What is the fuss about?

Warren Buffet is known as one of the most successful value investors of our time. He and his partner Charlie Munger lead Berkshire Hathaway, a $680 billion investment and holding company. Every year, Mr. Buffet writes a letter to his shareholder, summarizing his thoughts/learnings, and giving a snapshot of the performance of his company in the year gone by. This shareholder letter has nuggets of valuable investment lessons we all benefit from. Lets get started to learn from the one of the wisest folks in the investing world.

I have extracted 5 key investment lessons from the 2022 shareholder letter published by Mr. Buffet on 25th Feb, 2023. These lessons have appeared verbatim in the shareholder letter. You can read the original letter online here. I will present my interpretation of these learnings, and at times provide examples from the Indian stock market to help you apply these learnings in the Indian context.

Lesson 1: Business Mistakes are acceptable, personal misconduct is not

Investment managers often say that the fees they charge is to minimize risk, and a smaller part of their fees go into generating returns. This point gets exemplified in Mr. Buffet’s 2022 letter.

Business mistakes can be human errors of misjudgment. These happen, as to err is humane. Mr. Buffet says he has tolerance for business mistakes, as they happen all the time. However, if there is personal misconduct, then that is a red flag. Personal misconduct can refer to intentionally doing wrong things in order to benefit oneself.

 

There are two instances when Mr. Buffet took a stance on wrongdoings that were evident to him. The first was with Enron, a US energy conglomerate. Mr. Buffet commented on the Enron’s accounting footnotes as being unintelligible. He went ahead to say that –

“If you cannot explain your business in one or two short sentences, it’s probably representative of something you are doing wrong, something that might be just fraud.”

In the coming months, the Enron accounting scandal was revealed, taking down the US bluechip company.

The second instance was with Berkshire owned Benjamin Moore Paints company. Sales of this paints company was declining for 5 straight years, while the company’s CEO was splurging company’s money on parties and vacations. One such lavish party thrown by the CEO in a Bermuda island was the last straw. Soon after, the CEO was asked to exit.

The key investment lesson here is to check for any fraud in a company. Well managed companies are the ones to go for. If the CEO, or promoters are interested in making money for themselves, then us shareholders of the company will not benefit in the long run. It is better to be safe, than sorry. If you haven’t included fraud check on company’s management/promoters, do add it in your fundamental analysis checklist.

Lesson 2: Pick Businesses, not Stocks

As simple as this may sound, it is difficult to inculcate as an investing framework. To clarify, let me share the difference in a stock picking mindset from a business picking mindset. Below are a set of questions and statements you would ask if you are picking a stock, vs picking a business.

Mr. Buffet always says that he owns businesses, not stocks. Once you buy a share of company, you become a shareholder, or part-owner of the company. If you don the hat of the owner of a company, the type of questions you ask will be more deeper, and long term focused.

A company is not defined only by technical parameters, but defined by its vision, management, moats, efficient operations, and future growth strategy. When you sum the parts of knowing a company, it becomes your fundamental analysis framework.

 

If you want to own a company, your research will be more thorough. You will only invest if you are convinced in the company’s future. You will be tolerant to short term mistakes made by the company, or to macroeconomic headwinds the company faces. As long as the long term strategy of the company remains intact, you will continue your ownership. These are the building blocks of long term value investing strategy – the method Mr. Buffet has championed throughout most of his investing career.

Lesson 3: Efficient markets only exist in textbooks

To make stock market investing sound simple, Mr. Buffet explains why it is easy to make good use of inefficiencies in the stock market. In Mr. Buffet’s own words –

“One advantage of our publicly-traded segment is that — episodically — it becomes easy to buy pieces of wonderful businesses at wonderful prices. It’s crucial to understand that stocks often trade at truly foolish prices, both high and low.”

Market’s sentiment is like a pendulum, which keeps swinging in extremes of greed and fear. These swings are inevitable. These swings are the basic nature of the market. When market as a whole votes on a good looking stock, the stock enjoys premium valuation — a time to stay on the sidelines. On the other hand, when market as a whole has forgotten about a stock, or becomes pessimistic on the short term outlook for a stock — it is time to buy.

 

As per Mr. Buffet, stock market gives plenty such opportunities to buy fundamentally strong companies at foolishly discounted prices. An Indian context example is of the relation between Reliance’s share price and windfall tax. An increase in windfall tax increases the export duties on petrol and diesel. This negatively impacts the near term outlook for Reliance industries, whose majority business comes from the oil exports. Each time windfall taxes are increased by the Indian government, Reliance’s share price tumbles 5–6%, before recovering. Even though the market knows that changes in the windfall taxes are only temporary, and will be changed in due course of time, the market still reacts negatively.

Markets tend to over-react most of the times. If it is unfavorable news, the market turns more negative than needed, giving opportunity of buying good companies at a discount. On positive news, market overreacts, rising up more than needed, taking stocks to overvalued zone. The patient investor who makes good use of the market swings, will be able to benefit.

Lesson 4: Truly Good Investment decisions comes around once in 5 years

There are two key investment lessons hidden here. The first is that, do not always be on the lookout for the next multi bagger. Multi baggers do not pop up every now and then. And every prospective multi bagger does not turn out to be one. The second learning is that time in the market is more important, in order to be able to come across great investments once in a while, which have the potential to fast track your returns.

Mr. Buffet, in his 2022 shareholder letter, humbly says that in his 58 years of investing, the good results have come from just a dozen good decisions, which happen once every five years or so. Correspond this to what Mr. Rakesh Jhunjhunwala used to say, that an investor needs to hit two to three sixers in his lifetime, which should be enough. This translates to making 2–3 great investment decisions, on whose back you can ride gains for long periods of time.

But, how will you spot, and make these good investment decisions which appear every once in 5–6 years? Well, as an investor, you will have to be disciplined, patient, and remain true to your investment framework. Then you will be able to spot these good investments when they appear, and with conviction go in on them.

Lesson 5: The weeds wither away in significance, as the flowers bloom

Do not worry about those investment decisions which went wrong. As long as you know which investments are wrong, and are able to get out of them fast, that is enough. You need to be right less than 50% of the times in order to make great wealth. Do not aim to hit a six off each ball.

Mr. Buffet, writes a section in his shareholder letter titled ‘The Secret Sauce’. In this section he gives examples of two of his investments — Coca Cola and American Express. The dividends received from these companies alone are worth more than the invested money in these companies. Further, the price appreciation in these two stocks has been phenomenal, which boosted Berkshire’s wealth. Mr. Buffet then goes on to explain that if one of these investments, of same value, would have gone bad. Even then the loss, in 30 year time, would be insignificant to the gains his good investments would have made him.

Mr. Buffet ends the section by saying that it helps to start investing early, and live a long life :-). This indirectly refers to the magic of compounding in investing. The more time you give your good investments, higher the returns you make, and lower the pain from bad investments get.

Parting Thoughts

To summarize, screen out badly run companies before investing. Develop a mindset to picking businesses, and not stocks. Make use of the stock market mood swings to buy great companies at foolishly low prices. Be patient, good investment opportunities will come by over time. Few good investments will more than make up for the loss in bad investments.

The patient way of making money is not exciting, but is simple. Value investing requires you to let your good investments run, while trimming your bad investments early on. Investing as a contrarian to the stock market mood does not come naturally. Making small mistakes is essential to learn early, than fail big later.

Mr. Buffet’s shareholder letters are a treasure of investment lessons, available for free for everyone (link to the list of all letters is here).

Hope you learned something new, or your learning got reinforced. Revising the basics of investing every now and then reminds us retail investors to stick to the investment discipline.

Happy Investing!