Rule 1 of investing: Dont lose money
While value investing requires that you make some (well-researched) estimations of intrinsic business value, and it necessarily incurs a slight probability that you may turn out to be wrong, the way to avoid getting too many wrong too much is concentrate and focus on those companies that you are capable of understanding, and not be lured by greed and FOMO.
You only learn who has been swimming naked when the tide goes out – and what we are witnessing at some of our largest financial institutions is an ugly sight.
The Key Principles
Over and over again throughout the years, WB and Charlie Munger had stuck to their guns, and invested only in companies that they can understand, following the 4 key principles, and again, it pays to internalise them:
Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.
Key Principle: Durable Economic Characteristics
While every principle is important, and it's hard to choose which is the most important, or even which one to start with first (one has to start somewhere), the MOAT or durable economic characteristics or favourable long-term economics is an important one to get right. In this letter, WB goes on an extended discussion and explanation of the importance of this critical principle. However, no matter how good a moat is, it doesn't last forever. As the company grows in size and assets, it will become increasingly difficult to maintain the same levels of growth
Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large
portion of their earnings internally at high rates of return.
WB also explains why he doesn't invest in high-tech companies, as these industries by definition are prone to disruption.
Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
In this letter, WB also goes through several different categories of moat. He mentions low-cost producers such as GEICO and Costco, world-wide brands such as Coca-Cola, Gilette, American Express, Mayo Clinic.
Importance of ROE/ROIC
At the end of the day, a pure look at assets/earnings and even growth of assets year-to-year is not a good proxy for the growth of the company. If you use $10M to buy a property which generates 100k a year of rental, is that better or worse than if you use only $5M?
It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.
That doesn't mean such businesses shouldn't be considered, but it just means that it would be super-extraordinary, as you will need to invest money to make money.
Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn
considerably more money in this business ten years from now, but we will invest many billions to make it
The Great, the good and the gruesome
In this discussion, WB tries to classify businesses into 3 different categories. Obviously companies with strong economic characteristics will continue to do exceptionally well, without much more additional capital expenditure, and these are the truly great companies that everyone should try to get in on, as they will continue to generate high rates of returns on capital. Good companies dont necessarily enjoy the same economic barriers to entry, and will require substantial amounts of capital to continue generating good returns - this is not inherently bad, in fact, this is still good, you will still make good money off them, just not as extraordinary as the first category.
To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.
Our objective of course, is to do proper research and "marry" good companies and hold them forever. However, take heart in the fact that you may make many mistakes, and all it takes is a few good ones to "save" your investment returns. As WB quotes a Bobby Bare's song:
I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.
What's important is that we stick to our research and the 4 key principles, invest when we are confident, and you will turn out fine.
True test of performance
While Wall Street may continue to bid up stock prices and deviate from real business economics, WB focuses on the true underlying business and evaluates the companies' performance via a couple of indicators, which follows the 4 key principles, which forms your investment story. Unless the investment story changes drastically, you should stay invested.
The first test is improvement in earnings, with our making due allowance for industry conditions. The second test, more subjective, is whether their “moats” – a metaphor for the superiorities they possess that make life difficult for their competitors – have widened during the year.