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Five pearls of wisdom from Warren Buffett

FE Trustnet picks the highlights from the legendary investor’s annual letter to shareholders of Berkshire Hathaway.

Joshua Ausden

By Joshua Ausden, News Editor, FE Trustnet
Tuesday March 05, 2013

For only the ninth time in 48 years, Warren Buffett’s Berkshire Hathaway underperformed the S&P 500 in 2012.

ALT_TAG The company grew by 14.4 per cent – or $22.8bn – over the 12-month period, just a touch below the 15.22 per cent gain of the index in dollar terms.

Most investors would be pretty happy with this gain, but such are the standards of the legendary investor that Buffett (pictured) dismissed the performance as "sub-par".

He is sticking by the principles that have served him well though, lessons that not only chairmen of multi-national companies should take heed of, but the everyday private investor as well.

Here are five such lessons FE Trustnet picked out from Buffett’s annual letter to shareholders last week:

You’ve got to be in it to win it

While Buffett is in many ways a defensive investor, in that he tends to deliver his strongest performance during tough times, he is an optimist over the long-term.

He says one of the biggest mistakes investors can make is listening to short-term noise and trying to time the stock market.

"American business will do fine over time and stocks will do well just as certainly, since their fate is tied to business performance," he said.

"Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favour," he said.

"The Dow Jones Industrials advanced from 66 to 11,497 in the 20th century, a staggering 17,320 per cent increase that materialized despite four costly wars, a Great Depression and many recessions. And don’t forget that shareholders received substantial dividends throughout the century as well."

"Since the basic game is so favourable, Charlie [Munger, Berkshire Hathaway vice chairman] and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts', or the ebb and flow of business activity."

"The risks of being out of the game are huge compared to the risks of being in it."

Never chase returns

Even the great man is capable of making mistakes, which he says usually happens when he allows emotion to get in the way.

"We ask the managers of our subsidiaries to unendingly focus on moat-widening opportunities, and they find many that make economic sense – but sometimes our managers misfire," he said.

"The usual cause of failure is that they start with the answer they want and then work backwards to find a supporting rationale. Of course, the process is subconscious; that’s what makes it so dangerous."

"Your chairman has not been free of this sin. In Berkshire’s 1986 annual report, I described how 20 years of management effort and capital improvements in our original textile business were an exercise in futility."

"I wanted the business to succeed and wished my way into a series of bad decisions. I even bought another New England textile company. But wishing makes dreams come true only in Disney movies; it’s poison in business."

Don’t get obsessed with valuations

Buying low and selling high is at the very heart of every investment decision, but Buffett says putting too much emphasis on value can be very dangerous.

"More than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price," he explained.

"Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain-hunting, with results ranging from tolerable to terrible."

"Fortunately, my mistakes have usually occurred when I made smaller purchases. Our large acquisitions have generally worked out well and, in a few cases, more than well."

Equally, Buffett says paying too much for a good company can also be a bad investment, but believes prioritising quality tends to reward the investor in the long-run.

"Of course, a business with terrific economics can be a bad investment if the price paid is excessive," he explained.

"We have paid substantial premiums to net tangible assets for most of our businesses, a cost that is reflected in the large figure we show for intangible assets."

"Overall, however, we are getting a decent return on the capital we have deployed."

This may make interesting reading for investors looking to snap up high discounts in the investment trust sector.

Balance sheets are everything

Buffett operates with very little debt and sees healthy, growing balance sheets as the key to long-term success.

This, he says, is in part why Berkshire Hathaway underperformed last year.

"In years when the market is particularly strong, expect us to fall short," he said. "We do better when the wind is in our face."

"One thing of which you can be certain: whatever Berkshire’s results, I will not change yardsticks."

"It’s our job to increase intrinsic business value – for which we use book value as a significantly understated proxy – at a faster rate than the market gains of the S&P."

"If we do so, Berkshire’s share price, though unpredictable from year to year, will itself outpace the S&P over time."

"If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund."

Dividends are not the be-all and end-all

While the ability to pay dividends is often used as a measure to gauge the strength of a company, Berkshire Hathaway – one of the world’s largest public companies – does not have a policy.

Buffett has nothing against companies that pay a dividend and indeed invests in many himself. However, he does not think investors should view dividends as the be-all and end-all.

Buffett suggests not paying dividends is preferable for both shareholders and the firm, as it gives the company the flexibility to invest and grow as it sees fit – something that benefits both parties.

He says investors looking for a regular income should instead sell shares, in what he calls a "sell-off alternative".

This, he says, gives them greater flexibility than relying on a dividend.

"Aside from the favourable math, dividends impose a specific cash-out policy upon all shareholders," he explained. "If, say, 40 per cent of earnings is the policy, those who wish 30 per cent or 50 per cent will be thwarted."

"The sell-off alternative, on that other hand, lets each shareholder make his own choice between cash receipts and capital build-up."

He also says there are tax advantages of this sell-off approach.

"Under the dividend program, all of the cash received by shareholders each year is taxed, whereas the sell-off program results in tax on only the gain portion of the cash receipts," he explained.

Whether or not a company pays a dividend, Buffett says the key is to understand why the company chooses to pay dividends and vice versa.

"Above all, dividend policy should always be clear, consistent and rational," he said. "A capricious policy will confuse owners and drive away would-be investors."

"Most companies pay consistent dividends, generally trying to increase them annually and cutting them very reluctantly."

"Our 'big four' companies [American Express, Coca-Cola, IBM and Wells Fargo] follow this sensible and understandable approach and, in certain cases, also repurchase shares quite aggressively."

"We applaud their actions and hope they continue on their present paths. We like increased dividends, and we love repurchases at appropriate prices."

"At Berkshire, however, we have consistently followed a different approach that we know has been sensible and [understandable]."

"We will stick with this policy as long as we believe our assumptions about the book-value buildup and the market-price premium seem reasonable. If the prospects for either factor change materially for the worse, we will re-examine our actions," he added.

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Data provided by FE. Care has been taken to ensure that the information is correct, but FE neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.

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