Warren Buffett – Master Investor
Our Commentary on his Letters to Shareholders
Warren Buffett is probably unique among modern master investors in that it appears by personality that he is IDEALLY suited to be an investor. His brain is hardwired for what we call compounding. Let’s illustrate. If you ask an investor, what would you rather have 1) a stock this year that doubles in value, and then another stock for each of the next 2 years that also doubles, or 2) one stock that goes up 25% per year for the next 30 years? Invariably 99 out of 100 investors would say, “Give me the first scenario.”
People and investors are people that want the easy and quick way to make a buck, and who doesn’t? The answer is that Warren Buffett doesn’t. The investors’ approach that Warren Buffett uses is a COMPOUNDING APPROACH. It’s at the heart of who and what he is as a human being.
The Rule of 72 as applied by Warren Buffett
If you want to know how long it takes an investment to make a 100% return, than you use the rule of 72 which is something that Warren Buffett has memorized. Let’s say an investment is going up by 12% per year. You take 72 and divide it by the 12% rate of return, and you get 6. This means it takes 6 years for your investment to double at a 12% rate of return. At a 22% rate of return, it takes 3.6 years for an investment to double (72 divided by 22% = 3.6). As I mentioned, Warren Buffett has these computations memorized.
During the first half of his investing career, Warren Buffett obtained about a 29% per year return. He was doubling his money every 2.5 years (72 divided by 29 = 2.48 or roughly 2 ½ years). Warren Buffett during the last half of his career has continued to compound his wealth at a level of about 22% per year, still not chopped liver. Actually by money management standards, he’s doing fabulous. His money at that rate is doubling every 3.27 years or roughly every 3 years, 3 months.
How REAL WEALTH is CREATED – Warren Buffett style
We all know stories about people who bought their houses 25 years ago for a fraction of what they are worth today. Depending upon your age as the reader of this narrative, this may be true for you as well. It is certainly true for your mother and father. What happened is that your parent’s home went up at a rate of about 8 to 12% per year for 25 years, and this is why at the end of fairly long stretch of time, when COMPOUNDING KICKS IN, you come up with a seemingly fantastic number.
What seems so fantastic is not fantastic, it’s simply the COMPOUNDING EFFECT, and Warren Buffett is the master of this skill. Your parent’s house went up 12% per year for 25 years. At 12%, the house doubles in value every, how long now, do the math. Take 72 and divide by 12, and you get 6 years. They held the house for 25 years, which means they got 4 doubles out of the house. They paid a $100,000 for the house, and with four doubles, the numbers go $100,000 base, than $200,000 after the first double, $400,000, second double, $800,000 third double, and $1,600,000 fourth double. Remember they had a mortgage. They put 20% down, or $20,000. They made $1,580,000 on a $20,000 investment, minus the interest or cost to carry.
By the way with a 30 year mortgage, whatever they borrowed, they probably paid back close to 3 times what they borrowed in interest, do to the way amortization works. Keep in mind that houses don’t move up in value in a straight extrapolated line. During the Lyndon Johnson Presidency, we had guns and butter, similar to what we have today. Johnson refused to raise taxes sufficiently to cover the costs of the war, and therefore there was an associated burst of inflation that dramatically escalated the value of residential homes during that period.
Inflation is a way of life in America. It’s built into our system. People in a sense demand it. This is also why over a period of years, bonds will always lose out to stocks. With stocks over time, you have a living breathing corporation that can grow and prosper. You get a capital gain kicker. This is in no way true with bonds.
Back to houses for a moment, it’s good for you to know that since World War II, which is 1945, there has only been one year when houses on a annualized basis went down for the entire year, and that was 2005. This was after an enormous run in the housing market that lasted 5 years up until 2005. This is why the concept of owning your own house has been such a NATURAL WINNER for anyone who bought a house, and held long term since World War II.
You should always consider owning your own house as a first line investment strategy. It is also one of the truly unique investments that you CAN LIVE IN, or ENJOY. Owning stock certificates does not have the same effect as owning a house and watching it go up in value.
