Category Archives: Investment philosophy

Does Warren Buffett or Berkshire Hathaway hold certain stocks forever?

Does Warren Buffett or Berkshire Hathaway hold certain stocks forever?

To answer this question, one needs to go back to Berkshire Hathaway’s 2016 Annual Report 2016, in which chairman Warren Buffett said:  “Sometimes the comments of shareholders or media imply that we will own certain stocks “forever.” It is true that we own some stocks that I have no intention of selling for as far as the eye can see (and we’re talking 20/20 vision). But we have made no commitment that Berkshire will hold any of its marketable securities forever.”

What could have prompted the implication by shareholders and the media that Warren Buffett holds certain stocks forever?

Warren Buffett said in Berkshire Hathaway’s 2016 Annual Report said: “Confusion about this point may have resulted from a too-casual reading of Economic Principle 11 on pages 110 – 111, which has been included in our annual reports since 1983. That principle covers controlled businesses, not marketable securities. This year I’ve added a final sentence to #11 to ensure that our owners understand that we regard any marketable security as available for sale, however unlikely such a sale now seems.”

What is Warren Buffett’s Economic Principle 11 and what is the final sentence that was added in 2016 to this principle? Let’s explore.

Background: In June 1996, Berkshire’s chairman Warren Buffett  issued a booklet entitled “An Owner’s Manual” to Berkshire’s Class A and Class B shareholders. The purpose of the manual was to explain Berkshire’s broad economic principles of operation.

There were originally 13 economic principles which Warran Buffett set up in 1983. The 2016 Annual Report provided an updated version of “An Owner’s Manual”.

Economic Principle 11 goes like this:

You should be fully aware of one attitude Charlie and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub-par businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.) Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.
“We continue to avoid gin rummy behavior. True, we closed our textile business in the mid-1980’s after 20 years of struggling with it, but only because we felt it was doomed to run never-ending operating losses. We have not, however, given thought to selling operations that would command very fancy prices nor have we dumped our laggards, though we focus hard on curing the problems that cause them to lag. To clean up some confusion voiced in 2016, we emphasize that the comments here refer to businesses we control, not to marketable securities.”

The last sentence in Berkshire Hathaway Economic Principle 11 made it clear that Warren Buffett’s comments refer to businesses that Berkshire Hathaway owns and not to marketable securities.

The Fourth Law of Motion that Sir Isaac Newton failed to discover

“Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius,” Warren Buffett  said in a comment in Berkshire Hathaway’s FY2016 annual report.

” But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.”

“If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.”

To understand better why Sir Isaac Newton said “I can calculate the movement of the starts, but not the madness of men”,  read Buffettpedia’s post “Are you an intelligent investor?”.

Warren Buffett is set to win this US$500,000 wager

Background on Warren Buffett’s US$500,000 wager: Warren Buffett said in  Berkshire’s 2005 annual report that  active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still.

Recalling his argument, he said in his FY2016 letter to Berkshire Hathaway shareholders: “I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund. ..

“Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?
Mr Buffett went on to say: “What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds.

“I hadn’t known Ted before our wager, but I like him and admire his willingness to put his money where his mouth was. He has been both straight-forward with me and meticulous in supplying all the data that both he and I have needed to monitor the bet.

“For Protégé Partners’ side of our ten-year bet, Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. The five he selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager.
Each fund-of-funds, of course, operated with a layer of fees that sat above the fees charged by the hedge funds in which it had invested. In this doubling-up arrangement, the larger fees were levied by the underlying hedge funds; each of the fund-of-funds imposed an additional fee for its presumed skills in selecting hedge-fund managers.
“Here are the results for the first nine years of the bet – figures leaving no doubt that Girls Inc. of Omaha, the charitable beneficiary I designated to get any bet winnings I earned, will be the organization eagerly opening the mail next January.
“The compounded annual increase to date for the index fund is 7.1%, which is a return that could easily prove typical for the stock market over time. That’s an important fact: A particularly weak nine years for the market over the lifetime of this bet would have probably helped the relative performance of the hedge funds, because many hold large “short” positions. Conversely, nine years of exceptionally high returns from stocks would have provided a tailwind for index funds.

“Instead we operated in what I would call a “neutral” environment. In it, the five funds-of-funds delivered, through 2016, an average of only 2.2%, compounded annually. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000….”

