NOTE: This is the first in a new series of articles that focuses on lessons we can learn from the masters – the investing gurus. We’ll read their letters, listen to their interviews, or read their books with the intention of applying what we learn to our own investment process. Let’s get started … class is in session.
I’ve read some of Warren Buffett’s letters to shareholders (here’s 1977-2020) and there’s always at least one key takeaway. For many investors, the releasing of a new letter generates lots of excitement. I’m especially keen in looking at letters from rough times – 1973-1974, 1987, 2000-2002, 2008, 2020 – because Buffett is transparent in his thoughts and that’s the best time to learn. During good times when all boats are lifted, investors can get overconfident and feel like they are a genius. I’ve had moments like these and stubbornly learned a genius I am not. And retirees pay special attention to the lessons from hard times because portfolio protection is our priority.
9/11/01 hit Berkshire Hathaway’s insurance business hard and you’ll see much of this letter referencing those lessons. Remember, my takeaways could be different from yours due to my personal situation, experience, or interests. So, read the 2001 letter for yourself and perhaps you’ll find quotes that connect with you. Most importantly, find at least one thing that you can learn and apply it to your investing journey.
The Quotes
Two years ago, reporting on 1999, I said that we had experienced both the worst absolute and relative performance in our history. I added that “relative results are what concern us,” a viewpoint I’ve had since forming my first investment partnership on May 5, 1956. Meeting with my seven founding limited partners that evening, I gave them a short paper titled “The Ground Rules” that included this sentence: “Whether we do a good job or a poor job is to be measured against the general experience in securities.” We initially used the Dow Jones Industrials as our benchmark, but shifted to the S&P 500 when that index became widely used.
Page 3, Paragraph 3 of 2001 Letter to Shareholders
Determining how to measure your success is important. If you plan to run a 60% stock / 40% bond portfolio then you can’t just use the S&P 500 as your relative benchmark. If you did then you’d likely always think your portfolio isn’t performing well. It really depends on your portfolio.
For example, since I’m a large cap dividend investor then using the Dow Jones Industrials as a benchmark for my stock portfolio might be appropriate. If I was mainly a growth investor, then I might choose between the S&P 500 or an index with small cap stocks. Either way, choose your benchmark(s) and measure your portfolio against it.
The other point here is what get’s measure gets results. It’s important to see if your portfolio is doing what it’s designed to do. If it’s continually underperforming then it’s possible you need to make changes. But if you aren’t measuring results then you’ll never know.
One final thought about Berkshire: In the future we won’t come close to replicating our past record. To be sure, Charlie and I will strive for above-average performance and will not be satisfied with less. But two conditions at Berkshire are far different from what they once were: Then, we could often buy businesses and securities at much lower valuations than now prevail; and more important, we were then working with far less money than we now have. Some years back, a good $10 million idea could do wonders for us (witness our investment in Washington Post in 1973 or GEICO in 1976). Today, the combination of ten such ideas and a triple in the value of each would increase the net worth of Berkshire by only 1/4 of 1%. We need “elephants” to make significant gains now – and they are hard to find.
Page 4, Paragraph 1 of 2001 Letter to Shareholders
What Buffett describes here doesn’t apply to 99.9% of investors but it does hit on one important concept: How Many Stocks to Hold in a Portfolio. His point of needing to hit home runs because his portfolio is getting so large also applies to holding too many stocks.
On most occasions, investors find that 5-8 of their stocks are their biggest winners and drive most of their performance. But if you hold 100 stocks of fairly equal position, the success of those 5-8 big winners won’t impact your portfolio much. In other words, you’re going to need 20-30 big winners to have an impact on a portfolio with 100 stocks. And that is not easy to do.
His point is valid that the bigger (either quantity or portfolio value) the portfolio the harder is it to make gigantic gains. Buffet believes in diversification but not to the point that your winners can’t help your portfolio. And the same point is valid for those that hold too many stocks.