Back to WARREN Buffett
The next thing we would like to cover with you concerning Warren Buffett is that he is one of the few investors living that has created his own vehicle. Have you ever noticed how most major league investors own stock certificates? That’s what they do; they make investments in companies, and therefore take possession of stock certificates representing their ownership position. Yes, the brokerage firm or investment house they deal with may hold the certificates in street name, but the investor is the ultimate owner of those certificates.
Warren Buffett has changed this game not by a little bit, but by a lot. In the early 1970’s, he took control of a New England based textile manufacturing company that was down in the dumps named Berkshire Hathaway. Buffett had a vision which was to turn the stodgy and dying Berkshire Hathaway into a DYNAMIC financial services oriented company. He did, and Berkshire basically became an INSURANCE CONGLOMERATE.
Now the interesting thing about insurance companies is that if run them right, they have a unique capability that very few companies possess. They have use of the FLOAT. In an insurance company it works like this. I need insurance, let’s say a million dollars worth on my life. I pay the insurance company a fee every year, it’s really a BET. If I die, they pay my estate a million dollars.
If I live, I get to pay the insurance company a premium for the next year. I do this each year, until I die, or until the insurance policy is paid up, or until I decide not to renew. Insurance is a no-brainer for the insurance company. Think about it. I am going to do everything in my power to make sure I LIVE, and the insurance company wants me to LIVE. For them is win-win. I’m betting I die, and yet I do everything in my power to make sure I live. In essence, I am working for the insurance company.
They, the insurance companies only have to pay off if I die, and that’s not what I want to do in any event anyway. The insurance company is also spreading around their risk among thousands, maybe millions of insured policyholders, so the risk is thinning out, as it is spread out.
Meanwhile the insurance company gets to use all that PREMIUM money that was taken in from the people they insured, and use it until either it must be paid out to the estates of those who have died.
The insurance company must set up a reserve for how many people they think will die among their insured policyholders. That reserve doesn’t get taxed until well into the future. Once again, the insurance company gets to invest the reserves or FLOAT, sometimes for decades.
It’s a game folks, perhaps the best financial game ever invented, and Buffett figured it out, decades ago. This is why Berkshire Hathaway had such a huge position in GEICO, the auto insurance company. Warren Buffett has been an investor in GEICO since he became an adult, and visited the company while he was at Columbia Business School studying security analysis with the father of Security Analysis, Benjamin Graham. Berkshire now owns all of GEICO.
Looking at any Berkshire Hathaway shareholder letter, and we have supplied you with every one of them, and since the beginning in the 1970’s, Warren Buffett will always spend considerable time describing insurance matters in each letter. This is because Buffett is the MASTER OF INSURANCE. He is the best ALLOCATOR of insurance premiums to investments in the world – bar none.
In recent years, Warren Buffett has also gone after the casualty and reinsurance market, and he’s made a big splash. He’s betting on hurricanes happening, and tornados, and whether major American cities will get hit by nuclear weapons as a result of terrorists.
Yes we know he puts on a public façade of conservatism, but let me tell you, some of his investments aren’t that conservative. He is nonetheless, the master of making the estimates, allocations, and determining RISK – no one is better.
What about all those investments in COKE, Gillette, Flight Safety, etc
If you look at the Berkshire Hathaway shareholder letters that Warren Buffett writes personally, you will note that the investments the company holds in common stocks is simply a fraction, that’s right a fraction of the company’s net worth. Berkshire Hathaway is so big that it employs hundreds of thousands of people. In addition Buffett has about $100 billion dollars of free cash flow that he can invest from Berkshire’s war chest. You may not realize it but Berkshire is as big as any publicly traded corporate entity out there, and getting bigger all the time.
Buffett as a rule does not invest personally. Everything is done through his investment vehicle Berkshire Hathaway. The man has simplified his life to such an extent that he is probably the only wealthy person in America that DOES HIS OWN TAX RETURN. Everything is under the Berkshire umbrella. If it weren’t, he couldn’t do his own return. There are 900,000 pages to the modern tax code. No one man can do a tax return involving such complexity, unless the transactions were under an umbrella organization. I can assure you that Berkshire’s tax return is several thousand pages long.
Why read Warren Buffett ’s letter to shareholders?
The single hallmark of an absolutely extraordinary mind is the ability to distill major complicated events down to their essence, and make it so simple the rest of us mortals can understand the concept. This is what the Master Investor from Omaha does better than any other living investor.