Mr Buffett summed it up this way: “So that was my argument – and now let me put it into a simple equation. If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win…”

” The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: “In investment management, the progression is from the innovators to the imitators to the swarming incompetents”,” Mr Buffett said.

Mr Buffett’s bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

Philip Fisher’s five more don’ts for investors

1. Don’t overstress diversification
Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. “It never seems to occur to them, and much less to their advisors, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.
2. Don’t be afraid of buying on a war scare
War is always bearish on money. To sell stock at the threatened or actual outbreak of hostilities so as to get into cash is extreme financial lunacy. Actually just the opposite should be done. If an investor as about decided to buy a particular common stock and the arrival of a full-blown war scare starts knocking down the price, he should ignore the scare psychology of the moment and definitely begin buying. This is the time when having surplus cash for investment becomes least, not most, desirable…If war actually breaks out, the price would undoubtedly go still lower, perhaps a lot lower. Therefore the thing to do is to buy but buy slowly and at a scale down on just a threat of war. If war occurs, then increase the tempo of buying significantly. Just be sure to buy into companies with products or services the demand for which will continue in wartime, or which can convert their facilities to wartime operations.
3. Don’t forget your Gilbert and Sullivan
Gilbert and Sullivan are hardly considered authorities on the stock market. Nevertheless, we might keep in mind their “flowers that bloom in the spring, tra-la” which, they tell us, have “nothing to do with the case”.
Don’t be influenced by what doesn’t matter, says Philip Fisher. For some reason, the first thing that many investors want to see when they are considering buying a particular stock is a table giving the highest and lowest price at which the stock has sold in each of the past five or ten years. They go through a sort of mental mumbo-jumbo, and come up with a nice round figure which is the price they are willing to pay for the particular stock.
“Is this illogical? Is it financially dangerous?” asks Philip Fisher. His answer to both is an emphatic yes. It is dangerous because it puts the emphasis on what does not particularly matter, and diverts attention from what does matter. Another example is that many investors will give heavy weight to the per-share earnings of the past four or five years in trying to decide whether a stock should be bought. What counts is knowledge of background conditions. An understanding of what probably will happen over the next several years is of overriding importance.
4. Don’t fail to consider time as well as price in buying a true growth stock
5. Don’t follow the crowd

Five don’ts for Investors: Philip Fisher

Common Stocks and Uncommon Profits by Philip Fisher lists five don’ts for investors
1. Don’t buy into promotional companies
All too often, young promotional companies are dominated by one or two individuals who have great talent for certain phases of business procedure but are lacking in other equally essential talents. They may be superb salesmen but lack other types of business ability. More often they are inventors or production men, totally unaware that even the best products need skillful marketing as well as manufacture.
Their financing should be left to specialised groups. Ordinary individual investors should make it a rule never to buy into a promotional enterprise no matter how attractive it may appear to be.

2. Don’t ignore a good stock just because it is traded “over the counter”.
From the standpoint of marketability, a well-known, actively-traded stock on the New York Stock Exchange has advantage over the better over-the-counter stocks. But the better of the over-the-counter stocks are frequently more liquid than the shares of many of the companies listed on the American Stock Exchange and the various regional stock exchanges. “In short, so far as over-the-counter securities are concerned, the rules for the investor are not too different from those for listed securities. First, be very sure that you have picked the right security. Then be very sure that you have selected an able and conscientious broker. If an investor is on sound ground on both these respects, he need have no fear of purchasing stock just because it is traded ‘over the counter’ rather than on the exchange.”

3. Don’t just buy a stock because you like the “tone” of the annual report
Allowing the general wording and tone of an annual report to influence a decision to purchase a common stock is much like buying a product because of an appealing advertisement on the billboard.

