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1996 Shareholder Letter

Published on 28 February 1997

· Value Investing

The original 1996 Shareholder letter can be found here (https://www.berkshirehathaway.com/letters/1996.html)

Focus on Intrinsic Value

I know, this is starting to sound a little repetitive, but WB always emphasized the need to focus on Intrinsic Value, rather than any other measures (such as Book Value). Intrinsic value is a topic that has been touched on frequently by WB, and it's important that any value investor who wants to achieve spectacular returns gets a firm grasp on the subject matter - while any two investors may differ on the precise calculation of the intrinsic value, as long as you invest with a margin of safety, the investment should still turn out well.

I have repeatedly told you, what counts at Berkshire is intrinsic value, not book value.

Patience required

Again, WB advocates waiting for the market to give you a discount, rather than trying to be active for the sake of deploying your capital. As individual investors, there's really no hurry, and no need to chase after returns the way professional fund managers do.

Inactivity strikes us as intelligent behavior.

The philosophy that you should have, is to buy good businesses at a fair price, rather than trying to capitalize on any small or big market movement, or because some market analyst said something. Again, think like a business owner, and if your business is doing well, why would you want to sell it?

you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.

Portfolio Rebalancing

A lot of "professionals" will advocate that you rebalance your portfolio periodically, trimming those companies that have grown in size (and are maybe outsized in your portfolio) and adding on to those that have shrunk. This rebalancing philosophy is linked to the Dollar Cost Averaging mindset. From another perspective, if the "outsized" companies in your portfolio have become outsized because they have grown tremendously and have done superbly well, why would you want to sell some of their stock to buy companies that have not done so well?

To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.

Invest in things that are predictable

One of the first principles that we adhere to, is buying into companies that we can understand and will be able to understand. The principles doesn't really need to be followed in any particular order, or rather, you can start with any principle first, but the other, equally important principle, is that the company must have durable economic characteristics, which will give us confidence in how it will perform in the next decade. For this to be true, you must both understand the industry/company AND be convinced that it will not change much.

you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.

One major difficulty with this approach is that most of us, in our daily lives, crave innovative new products, and we're always looking for change, transformation, innovation: but in investing, our returns are highly dependent on our ability to predict the future in some way, and the easiest way to do that, is to focus on businesses in industries that's unlikely to change.

I should emphasize that, as citizens, Charlie and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country's standard of living to rise, and that's clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride.

Again, this is hard, and perhaps precisely the reason why Berkshire has lagged the S&P500 in the last decade (2010 - 2020). This is actually, quite an emotional topic, as many investors (including me) are simultaneously trying to get a "sure thing" and trying to avoid missing out on the next great thing.

Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables. But I would rather be certain of a good result than hopeful of a great one.

Invest in your circle of competence

Again and again, we all must remember the key mantra, which is to think like a business owner, and just like all owners, we must understand the business and the competitive market that it is in, well. Invest in a company that's easy to understand, and that you understand. When you have a sufficiently high level of understanding, then you will be much better placed to predict its business trajectory for the next 10 years.

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.

This is a particularly important lesson. Later down in the letter, WB summarises the entire philosophy in value-investing, as well as the important mindsets required in investing.

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.

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