Warren Buffett, the CEO and Chairman of Berkshire Hathaway (BRK.A), has a reputation for taking a long-term view of the market when other investors get distracted by the day-to-day fluctuations and sometimes make short-sighted situations that are often at odds with their long-term interests. I went through Buffett's most recent Letter to Shareholders (pdf link here: http://www.berkshirehathaway.com/letters/2010ltr.pdf ), and picked out my five favorite quotes that are helpful for clarifying the mentality and approach to investing for the long haul.
1. Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of "great uncertainty." But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain. Don't let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential - a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War - remains alive and effective.
This seems to reinforce the notion that the "night is darkest right before the dawn." Warren Buffett has made his fortune in investing by buying companies at moments when they are at the peak of unpopularity. He swooped in and bought shares of American Express (AXP) after the salad oil scandal in the 1960s, he bought The Washington Post (WPO) in the 1970s when there were lingering questions about the strength of the company's management, he loaded up on shares of Coca-Cola (KO) when most analysts believed that the company had saturated the domestic market and had little room for growth, and he bought Wells Fargo (WFC) in the early 1990s and today during times of financial crises when most investors were too scared to even consider establishing positions in banks. When I look back at some of the absurdly low prices in 2008 and 2009-General Electric (GE) at $6 or Wells Fargo at $8, it's easy to forget the cloud of uncertainty that surrounded those companies at the time, deterring investors from keeping their money in the market and adding to their investments. The key to earning these superior returns hinges on having an established plan that involves purchasing securities during times when the market tanks.
2. Charlie and I believe that those entrusted with handling the funds of others should establish performance goals at the onset of their stewardship. Lacking such standards, managements are tempted to shoot the arrow of performance and then paint the bull's-eye around wherever it lands. In Berkshire's case, we long ago told you that our job is to increase per-share intrinsic value at a rate greater than the increase (including dividends) of the S&P 500. In some years we succeed; in others we fail. But, if we are unable over time to reach that goal, we have done nothing for our investors, who by themselves could have realized an equal or better result by owning an index fund.
The goal that Buffett sets for himself is not a bad yardstick for most investors to measure themselves by as well. Now, to be sure, there are plenty of circumstances when using the S&P 500 might not be the best frame of reference for investors. For example, if you focus on dividend-growth stocks like Pepsi (PEP), Johnson & Johnson (JNJ), and Proctor & Gamble (PG) to generate income, your primary focus will be on establishing a purchase price above a 3% yield, and then watching the annual income on those investments grow by 7-10% annually. In this circumstance, the 2% annual dividend from the S&P 500 is of little good for the income-oriented investor. But Buffett is correct in asserting that investors should establish investing objective before they begin investing, lest they change their goals mid-way through to justify their strategies. Be clear in establishing a yardstick for your own investments so that you may honestly appraise your own performance over time-objective criteria from the onset will prevent you from introducing your own biased, subjective criteria as mid-way through.
3. This "what-will-they-do-with-the-money" factor must always be evaluated along with the "what-do-we-have-now" calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value. That's because an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company's current value; if the CEO's talents or motives are suspect, today's value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck's or Montgomery Ward's CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.
One of the hard-to-shake tenets of investing is the tendency to consider all retained earnings equally. Let's pretend that ExxonMobil (XOM), Chevron (CVX), and ConocoPhillips (COP) each had a 40% payout ratio over the past five years-it's doubtful that most investors would value the retained earnings as "superior" in the hands of one company over the other. Of course, if you believe that a particular company is doing something better with retained earnings than its competitors, then you should definitely consider that opportunity for investment. Otherwise, you should look for companies that largely remove retained earnings from the equation-look to companies that have a strong (and growing) dividend commitment that forces the management team to act discipline and only put the retained earnings toward necessary operations to preserve and grow the company.
4. Our second advantage relates to the allocation of the money our businesses earn. After meeting the needs of those businesses, we have very substantial sums left over. Most companies limit themselves to reinvesting funds within the industry in which they have been operating. That often restricts them, however, to a "universe" for capital allocation that is both tiny and quite inferior to what is available in the wider world. Competition for the few opportunities that are available tends to become fierce. The seller has the upper hand, as a girl might if she were the only female at a party attended by many boys. That lopsided situation would be great for the girl, but terrible for the boys.
One of Buffett's greatest talents is that he doesn't put self-imposed constraints upon himself in his pursuit of investment opportunities. He generally tries to find the greatest amount of future profits possible at the lowest possible price, on a risk-adjusted basis. By expanding his sphere of competence over the years to include insurance companies, financials, manufacturing companies, and consumer staples, Buffett has been able to find the best opportunity available for his company. If you think that Wells Fargo is a good deal at $28 per share, the next question you have to ask yourself is: Compared to what? Is Wells Fargo at $28 better for you on a risk-adjusted basis than General Electric at $17? These are the types of questions that investors always need to be asking themselves, and the wider their sphere of competence, the greater amount of opportunities they can consider when looking for the best place to put their money.
5. In our reported earnings we reflect only the dividends our portfolio companies pay us. Our share of the undistributed earnings of these investees, however, was more than $2 billion last year. These retained earnings are important. In our experience - and, for that matter, in the experience of investors over the past century -undistributed earnings have been either matched or exceeded by market gains, albeit in a highly irregular manner. (Indeed, sometimes the correlation goes in reverse. As one investor said in 2009: "This is worse than divorce. I've lost half my net worth - and I still have my wife.") In the future, we expect our market gains to eventually at least equal the earnings our investees retain.
Buffett is claiming that retained earnings matter should affect your investment calculations. Let's say that you own 1000 shares of Kraft (KFT). That pays out $1,160 in annual dividends. But it's also relative to $1,830 worth of TTM earnings. Your ownership claim represents that $670 worth of Kraft retained earnings that is not paid out to you as dividends, and you should not neglect that money in your personal calculations. Of course, as one of the above quotes notes, there is a difference between giving retained earnings in 1970 to Sam Walton or the CEO of Sear's. But just because you can't precisely calculate the future of those earnings does not mean that you should ignore their value.