4. Don’t assume that the high price at which a stock may be selling in relation to earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the price

Philip Fisher uses a fictitious company XYZ to highlight a costly error in investment reasoning. XYZ has qualified magnificiently for years in regard to Philip Fisher’s 15 points (Philip Fisher’s “Fifteen Points to Look for in a Common Stock”)). The stock has sold for years from 20 to 30 times current earnings as the financial community appreciated XYZ’s excellence in terms of constant growth in sales and profits. This is nearly twice as much for each dollar earned as the sale price of the average stock that has made up, say, the Dow Jones Industrial Averages.
Now XYZ has just issued a forecast indicating it expects to double earnings in the next five years. On this basis, some investors jump to the false conclusions that since XYZ is selling twice as high as stocks in general and since it will take five years for XYZ’s earnings to double, the present price of XYZ is discounting future earnings ahead and is therefore overpriced. The fallacy in the reasoning here lies in the assumption that five years from now XYX will be selling on the same price-earnings ratio as will the average Dow Jones stock.
If XYZ continues its same policies, five years from now its management will bring out still another group of new products that will swell earnings. If this happens, why shouldn’t this stock sell five years from now for twice the price-earnings ratio of the more ordinary stocks as it is doing for now and has done for many years past? This is why some of the stocks that at first glance appear highest priced may upon analysis, be the biggest bargain, said Philip Fisher.

5. Don’t quibble over eights and quarters
Here Philip Fisher uses a real example. A gentleman who has demonstrated a high order of investment ability wanted to buy 100 shares of a stock that was trading at 35.5. He put his order in at 35 as he wanted to save fifty dollars. The stock never sold again at 35. Twenty-five years later, it was selling at over 500. In an attempt to save fifty dollars, the investor failed to make at least $46,500.

Philip Fisher’s scuttlebutt method

For a man like Berkshire Hathaway chairman Warren Buffett who doesn’t personally own an iPhone, one wonders why he more than doubled Berkshire Hathaway’s holdings in Apple to about 2.5 per cent in January 2017. At that point, Mr Buffett owned US$17 billion worth of the tech giant’s stock

In a CNBC report on 27 February 2017 titled “Billionaire Warren Buffett more than doubled his holdings in Apple in 2017”, Mr Buffett, when asked why he raised the stake in Apple, was quoted as saying “because I liked it”. The legendary investor cited Apple’s
consumer-retaining power and CEO Tim Cook’s smart capital deployment strategy.

“Apple strikes me as having quite a sticky product, and an enormously useful product to people that use it,” Buffett said.

What was interesting is that Mr Buffett went on to say that the late investor Philip Fisher’s 1958 book “Common Stocks and Uncommon Profits” had inspired him to research how consumers felt about Apple products.
Mr Fisher talked about something called the “scuttlebutt method“, Mr Buffett said, adding that this method “made a big impression on me at the time, and I used it a lot”.

The “scuttlebutt method”, said Mr Buffett, is essentially going out and finding out as much as you can about how people feel about the products that they use.

Let’s look further into who Philip Fisher was and what his “scuttlebutt method” was all about.

American stock investor Philip Arthur Fisher (September 8, 1907 – March 11, 2004) was best known as the author of the investment guide book known as  Common Stocks and Uncommon Profits. The book has the reputation of staying in print since it  first published in 1958.

Phillip Fisher was referred to by Mr Buffett as “a respected investor and author” in a  letter to Berkshire Hathaway shareholders. Among his best-known  followers is Mr Buffett  who reportedly has said on some occasions that “he is 85% (Benjamin) Graham and 15% (Philip) Fisher”. Benjamin Graham (May 8, 1894 – September 21, 1976) is the father of value investing and Mr Buffett is his best known student.

Back to the “scuttlebutt method”, which provides clues that are needed to find really outstanding investments. Philip Fished said he called it “scuttlebutt method” for lack of a better term.

“The business ‘grapevine’ is a remarkable thing,” said Philip Fisher. “It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a representative cross-section of the opinions of those who in one way or another are concerned with any particular company.”

“Most people, particularly if they feel sure there is no danger of their being quoted, like to talk about the field of work in which they are engaged and will talk rather freely about their competitors. Go to five companies in an industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine times out of ten a surprisingly detailed and accurate picture of all five will emerge,” said Mr Fisher.

According to Philip Fisher, competitors are only one and not necessarily the best source of informed opinion. Much also can be learned from both vendors and customers about the real nature of the people with whom they deal. Research scientists in universities, in government and in competitive companies are another fertile source of worthwhile data. So are executives of trade associations, according to Philip Fisher.

“The next step is to contact the officers of the company to try and fill out some of the gaps still existing in the investor’s picture of the situation being studied,” said Mr Fisher.