Buffett:
berkshirehathaway.com (see W.B.'s Letters to Shareholders)
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We have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future. What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic- depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.
Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."
Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising "Take two aspirins"?
The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben's Mr. Market concept firmly in mind.
Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful.
The market may ignore business success for a while, but eventually will confirm it. As Ben said: "In the short run, the market is a voting machine but in the long run it is a weighing machine." The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price. Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better.
We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time.
(Of Wall Street maxims the most foolish may be "You can't go broke taking a profit.") We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.
Many commentators, however, have drawn an incorrect conclusion upon observing recent events: They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. This conclusion is dead wrong: Such markets are ideal for any investor - small or large - so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
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Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It's the seller of food who doesn't like declining prices.)
The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.
None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do."
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In the past, I've observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess. Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations. Initially, disappointing results only deepen their desire to round up new toads. ("Fanaticism," said Santyana, "consists of redoubling your effort when you've forgotten your aim.") Ultimately, even the most optimistic manager must face reality. Standing knee-deep in unresponsive toads, he then announces an enormous "restructuring" charge. In this corporate equivalent of a Head Start program, the CEO receives the education but the stockholders pay the tuition.
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VALUE VS. GROWTH:
But how, you will ask, does one decide what's "attractive"? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross- dressing.
We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
In addition, we think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).
Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price- earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.
Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.
In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future "coupons." Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity "coupons."
The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.
Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.
Though the mathematical calculations required to evaluate equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons." At Berkshire, we attempt to deal with this problem in two ways.
First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.
Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.
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By periodically investing in an index fund, for example, the know- nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly- priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: "Too much of a good thing can be wonderful.
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we purchased
several companies whose earnings will almost certainly decline this year from peaks they reached in 1999 or 2000.
The declines make no difference to us, given that we expect all of our businesses to now and then have ups and
downs. (Only in the sales presentations of investment banks do earnings move forever upward.) We don’t care
about the bumps; what matters are the overall results. But the decisions of other people are sometimes affected by
the near-term outlook, which can both spur sellers and temper the enthusiasm of purchasers who might otherwise
compete with us.
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Agonizing over errors is a mistake. But acknowledging and analyzing them can be useful, though that
practice is rare in corporate boardrooms. There, Charlie and I have almost never witnessed a candid post-mortem of
a failed decision, particularly one involving an acquisition. A notable exception to this never-look-back approach is that of The Washington Post Company, which unfailingly and objectively reviews its acquisitions three years after they are made. Elsewhere, triumphs are trumpeted, but dumb decisions either get no follow-up or are rationalized. The financial consequences of these boners are regularly dumped into massive restructuring charges or write-offs that are casually waved off as “nonrecurring.” Managements just love these. Indeed, in recent years it has seemed that no earnings statement is complete without them. The origins of these charges, though, are never explored. When it comes to corporate blunders, CEOs invoke the concept of the Virgin Birth.
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VALUATION:
Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the
formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by
a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in
the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain
are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the
risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three
questions, you will know the maximum value of the bush ¾ and the maximum number of the birds you now
possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays
for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam
engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota — nor will the
Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital
throughout the universe.
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth
rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash
flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a
project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.
Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting
approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component ¾
usually a plus, sometimes a minus ¾ in the value equation.
Alas, though Aesop’s proposition and the third variable ¾ that is, interest rates ¾ are simple, plugging in
numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a
range of possibilities is the better approach.
Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even
very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in
relation to value. (Let’s call this phenomenon the IBT ¾ Inefficient Bush Theory.) To be sure, an investor needs
some general understanding of business economics as well as the ability to think independently to reach a wellfounded
positive conclusion. But the investor does not need brilliance nor blinding insights.
At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction
about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty
frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort,
any capital commitment must be labeled speculative.
Now, speculation — in which the focus is not on what an asset will produce but rather on what the next
fellow will pay for it — is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I
wish to play. We bring nothing to the party, so why should we expect to take anything home?
The line separating investment and speculation, which is never bright and clear, becomes blurred still
further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses
of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that
of Cinderella at the ball. They know that overstaying the festivities ¾ that is, continuing to speculate in companies
that have gigantic valuations relative to the cash they are likely to generate in the future ¾ will eventually bring on
pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the
giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in
a room in which the clocks have no hands.
Last year, we commented on the exuberance ¾ and, yes, it was irrational ¾ that prevailed, noting that
investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a
Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their
opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged
19%. That, for sure, was an irrational expectation: For American business as a whole, there couldn’t possibly be
enough birds in the 2009 bush to deliver such a return.
Far more irrational still were the huge valuations that market participants were then putting on businesses
almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and
ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals
as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from
the values of the businesses that underlay them.
This surreal scene was accompanied by much loose talk about “value creation.” We readily acknowledge
that there has been a huge amount of true value created in the past decade by new or young businesses, and that
there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime,
no matter how high its interim valuation may get.
What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly
merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the
public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed
the creation of bubble companies, entities designed more with an eye to making money off investors rather than for
them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business
model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers
acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns
some very old lessons: First, many in Wall Street ¾ a community in which quality control is not prized ¾ will sell
investors anything they will buy. Second, speculation is most dangerous when it looks easiest.
At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven
enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600-year-old
equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when
they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five
in the phonebook.”).
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Charlie and I think it is both deceptive and dangerous for
CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both
analysts and their own investor relations departments. They should resist, however, because too often these
predictions lead to trouble.
It’s fine for a CEO to have his own internal goals and, in our view, it’s even appropriate for the CEO to
publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a
major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court
trouble.
That’s true because a growth rate of that magnitude can only be maintained by a very small percentage of
large businesses. Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980
and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that
only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable
companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years.
The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more
troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many
instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they
had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide
variety of accounting games to “make the numbers.” These accounting shenanigans have a way of snowballing:
Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to
engage in further accounting maneuvers that must be even more “heroic.” These can turn fudging into fraud.
(More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.) |
