The Single Most Important Indicator (AGAIN)
Immediately in the first paragraph, Warren Buffet repeats his emphasis on the most important indicator - the return on beginning equity capital (with securities valued at cost), and adds a caveat: that understanding this indicator requires "an understanding of many factors, including accounting policies, historical carrying values of assets, financial leverage, and industry conditions". This means that when we try to beat the market/benchmark through value-investing, we really need to understand the company that we're buying --- and that includes understanding the surrounding universe - finance and accounting policies, industry overall, debt levels etc.
Pragmatism - The WB Way
This particular shareholder letter published 38 years ago is full of pragmatic advice. As emphasised in previous posts, value-investing involves a high level of discipline, logical and rational thinking, and not being caught up in the hype and excesses of the day. This letter has several reminders:
(A) Focus on behaviour, not just on intent: While an important factor in our investing consideration is whether the management has the shareholders' interests at heart, whether they are good at what they do etc; what REALLY matters is what they actually do (or their track record of what they do). This is why its so important to spend a couple of hours annually to keep track of any EVENTS in the company, simply because management may change, or they may suddenly take out-of-norm actions. At the end of the day, whether your invested company will continue to thrive, will largely depend on the things that the management actually executes on, rather than who the management is.
(B) Your investment must beat inflation. Period: Again, a very fundamental truth when it comes to investing. At the end of the day (or at the end of our lives), our investments must glean actual, real, tangible returns for us; but not just in terms of numerical dollars, but in our quality of life. For example, if your investment of $10,000 becomes $26,532 in 20 years, but inflation has been around 5% annually, then essentially you have not made any real money from investing. (Warren Buffet makes additional points on the effect of income tax which doesn't quite apply to Singapore).
You may feel richer, but you won’t eat richer.
(C) Management's skill cannot beat the general business/industry: Warren Buffet reminds us that there are many who will profess that they can "turn it around" or "revive a nearly-dead horse", but in general, these are difficult to pull-off and in the vast majority of cases, doesn't work.
Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.
(A) Repurchase of shares / Share buy-back: Again, in the 12th paragraph, Warren Buffet re-emphasises his belief that he particularly likes companies who repurchases their own shares. It's useful to read it in its entirety here:
One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price?
(B) Auction nature of markets: In the same paragraph, and this is worth repeating, Warren Buffet repeats the fundamental truth of the markets: the market functions like an auction. While typical M&A activity requires a payment-in-full of the intrinsic value of the acquired business, sometimes it's possible to get bargains in the open market.
The competitive nature of corporate acquisition activity almost
guarantees the payment of a full - frequently more than full
price when a company buys the entire ownership of another
enterprise. But the auction nature of security markets often
allows finely-run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise.
(C) Value-investing works... eventually: Worth noting again, that while markets may be volatile (that's why we can find bargains), and are not inefficient in the long run, eventually, the market price will match the intrinsic value of the company - just as long as you buy at an "attractive price".
... when purchase prices are sensible, some long-term market recognition of the accumulation of retained earnings almost certainly will occur
(D) We want to make money; we can still keep our soul: In the last section of the letter, Warren Buffet shares his testimony of one of his "employees": Gene Abegg. It's worth reading, because in business, it's sometimes easy to start thinking that it's a "dog-eat-dog" world, and that everyone's out to make money at the expense of everyone else. This last section's worth reading because there are good talent out there who can make money; and be a decent human being at the same time.