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2005 Shareholder Letter

Published on 28 February 2006

· Value Investing

Focus on Intrinsic Value

At the risk of sounding repetitive, it's important for everyone to at least learn the foundations of estimating Intrinsic Value of a company, specifically intrinsic value per share. When intrinsic value per share of a company falls below the market price of a share in the stock market, it's undervalued. If you want to have a good "margin of safety", you can calculate how much it is undervalued, but only if you have an Intrinsic Value to benchmark against. However, intrinsic value calculations are, almost by design, inaccurate and imprecise, but it's your best bet at a "true north".

I say “estimate” because calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base.

Key Principle: Widen the moat

One of the 4 key principles of value-investing is "durable economic characteristics", what many refer to as the Moat. Just like a castle uses a moat to protect itself, good and enduring companies will also have some kind of protective barrier around its business: it could be Branding, Low-cost, Network etc. Everytime we evaluate a company, we must continually re-evaluate the probability of its moat being intact in the next 10 years (whether it will become obsolete by new developments) or even better, whether its moat will widen.

If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though,
their consequences are enormous. When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence.

Common Sense: Stock Price should be related to Earnings

It's important to separate what's hype, what's conjecture versus what's real and what's truth. Too many people tend to judge whether the stock price will go up or not based not on objective business indicators like cashflow and earnings, but on whether everyone else is buying it or dumping it. Trying to predict how the stock price moves based on factors that has nothing to do with the business is foolhardy and unlikely to pan out in the long term. As investor (especially as a value-investor), is it possible for you to consistently make more money than your portfolio companies?

...the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn.
True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth
from their companies beyond that created by the companies themselves.

Friction erodes returns

In this letter, WB gave a rather interesting story of how the burgeoning industry of "advisors" have eroded returns for many many investors: the story of the family of gotrocks. It's a useful story to read and understand, but basically be very careful when the very person who benefits from your investment activity, is encouraging more activity. A good read.

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