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Warren Buffett's 50th annual letter to shareholders: Key investment themes

Apart from his usual look back at Berkshire's performance in 2014, Buffett also went through the history of his leadership

Sheetal Agarwal  |  Mumbai 

A woman whispers something to Berkshire Hathaway CEO Warren Buffett at the Berkshire-owned Borsheims jewelry store where Buffett was selling jewellery as part of the company annual meeting weekend in Omaha, Nebraska

Investment guru Warren Buffett's annual letter to the Berkshire Hathaway shareholders is keenly awaited by the investor community and regarded as the gospel of investing by many. This time the importance in magnified as the letter for 2014 rewinds the key experiences in Buffett's 50 year long journey with Berkshire Hathaway and also provides a glimpse of the road ahead for the company.

Buffett gets nostalgic in the letter and describes acquisition of controlling stake in the troubled textile firm Berkshire Hathaway in 1965 as "I became the dog who caught the car". He talks about the company's 18 year long struggle to survive, his reluctance to close down the textile business and eventual shut down of the business in 1985.

Bill Gates in a tweet and video said that this letter is the most important letter Buffett has ever written. Gates serves on Berkshire’s board and also owns the company’s stock. Gates says that what works about what he calls the "Berkshire system" is that it maximises the potential of businesses by giving them autonomy as well as the explicit support of the whole Berkshire organisation, even if mistakes are made. Gates added that, "What really struck me this time about the letter was the value of experience. [Buffett] is better today than ever because he's seen so many businesses and he understands business profitability so incredibly well."

Buffett talks about his long standing association with Charles (Charlie) Munger, the Vice Chairman at Berkshire Hathaway and how the latter has provided him sound advice and support. "Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices, was the blueprint Charlie gave me. Consequently, Berkshire has been built to Charlie’s blueprint. My role has been that of general contractor, with the CEOs of Berkshire’s subsidiaries doing the real work as sub-contractors."


Buffett talks about Berkshire's conglomerate structure and how it works better to keep the businesses under one company rather than de-merging them. Talking of the next 50 years of Berkshire, he stated that the company's per share intrinsic business value is certain to advance over time and cited that the company's policy of keeping a healthy cash kitty will guard it against any big financial problem. But, Berkshire's long term gains (in percentage) will not come close to that achieved in earlier 50 years due to its sheer size. From 10-20 years from now, the company will distribute excess earnings via a dividend and/or share repurchases.

Buffett has also indicated that his son Howard will succeed him as non-executive Chairman, subject to board approvals. He believes Howard will ensure that the new CEO is working in-line with Berkshire culture and will not hesitate to replace the CEO if he fails to do so. While not naming the future CEO, Buffett did indicate that he will be from within the company and will be relatively younger.

Investors, both large and small, try to learn from the ace investor's pearls of wisdom and investment strategies. In his letter for calendar year 2014 as well, Buffett has reflected on a few investment strategies and their implementation.

Cigar-butt strategy

As per this strategy, one can invest in mediocre companies at inexpensive prices. "I purchased Buffett Partnership Ltd. (BPL)’s first shares of Berkshire in December 1962, anticipating more closings and more repurchases. The stock was then selling for $7.50, a wide discount from per-share working capital of $10.25 and book value of $20.20. Buying the stock at that price was like picking up a discarded cigar butt that had one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected", Buffett wrote in the letter. He adds that the 1950s decade was best in terms of investment returns he made while applying this strategy. However, this strategy is more short-term in nature and is not scalable. Hence, it will not work in case of larger investments.

Intrinsic value

Intrinsic value is the actual value of a business or a stock after considering both qualitative and quantitative fundamentals regarding the business, future prospects, financial ratios, amongst others. It may or may not be same as the current market value of the shares. Investors thus scout for stocks having higher intrinsic value vis-a-vis market value.

Buffett re-emphasised the importance of intrinsic value while investing/buying out a company in an all stock deal. He writes, "the intrinsic value of the shares you give in an acquisition must not be greater than the intrinsic value of the business you receive." He asserts that the premium over intrinsic value should thus be reasonable and not follow the premium valuations offered in similar deals in recent times.

Cash is king

Too often investors and analysts question a company's huge cash kitty. In Indian context, companies such as Infosys have always witnessed analysts emphasising of efficient use of cash either in the form of an acquisition or towards higher dividend payouts. Buffett though differs. He believes companies should have good cash and cash equivalents which can come handy in weak economic cycles.

"In a three-week period spanning late September and early October 2008, we supplied $15.6 billionof fresh money to American businesses. We could do that because we always maintain at least $20 billion - and usually far more - in cash equivalents. And by that we mean U.S. Treasury bills, not other substitutes for cash that are claimed to deliver liquidity and actually do so, except when it is truly needed", he writes.

BUFFETOLOGY
* A sound investment can morph into a rash speculation if it is bought at an elevated price.
* Financial staying power requires a company to maintain three strengths under all circumstances: (1) a large and reliable stream of earnings; (2) massive liquid assets and (3) no significant near-term cash requirements.
* Post mortems of acquisitions, in which reality is honestly compared to the original projections, are rare in American boardrooms. They should instead be standard practice.
* Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.

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First Published: Fri, March 20 2015. 15:56 IST
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