As you read these shareholder letters we suggest you start with the very first one, and begin to work your way forward to the most recent letter. You will be able to follow the intellectual growth of the man as he becomes better and better at allocating capital. It is a rather remarkable evolution to watch.
This is what we found. Warren Buffett started out as a classic Benjamin Graham style investor. Graham is considered the father of security analysis, and for many years lectured as a Professor at the Graduate School of Business of Columbia University. He is the author of Security Analysis, the classic textbook on the subject still used in many graduate courses today. If you look at our “Book Reviews” section, you will find our thoughts on each of Benjamin Graham’s books.
Graham always wanted to buy dirt cheap. The problem became sometimes you wind up buying DIRT when you use that approach. Nevertheless for decades, Buffett couldn’t bring himself to PAY UP for a stock. This is how he missed Wal-Mart which would have been one of his biggest hits.
Buffett started buying Wal-Mart years before it became enormously popular, but the stock moved up in price very quickly on him, and he stopped buying. There was also a point when Buffett owned about a third of the Walt Disney Corporation, and sold up for a modest profit. Either of those two investments would have made Berkshire Hathaway, and Warren Buffett much wealthier investors than what he did achieve.
What happened next is very interesting. Buffett met up with another investment genius named Charlie Munger, a Harvard trained lawyer who is about a decade older than Buffett and has wielded great influence on Buffett ’s evolution. Charlie Munger believed that you do have to pay up for stocks. He believed that certain stocks that should be owned were never going to be available at a cheap price. You either own them at the price you have to pay, or you never get to ride the train as they say. Munger is now Vice-Chairman of Berkshire Hathaway.
Buffett went for the idea, and in later years we see the Master paying fairly high price earnings ratios to buy whole companies like Flight Safety International, Flex Jet, and Gillette. Buffett in decades past could never have been able to bring himself to make such purchases. It’s all in the letters folks, and you really want to dip into them. They are full of wisdom.
The other vital point about the shareholder letters is that Buffett takes the time to sit down and write them himself in his own hand. Out of the thousands of shareholder letters that are written every year, this may well be the ONLY one that is written by the Chairman himself. Most of them are farmed out to committees, some to public relations firms, but not Buffett , no, no, no.
Buffett takes the time to write what is going on in his own mind. It’s his writing style you are seeing, and his thoughts, as they flow from the greatest investment mind of his century. Many great investors have taken the time to write a book about their lives. J. Paul Getty the billionaire did, as did Phil Fisher, Benjamin Graham, John Neff, Ken Fisher, Jesse Livermore, Barton Biggs, and hedge fund managers, George Soros, Michael Steinhart, and Julian Robinson.
Warren Buffett on the other hand has not taken the time to write a book, and it is a TERRIBLE LOSS for the rest of us. What he has done however is left us his shareholder letters, and each one is a GEM. What I do is make a copy of one from time to time. They usually run about 20 to 30 pages. I underline, circle, paraphrase, and annotate the entire copy. I take the time to make it mine. This is how you get to OWN knowledge. Take advantage of the technique.
You don’t want to leave books and papers in pristine condition. That’s a mistake. You want to make the knowledge that is contained in them YOURS. You do it by getting physically involved with the author’s writing. If you were to look at any book that I read, and I read on average a book a day, you would see hundreds of annotations in every volume. Whole sentences are copied onto the back pages which are normally left blank. Once you own the knowledge you can ACT ON IT. We will leave that for another essay.
In the interim, take the time to read through the shareholder narratives. Using Warren Buffett as a model to copy and replicate his success. Write down the thoughts you find interesting. Find those concepts that you disagree with, or couldn’t possibly make work for you. We are each UNIQUE investors, possessing a unique thumbprint or way of operating that is different from others. It doesn’t make others better or worse, JUST DIFFERENT.
There are areas of commonality. You will find them with Buffett . When you do, acknowledge them to yourself, and see how you can put the ideas into action. In this way, when you do make investments, you will be able to go back whether they were successful or not, and learn from the mistakes. You will also learn from the successes. Good Luck and don’t forget to write, to tell us how you made out.
"The Ideas have been fantastic......."
Former Chairman, Lehman Brothers
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