Two investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we cover the 1997 letter.
In the 1996 shareholder letter, Buffett wrote that investment students need only two courses: How to Value a Business and How to Think About Market Prices. In the 1997 letter, Buffett included a section on market fluctuations, which is definitely worth considering.
How Berkshire thinks about market fluctuations
If you are a consumer and not a producer, it is obvious you want lower prices for the things you want to consume. Buffett gives the example of hamburgers and cars as an analogy.
Buffett then asked if you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? He said many investors get the answer wrong. Investors become elated when stock prices rise and depressed when they fall. This is equivalent to hoping for higher hamburger prices when you are the buyer of them and, therefore, does not make sense. Only those who will be sellers of stocks in the near future should be happy at seeing stocks rise, otherwise, Buffett said, prospective purchasers “should much prefer sinking prices.”
When it comes to Berkshire, Buffett noted the company “saves” for its investors by retaining all the earnings. These savings are used to buy businesses and securities. It follows then that the more cheaply the conglomerate make these acquisitions, the more profitable its owners' indirect savings program will be.
The Oracle of Omaha also reminded readers that many of Berkshire’s investments are major positions in companies that consistently repurchase their shares, which means falling prices offer greater benefits. He wrote:
"When stock prices are low, the funds that an investee spends on repurchases increase our ownership of that company by a greater amount than is the case when prices are higher…. At the end of every year, about 97% of Berkshire's shares are held by the same investors who owned them at the start of the year. That makes them savers. They should therefore rejoice when markets decline and allow both us and our investees to deploy funds more advantageously."
So instead of feeling loss when markets fall, Buffett is saying long-term investors are gaining by getting the opportunity to buy more investments cheaply. People often forget the truism that there is a buyer for every seller and what hurts one necessarily helps the other. He then used a golf analogy to better emphasize his point: "Every putt makes someone happy."
Buffett said Berkshire gained enormously from the low prices placed on many equities and businesses in the 1970s and 1980s, writing:
"Markets that then were hostile to investment transients were friendly to those taking up permanent residence. In recent years, the actions we took in those decades have been validated, but we have found few new opportunities."
Ben Graham’s margin of safety
The guru noted that Berkshire does not attempt to predict the movements of the stock market, but it does try, “in a very rough way,” to value it. Buffett wrote:
"At the annual meeting last year, with the Dow at 7,071 and long-term Treasury yields at 6.89%, Charlie and I stated that we did not consider the market overvalued if 1) interest rates remained where they were or fell, and 2) American business continued to earn the remarkable returns on equity that it had recently recorded. So far, interest rates have fallen -- that's one requisite satisfied -- and returns on equity still remain exceptionally high. If they stay there -- and if interest rates hold near recent levels -- there is no reason to think of stocks as generally overvalued. On the other hand, returns on equity are not a sure thing to remain at, or even near, their present levels."
In the summer of 1979, Buffett wrote a Forbes article entitled "You pay a very high price in the stock market for a cheery consensus." Buffett’s point out in that article that investors should take advantage of the pessimism which had driven down stock prices to “truly attractive levels.” Fast forward to 1997 and Buffett wrote in his letter that there is a “a very cheery consensus.” He said:
"That does not necessarily mean this is the wrong time to buy stocks: Corporate America is now earning far more money than it was just a few years ago, and in the presence of lower interest rates, every dollar of earnings becomes more valuable. Today's price levels, though, have materially eroded the 'margin of safety' that Ben Graham identified as the cornerstone of intelligent investing."
Coca-Cola’s Roberto Goizueta
In the 1996 letter, Buffett wrote about Coca-Cola (KO, Financial) and how the company had continued to increase its market dominance throughout the world thanks to the management of CEO Roberto Goizueta, who had been in charge since 1981. Goizueta died in October 1997. Buffett wrote that after his death, he read every one of the more than 100 letters and notes Goizueta had written him over the past nine years.
"Those messages could well serve as a guidebook for success in both business and life. In these communications, Roberto displayed a brilliant and clear strategic vision that was always aimed at advancing the well-being of Coke shareholders. Roberto knew where he was leading the company, how he was going to get there, and why this path made the most sense for his owners -- and, equally important, he had a burning sense of urgency about reaching his goals. An excerpt from one handwritten note he sent to me illustrates his mind-set: 'By the way, I have told Olguita [Goizueta’s wife] that what she refers to as an obsession, you call focus. I like your term much better.'"
Buffett praised Goizueta for having “prepared for a seamless succession long before it seemed necessary” and that because of this, Coca-Cola “will be the same steamroller under Doug [Ivester – Coke’s new leader] as it was under Roberto.”
