shares, that enhances your share of future earnings.
  • If their earnings grow substantially, dividends to you will increase over time, assuming that the stocks you own pay dividends.

At Berkshire, we much prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business; it's better to have a partial interest in the Hope diamond than to own all of a rhinestone.

This too applies directly to you. As the capital allocator, you get to choose the businesses in which you will own a stake. The type of business you invest in is entirely up to you.

Quality is an amorphous and somewhat subjective concept. Over the course of his investing life, Buffett has come to see the advantages of owning "wonderful companies" instead of "cigar butts." Great companies are reliable, they grow, and their managements can be trusted to usually do the right thing for the business and for shareholders.

Our flexibility in capital allocation - our willingness to invest large sums passively in non-controlled businesses - gives us a significant advantage over companies that limit themselves to acquisitions they can operate.

This is one of the key advantages to the individual investor. Most companies, in considering acquisitions, look for companies in related businesses that they can operate. As a conglomerate, you are not restricted in that way.

To the point, you can look for businesses that have the financial and competitive qualities that you prefer, and it does not matter whether they relate to each other. You can purchase any kind of business that you like. You won't operate them, so it does not matter whether they can be combined in any way. You will depend on their managements to run them.

Your main job is to do due diligence on the companies that you buy, and then manage your portfolio effectively.

Charlie Munger, Berkshire's vice chairman and my partner, and I believe both Berkshire's book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong - as we did in 2013. We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%.

This is the experience of most value-based strategies. They tend to outperform when the market is down, flat, or moderately up, but to underperform when the market rockets ahead.

I consider dividend growth investing to be a niche of value investing. My public Dividend Growth Portfolio's performance for the past five-plus years (since inception) pretty much illustrates what Buffett says above. The table below shows total returns with dividends reinvested for my demonstration portfolio and the S&P 500 (NYSEARCA:SPY).

Year

SPY (proxy for broad market)

Dividend Growth Portfolio

Difference

DGP - SPY

2008 (partial year)

-34.5%

-21.9%

12.6%

2009

26.4%

14.2%

(12.2%)

2010

15.1%

16.6%

1.5%

2011

1.9%

15.4%

13.5%

2012

16.0%

5.3%

(10.7%)

2013

32.3%

19.2%

(13.1%)

In his annual inside-front-cover table, Buffett compares each year's performance of Berkshire to the S&P 500 in a fashion similar to the table above. However, he does not compare BRK's actual stock market value to the S&P 500, he compares changes in BRK's book value to the index. By his measure, BRK underperformed the index in 2009, 2010, 2012, and 2013.

Looking at actual market values, my portfolio underperformed in the same years, except for 2010, when I scraped out a small additional return compared to the S&P 500. The point, is, not every investing strategy is optimal in all circumstances. Understand the likely outcomes of your strategy, and don't get flustered when they happen.

My strategy is not focused on price or total returns, it is focused on dividend returns. It delivers about twice the dividend returns of the S&P 500, in accordance with its goals.

Of course, a business with terrific economics can be a bad investment if the purchase price is excessive.

I understand that not everyone is a value investor. But if you are, then obviously valuation is important.

Some investors, especially beginners, confuse price with valuation. Obviously they are related, but knowing price alone is insufficient to judge valuation. As Buffett has said, "price is what you pay, value is what you get."

Even knowing that a price has recently gone up or down is not enough. Knowing that the price today is lower than it was last month is insufficient to judge valuation. The price may still be excessive. In order to determine valuation, you need to compare the current price to some assessment of the intrinsic value of the company, not to the price at some prior time.

There are a variety of ways to determine intrinsic value, and there is not sufficient space here to describe them all. I use two simple methods: Morningstar and FASTGraphs. Morningstar's stars are actually valuation grades. They compare a stock's current price to their assessment of if its fair value, which they compute using a detailed net present value calculation. Here is their current view of Apple (NASDAQ:AAPL):

The three stars indicate fair valuation on Morningstar's 5-star system. Here is FASTGraph's reckoning of AAPL's valuation:

By this reckoning, AAPL is undervalued, even though its price rose significantly in the second half of 2013. Its black price line is more than 10% below the default orange fair value line computed at a P/E ratio of 15. Furthermore, it is about 40% below fair value computed by using AAPL's actual 10-year P/E of 21.2 (shown by the magenta line).

How you put together these or other assessments of valuation is up to you, but if you are a value investor, some step like this is necessary.

Buffett openly solicits companies to offer themselves to be acquired by Berkshire, and he requests that offerors suggest a price. He says he will get back to them in a short period of time. During that time, he values the business offer. So it does not have to take long, but you do need a way to do it.

Buying at good valuations is a key determinant of future returns. At the top of the FASTGraph, the 5-year estimated total return is based on the stock's current valuation and projected growth in earnings.

A few [investments], however, have very poor returns, a result of some serious mistakes I made in my job of capital allocation. I was not misled: I simply was wrong in my evaluation of the economic dynamics of the company or the industry in which it operated....I have not, however, made my last mistake in purchasing either businesses or stocks. Not everything works out as planned.

Buffett makes mistakes. We all do. Mistakes are a predictable part of investing.

It is a best practice to lay out, beforehand, what you will do if your investment thesis fails. If you are a dividend investor, will you sell if the company cuts its dividend? If your approach is not to sell outright, what are the parameters you will examine to determine what to do? If you are a momentum investor, what technical factors will you use to decide whether a stock has turned into a mistake for you? Do you stop yourself at a 10% or 15% loss?

The best time to deal with mistakes is before they happen. Many mistakes can be prevented by having a businesslike discipline about purchasing. You ought to know in advance what sorts of stocks you want, what characteristics they will have, and what kinds of stocks you will avoid. You should know the red flags that will stop you in your tracks. Every purchase should have an investment thesis. You will use that to guide your purchases, and then to evaluate them as time goes by.

Investment is most intelligent when it is most businesslike.- The Intelligent Investor by Benjamin Graham… You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences.

Buffett opened the investing section of his letter with the quote from Benjamin Graham. All of this article has been about taking a thoughtful and businesslike approach to investing, trying to chart "a course certain to work reasonably well."

For me, that means having a business plan. I call my business plan the Constitution. (You can see it here.) It is a high-level document that sets out clear goals and the strategies that I use to try to achieve those goals. It answers all of the questions posed above.

My opinion is that an investor should have such a plan at least roughed out before purchasing a single share of stock. Every company I ever worked for had goals and strategies, and the best of them worked hard on those, reassessing themselves every year and keeping the core documents updated. I know that I get my best results when I do the same.

Source: How You Can Invest Like Warren Buffett