The Open Curriculum

The Market · Level 2

The Essays of Warren Buffett

Warren Buffett (ed. Lawrence A. Cunningham) · 1997

Thesis

Investing well and running a company well rest on the same discipline: treat a stock as part ownership of a business, value the business by the cash it can produce over its life, buy only within what you understand and only at a sensible price, and let managers and shareholders act as partners rather than as rivals.

The main ideas

Owners and partners

Lawrence Cunningham's collection arranges Warren Buffett's letters to Berkshire Hathaway shareholders by theme instead of by year. It opens with the owner-related business principles Buffett first set down in 1983 and later issued as an owner's manual. The first reads: "Although our form is corporate, our attitude is partnership."

The principle shapes everything else in the book. Buffett and Charlie Munger think of shareholders as co-owners and of themselves as managing partners. They aim to report to shareholders the facts they would want if their positions were reversed, to avoid issuing shares at less than they are worth, and to judge the company by the progress of its intrinsic value per share, not by its size or its stock price.

The mechanism is alignment. Managers who think of themselves as partners act like owners, with their own money at stake, rather than as employees who benefit from growth for its own sake.

Implication: as an investor, ask whether a company's managers treat shareholders as partners, in how they report, pay themselves and use the company's capital. As a manager, report to owners what you would want to know in their place.

Mr. Market

In his 1987 letter, Buffett passes on Benjamin Graham's image of the market as a partner, Mr. Market, who every day offers to buy your interest or sell you his, at a price that swings with his moods. "Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful."

The same reasoning drives Buffett's best-known line, from his 1986 letter: "we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." Prices are set by crowds whose moods overshoot in both directions, so the best opportunities come when others are most frightened.

The mechanism is that market prices reflect emotion as well as value. An investor who judges by value can use the emotion of others rather than share it.

Implication: let the business, not the stock price, tell you how your investment is doing. Treat periods of widespread fear as times to look for bargains, and widespread enthusiasm as a reason for caution.

Intrinsic value

Buffett defines intrinsic value as "the discounted value of the cash that can be taken out of a business during its remaining life." It cannot be calculated precisely, but it is the only figure that measures what a business is worth. Book value, what has been put into the business, is a poor guide. His example, in the 1994 letter, is Scott Fetzer, which Berkshire bought for $315.2 million when its book value was $172.6 million; the company's intrinsic value far exceeded its book value because of what it could earn on that capital.

In his 1986 letter, he defines owner earnings, the cash figure that matters to owners: reported earnings plus depreciation and similar non-cash charges, minus the average capital spending the business needs to maintain its competitive position and its unit volume. Reported earnings can overstate or understate this, depending on how much reinvestment the business requires just to stand still.

The mechanism is that owners can only spend cash, and a business that must reinvest most of its earnings to keep its position is worth less than its reported profits suggest.

Implication: value a business by the cash it can return to owners over time, after the spending needed to sustain it, not by book value or headline earnings.

Wonderful businesses

Buffett's 1989 letter contains a section titled "Mistakes of the First Twenty-five Years." The first, he says, was buying control of Berkshire itself, a textile manufacturer whose business he knew to be unpromising, because the price looked cheap. He calls this cigar-butt investing: buying a poor business so cheaply that one last puff of profit remains. The trouble is that time is the friend of the wonderful business and the enemy of the mediocre one. His conclusion: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner."

What makes a business wonderful is a durable advantage. In his 2007 letter he wrote that a truly great business must have an enduring "moat" that protects its excellent returns on capital, because competitors will repeatedly assault any business castle that earns high returns.

The mechanism is compounding. A business that earns high returns on its capital and can reinvest them grows more valuable every year; a poor business, however cheaply bought, erodes.

Implication: prefer businesses with lasting competitive advantages and high returns on capital, even at a fair price, over poor businesses at a low one.

Circles of competence and index funds

In his 1996 letter, Buffett writes: "You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital."

For investors who cannot or will not evaluate businesses at all, he recommends the opposite of stock picking. In the 1993 letter he argued that an investor who buys an index fund regularly over time can outperform most investment professionals, and that when such dumb money acknowledges its limitations, it ceases to be dumb. In 1996 he wrote that most investors, institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.

The mechanism is that losses come mainly from acting outside what one understands. Admitting the limits of one's knowledge, and choosing a method that does not depend on knowledge one lacks, avoids them.

Implication: invest actively only in businesses you can evaluate. For everything else, or if you cannot evaluate businesses at all, own a low-cost index fund.

Accounting and capital

Several sections deal with how accounting and capital decisions can mislead shareholders. In his 1992 letter, Buffett attacks the treatment of stock options. If options are a form of compensation, he argues, they are an expense, and expenses belong in the calculation of earnings; excluding them overstates profits.

On share repurchases, he takes the same owner's view. In 1984 he wrote that when a company's shares sell well below intrinsic value, no alternative action can benefit shareholders as surely as repurchases. But in 1999 he warned that continuing shareholders are penalized by repurchases above intrinsic value. In 2011 he set two conditions: the company must have ample funds for its operations, and the stock must sell at a material discount to its intrinsic business value, conservatively calculated.

The mechanism is that the effect of any capital decision depends on price relative to value, not on the action itself.

Implication: read beyond reported earnings to the costs they exclude, and judge buybacks and acquisitions by whether the price paid is below what is received.

Limits

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