Reminder of Key Principles
Almost every year, WB will remind everyone of the core principles in investing that he has adhered to, for the last few decades. 1994 is no different. In addition, for many years now, he has consistently warned shareholders that due to their size, it's getting increasingly harder to generate the same level of returns as in the past. However, his "formula" for making good investments still stand, and he still believes in it.
we believe that our formula - the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people - is certain to produce reasonable success.
Further down in the letter, he restates it again
Our goal will be to acquire either part or all of businesses that we believe we understand, that have good, sustainable underlying economics, and that are run by managers whom we like, admire and trust.
And again, later down in the letter,
Our investments continue to be few in number and simple in concept: The truly big investment idea can usually be explained in a short paragraph. We like a business with enduring competitive advantages that is run by able and owner-oriented people. When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong (a challenge we periodically manage to overcome).
1st Principle: Buy only businesses that you understand
WB also emphasizes that they will only buy businesses that they understand (and can understand). For most of us, the first important question to answer is whether you can understand the company (and the industry) that it is. Without this understanding, it will be difficult to predict and estimate how well the company will do in the future. In investing, we are not trying to challenge ourselves by researching difficult and complicated companies, that has no additional advantages, and introduces new variables that you, too, have to get right.
Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.
Size affects returns
Again, and again, WB reminds shareholders that they are a victim of their own success, that as Berkshire gets bigger (compounding at >20% a year will do that to you in no time), it gets more and more difficult to find investments that will make a dent in their returns, as the investment size will need to be big. The converse is probably true: the smaller you are, the bigger the investment universe is for you, the higher the probability that you can find a reasonable investment.
A fat wallet, however, is the enemy of superior investment results.
Patience is key
As we need to wait for the right pitch, for the right price to be offered to us, we may spend many months just waiting. But this is definitely the correct attitude to have in value-investing, that patience is key, and that you need to wait for the right deal at the right price to come along.
Ted Williams, in The Story of My Life, explains why: "My argument is, to be a good hitter, you've got to get a good ball to hit. It's the first rule in the book. If I have to bite at stuff that is out of my happy zone, I'm not a .344 hitter. I might only be a .250 hitter." Charlie and I agree and will try to wait for opportunities that are well within our own "happy zone."
Market Events gives you deals - dont run away
For the right pitch to appear, there must be some event that affects stock prices, or create temporary economic conditions such that the stock prices take a dive. It is vitally important to have a strong understanding of the business and the industry, and to be convinced of your "investment story" when it comes to the crunch.
Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.
Focus on Intrinsic Value
Consistently throughout the letters, WB focuses on Intrinsic Value, and again here in this letter, he lays out the definition as well as the caveats
We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
4th Principle: Buying at a sensible Price
The first 3 principles have both qualitative and quantitative aspects that you can look at, but the 4th principle is a pure mathematical one: Once you have established that the intrinsic value of the business is $X, how much should you buy it for?
We try to price, rather than time, purchases. In our view, it
is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess?