“Investment is most intelligent when it is most business like.” -Benjamin Graham, The Intelligent Investor.
It is fitting to have a Ben Graham quote open this essay because I owe
so much of what I know about investing to him. I will talk more about
Ben a bit later and I will even sooner talk about common stocks. But let
me first tell you about two small nonstock investments that I made long
ago. Though neither changed my net worth by much, they are instructive.
Two small nonstock investments
This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced
an explosion in farm prices, caused by a widespread belief that runaway
inflation was coming and fuelled by the lending policies of small rural
banks. Then the bubble burst, bringing price declines of 50 percent or
more that devastated both leveraged farmers and their lenders. Five
times as many Iowa and Nebraska banks failed in that bubble’s aftermath
as in our recent Great Recession.
In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha,
from the FDIC. It cost me US $ 280,000, considerably less than what a
failed bank had lent against the farm a few years earlier. I knew
nothing about operating a farm. But I have a son who loves farming, and I
learned from him both how many bushels of corn and soybeans the farm
would produce and what the operating expenses would be. From these
estimates, I calculated the normalized return from the farm to then be
about 10 percent. I also thought it was likely that productivity would
improve over time and that crop prices would move higher as well. Both
expectations proved out.
I needed no unusual knowledge or intelligence to conclude that the
investment had no downside and potentially had substantial upside. There
would, of course, be the occasional bad crop, and prices would
sometimes disappoint. But so what? There would be some unusually good
years as well, and I would never be under any pressure to sell the
property. Now, 28 years later, the farm has tripled its earnings and is
worth five times or more what I paid. I still know nothing about farming
and recently made just my second visit to the farm.
In 1993, I made another small investment. Larry Silverstein, Salomon’s
landlord when I was the company’s CEO, told me about a New York retail
property adjacent to New York University that the Resolution Trust Corp.
was selling. Again, a bubble had popped -- this one involving
commercial real estate -- and the RTC had been created to dispose of the
assets of failed savings institutions whose optimistic lending
practices had fuelled the folly.
Here, too, the analysis was simple. As had been the case with the farm,
the unleveraged current yield from the property was about 10 percent.
But the property had been undermanaged by the RTC, and its income would
increase when several vacant stores were leased. Even more important,
the largest tenant -- who occupied around 20 percent of the project’s
space -- was paying rent of about US $ 5 per foot, whereas other tenants
averaged US $ 70. The expiration of this bargain lease in nine years
was certain to provide a major boost to earnings. The property’s
location was also superb: NYU wasn’t going anywhere.
I joined a small group -- including Larry and my friend Fred Rose -- in
purchasing the building. Fred was an experienced, high-grade real estate
investor who, with his family, would manage the property. And manage it
they did. As old leases expired, earnings tripled. Annual distributions
now exceed 35 percent of our initial equity investment. Moreover, our
original mortgage was refinanced in 1996 and again in 1999, moves that
allowed several special distributions totalling more than 150 percent of
what we had invested. I’ve yet to view the property.
Income from both the farm and the NYU real estate will probably increase
in decades to come. Though the gains won’t be dramatic, the two
investments will be solid and satisfactory holdings for my lifetime and,
subsequently, for my children and grandchildren.
“You don’t need to be an expert in order to achieve satisfactory investment returns”
I tell these tales to illustrate certain fundamentals of investing:
You don’t need to be an expert in order to achieve satisfactory
investment returns. But if you aren’t, you must recognize your
limitations and follow a course certain to work reasonably well. Keep
things simple and don’t swing for the fences. When promised quick
profits, respond with a quick “no.”
Focus on the future productivity of the asset you are considering. If
you don’t feel comfortable making a rough estimate of the asset’s future
earnings, just forget it and move on. No one has the ability to
evaluate every investment possibility. But omniscience isn’t necessary;
you only need to understand the actions you undertake.
If you instead focus on the prospective price change of a contemplated
purchase, you are speculating. There is nothing improper about that. I
know, however, that I am unable to speculate successfully, and I am
sceptical of those who claim sustained success at doing so. Half of all
coin-flippers will win their first toss; none of those winners has an
expectation of profit if he continues to play the game. And the fact
that a given asset has appreciated in the recent past is never a reason
to buy it.
With my two small investments, I thought only of what the properties
would produce and cared not at all about their daily valuations. Games
are won by players who focus on the playing field -- not by those whose
eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays
without looking at stock prices, give it a try on weekdays.
Forming macro opinions or listening to the macro or market predictions
of others is a waste of time. Indeed, it is dangerous because it may
blur your vision of the facts that are truly important. (When I hear TV
commentators glibly opine on what the market will do next, I am reminded
of Mickey Mantle’s scathing comment: “You don’t know how easy this game
is until you get into that broadcasting booth.”)
My two purchases were made in 1986 and 1993. What the economy, interest
rates, or the stock market might do in the years immediately following
-- 1987 and 1994 -- was of no importance to me in determining the
success of those investments. I can’t remember what the headlines or
pundits were saying at the time. Whatever the chatter, corn would keep
growing in Nebraska and students would flock to NYU.
There is one major difference between my two small investments and an
investment in stocks. Stocks provide you minute-to-minute valuations for
your holdings, whereas I have yet to see a quotation for either my farm
or the New York real estate.
“A climate of fear is your friend when investing; a euphoric world is your enemy”
It should be an enormous advantage for investors in stocks to have those
wildly fluctuating valuations placed on their holdings -- and for some
investors, it is. After all, if a moody fellow with a farm bordering my
property yelled out a price every day to me at which he would either buy
my farm or sell me his -- and those prices varied widely over short
periods of time depending on his mental state -- how in the world could I
be other than benefited by his erratic behaviour? If his daily
shout-out was ridiculously low, and I had some spare cash, I would buy
his farm. If the number he yelled was absurdly high, I could either sell
to him or just go on farming.
Owners of stocks, however, too often let the capricious and irrational
behaviour of their fellow owners cause them to behave irrationally as
well. Because there is so much chatter about markets, the economy,
interest rates, price behaviour of stocks, etc., some investors believe
it is important to listen to pundits -- and, worse yet, important to
consider acting upon their comments.
Those people who can sit quietly for decades when they own a farm or
apartment house too often become frenetic when they are exposed to a
stream of stock quotations and accompanying commentators delivering an
implied message of “Don’t just sit there -- do something.” For these
investors, liquidity is transformed from the unqualified benefit it
should be to a curse.
A “flash crash” or some other extreme market fluctuation can’t hurt an
investor any more than an erratic and mouthy neighbour can hurt my farm
investment. Indeed, tumbling markets can be helpful to the true investor
if he has cash available when prices get far out of line with values. A
climate of fear is your friend when investing; a euphoric world is your
enemy.
During the extraordinary financial panic that occurred late in 2008, I
never gave a thought to selling my farm or New York real estate, even
though a severe recession was clearly brewing. And if I had owned 100
percent of a solid business with good long-term prospects, it would have
been foolish for me to even consider dumping it. So why would I have
sold my stocks that were small participations in wonderful businesses?
True, any one of them might eventually disappoint, but as a group they
were certain to do well. Could anyone really believe the earth was going
to swallow up the incredible productive assets and unlimited human
ingenuity existing in America?
When Charlie Munger and I buy stocks -- which we think of as small
portions of businesses -- our analysis is very similar to that which we
use in buying entire businesses. We first have to decide whether we can
sensibly estimate an earnings range for five years out or more. If the
answer is yes, we will buy the stock (or business) if it sells at a
reasonable price in relation to the bottom boundary of our estimate. If,
however, we lack the ability to estimate future earnings -- which is
usually the case -- we simply move on to other prospects. In the 54
years we have worked together, we have never forgone an attractive
purchase because of the macro or political environment, or the views of
other people. In fact, these subjects never come up when we make
decisions.
“Ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm”
It’s vital, however, that we recognize the perimeter of our “circle of
competence” and stay well inside of it. Even then, we will make some
mistakes, both with stocks and businesses. But they will not be the
disasters that occur, for example, when a long-rising market induces
purchases that are based on anticipated price behaviour and a desire to
be where the action is.
Most investors, of course, have not made the study of business prospects
a priority in their lives. If wise, they will conclude that they do not
know enough about specific businesses to predict their future earning
power.
I have good news for these nonprofessionals: The typical investor
doesn’t need this skill. In aggregate, American business has done
wonderfully over time and will continue to do so (though, most
assuredly, in unpredictable fits and starts). In the 20th century, the
Dow Jones industrial index advanced from 66 to 11,497, paying a rising
stream of dividends to boot. The 21st century will witness further
gains, almost certain to be substantial. The goal of the nonprofessional
should not be to pick winners -- neither he nor his “helpers” can do
that -- but should rather be to own a cross section of businesses that
in aggregate are bound to do well. A low-cost S&P 500 index fund
will achieve this goal.
That’s the “what” of investing for the nonprofessional. The “when” is
also important. The main danger is that the timid or beginning investor
will enter the market at a time of extreme exuberance and then become
disillusioned when paper losses occur. (Remember the late Barton Biggs’s
observation: “A bull market is like sex. It feels best just before it
ends.”) The antidote to that kind of mistiming is for an investor to
accumulate shares over a long period and never sell when the news is bad
and stocks are well off their highs. Following those rules, the
“know-nothing” investor who both diversifies and keeps his costs minimal
is virtually certain to get satisfactory results. Indeed, the
unsophisticated investor who is realistic about his shortcomings is
likely to obtain better long-term results than the knowledgeable
professional who is blind to even a single weakness.
If “investors” frenetically bought and sold farmland to one another,
neither the yields nor the prices of their crops would be increased. The
only consequence of such behaviour would be decreases in the overall
earnings realized by the farm-owning population because of the
substantial costs it would incur as it sought advice and switched
properties.
Nevertheless, both individuals and institutions will constantly be urged
to be active by those who profit from giving advice or effecting
transactions. The resulting frictional costs can be huge and, for
investors in aggregate, devoid of benefit. So ignore the chatter, keep
your costs minimal, and invest in stocks as you would in a farm.
“Of all the investments I ever made, buying Ben’s book was the best”
My money, I should add, is where my mouth is: What I advise here is
essentially identical to certain instructions I’ve laid out in my will.
One bequest provides that cash will be delivered to a trustee for my
wife’s benefit. (I have to use cash for individual bequests, because all
of my Berkshire Hathaway shares will be fully distributed to certain
philanthropic organisations over the 10 years following the closing of
my estate.) My advice to the trustee could not be more simple: Put 10
percent of the cash in short-term government bonds and 90 percent in a
very low-cost S&P 500 index fund. (I suggest Vanguard’s. I believe
the trust’s long-term results from this policy will be superior to those
attained by most investors -- whether pension funds, institutions, or
individuals -- who employ high-fee managers.
And now back to Ben Graham. I learned most of the thoughts in this
investment discussion from Ben’s book The Intelligent Investor, which I
bought in 1949. My financial life changed with that purchase.
Before reading Ben’s book, I had wandered around the investing
landscape, devouring everything written on the subject. Much of what I
read fascinated me: I tried my hand at charting and at using market
indicia to predict stock movements. I sat in brokerage offices watching
the tape roll by, and I listened to commentators. All of this was fun,
but I couldn’t shake the feeling that I wasn’t getting anywhere.
In contrast, Ben’s ideas were explained logically in elegant,
easy-to-understand prose (without Greek letters or complicated
formulas). For me, the key points were laid out in what later editions
labelled Chapters 8 and 20. These points guide my investing decisions
today.
A couple of interesting sidelights about the book: Later editions
included a postscript describing an unnamed investment that was a
bonanza for Ben. Ben made the purchase in 1948 when he was writing the
first edition and -- brace yourself -- the mystery company was Geico. If
Ben had not recognized the special qualities of Geico when it was still
in its infancy, my future and Berkshire’s would have been far
different.
The 1949 edition of the book also recommended a railroad stock that was
then selling for US $ 17 and earning about US $ 10 per share. (One of
the reasons I admired Ben was that he had the guts to use current
examples, leaving himself open to sneers if he stumbled.) In part, that
low valuation resulted from an accounting rule of the time that required
the railroad to exclude from its reported earnings the substantial
retained earnings of affiliates.
The recommended stock was Northern Pacific, and its most important
affiliate was Chicago, Burlington & Quincy. These railroads are now
important parts of BNSF (Burlington Northern Santa Fe), which is today
fully owned by Berkshire. When I read the book, Northern Pacific had a
market value of about US $ 40 million. Now its successor (having added a
great many properties, to be sure) earns that amount every four days.
I can’t remember what I paid for that first copy of The Intelligent
Investor. Whatever the cost, it would underscore the truth of Ben’s
adage: Price is what you pay; value is what you get. Of all the
investments I ever made, buying Ben’s book was the best (except for my
purchase of two marriage licences).
(Warren Buffett is the CEO of
Berkshire Hathaway. This essay is an edited excerpt from his annual
letter to shareholders. This story is from the March 17, 2014 issue of
Fortune)
www.dailymirror.lk
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