Two value investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about value 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 go over the 1987 letter.
Business analysts
Given that Benjamin Graham’s most famous book is called "Security Analysis," it is interesting that in this shareholder letter, Buffett says of his investing: “We view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts.”
Mr. Market
The 1987 letter discusses at length some of Graham’s teachings, for instance:
"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.'"
Given academic financial theory had advanced a lot by 1987 on the back of options pricing, Buffett said it might seem the Mr. Market allegory is out of date. But Buffett has no time for all these new-fangled techniques, writing, “After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins?'”
Rather, Buffett felt “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.” He then went on to say he found it highly useful to keep the Mr. Market concept firmly in mind.
Intrinsic value
This means Berkshire does not pay much attention to price quotes for its holdings. Instead, the guru focuses on the operating results. The market may ignore business success for a while, but eventually will confirm it. As Graham said, "In the short run, the market is a voting machine but in the long run it is a weighing machine." He does not worry about the speed at which a business' success is recognized, so long as the company's intrinsic value is growing nicely. If the market does not recognize the value, Buffett is happy that he has the chance to “buy more of a good thing at a bargain price.”
When the flip side is true, and the market is too optimistic, that is the time when Buffett looks to sell. Another point he made is that investors should not look at intrinsic value in isolation. When funds are limited, you want to invest in the stocks that show the most intrinsic value, which means you might need to push out stocks that are valued fairly or even are showing some intrinsic value. This means we should always be searching for intrinsic value so that we can, over the long term, capture the most upside. Another one of Buffett’s reasons to buy or sell stocks is that you want to own businesses that you understand, so if you understand something better, and it has intrinsic value, that is the ideal combination. Hence, Buffett called himself a “business analyst.”
He also reminded readers they should not sell just because something has gone up, noting, "Of Wall Street maxims, the most foolish may be 'You can't go broke taking a profit.'"
Many people make this mistake, but logic dictates the saying is truly foolish.
Interestingly, however, Buffett said:
"Three marketable common stocks that we would not sell even though they became far overpriced in the market. In effect, we view these investments exactly like our successful controlled businesses - a permanent part of Berkshire rather than merchandise to be disposed of once Mr. Market offers us a sufficiently high price. To that, I will add one qualifier: These stocks are held by our insurance companies and we would, if absolutely necessary, sell portions of our holdings to pay extraordinary insurance losses. We intend, however, to manage our affairs so that sales are never required."
Those stocks in 1987 were Capital Cities/ABC Inc., GEICO Corp. and The Washington Post Co.
Relationships
The reason, Buffett said, is because this position "fits our personalities and the way we want to live our lives… …we would rather achieve a return of X while associating with people whom we strongly like and admire than realize 110% of X by exchanging these relationships for uninteresting or unpleasant ones.”
So even Buffett and Charlie Munger (Trades, Portfolio) occasionally held good stocks simply because they wanted to.