In the frontispiece to Security Analysis, Ben Graham and Dave Dodd quoted Horace: “Many shall be restored that now are fallen and many shall fall that are now in honor.” Fifty-two years after I first read those lines, my appreciation for what they say about business and investments continues to grow.
Page 6, Paragraph 4 of 2001 Letter to Shareholders
There’s a lot of wisdom in that quote from Horace. There’s plenty of evidence that most stocks are losers and I’m likely holding onto some of them now. Though we want to be buy and hold investors, it’s possible that Johnson & Johnson, Coca-Cola, or Procter & Gamble could fall from grace one day. All we have to do is look at the list of former large cap stocks that are a shadow of themselves 20 years later (Hi, General Electric).
Today’s industry leader could be tomorrow’s next bankruptcy. When buying stocks, quality is always top of the list in requirements. But there are so many other things that we should consider too. Let’s face it, we aren’t Nosyrodamos – we do the best we can in picking companies we think will still thrive for 30-50 years. There’s a reason JNJ, KO, and PG are still paying growing dividends 50+ years later but that doesn’t guarantee they’ll make it another 50 years.
On the flip-side of the Horace statement are those that have fallen but recovered. If you can find value in a beaten down company, perhaps even a super-compounder, then follow that recipe for great wealth. But these can be dangerous waters (I’ve found this out the hard way) so tread lightly. Remember, there is a difference between low price and value. There are many things to consider before we purchase that next deep value stock.
The probability of such mind-boggling disasters, though likely very low at present, is not zero.
Page 8, Paragraph 7 of 2001 Letter to Shareholders
Here, Buffett was describing terrorism risk (i.e. 9/11) but the point is always valid. We are investors of businesses that are dealing with risks. Johnson & Johnson has talcum powder and opioid issues they are dealing with. 3M has chemical and other lawsuits they are addressing. Pretty much every product has some risk associated with it.
And to Buffett’s point, the probability of those risks might be extremely low but they are not zero. These risks, if they occur, can negatively impact a stock.
Why, you might ask, didn’t I recognize the above facts before September 11th? The answer, sadly, is that I did – but I didn’t convert thought into action. I violated the Noah rule: Predicting rain doesn’t count; building arks does. I consequently let Berkshire operate with a dangerous level of risk – at General Re in particular.
Page 9, Paragraph 1 of 2001 Letter to Shareholders
Overall, this is a good lesson for life but translating it for finance works too. We can look at this in several ways but let’s keep it simple. You know (and might even have a rule) that you can’t put too much into one stock. You might have a stock that is 25% of your portfolio and you predict it could go down in price and even ruin your chance to retire. Thinking or predicting is different than doing or taking action. Observation won’t trim that position from 25% to 10% only action will capture the gain and rebalance the portfolio.
Another example might be that the stock market is getting a little pricey and you predict that we could see a correction. You have little cash on hand and the prudent thing would be to raise some cash to take advantage of potentially future lower prices. Instead, you spend $5,000 on that 1-week vacation or you buy a stock that is overvalued. The market corrects and you have no cash on hand to take advantage.
His extraordinary discipline, of course, does not eliminate losses; it does, however, prevent foolish losses. And that’s the key: Just as is the case in investing, insurers produce outstanding long-term results primarily by avoiding dumb decisions, rather than by making brilliant ones.
Page 9, Paragraph 11 of 2001 Letter to Shareholders
The power of not making stupid mistakes is something that Charlie Munger (Buffett’s partner) talks about regularly. Dumb decisions are things that enable you to lose capital. Remember Buffett saying “Rule #1: never lose money. Rule #2: never forget rule #1.” I’ve broken this rule often in my younger years. The quicker you learn this the more wealth (and compounding) you’ll create.
Create an approach to investing and stick to it … stay within your lane. If the market drops have the discipline to hold or buy more but certainly don’t sell. Have the discipline to rebalance your portfolio at regular intervals. Don’t be an emotional investor, which will lead to dumb decisions. And remember, you (we) aren’t smarter than the market …. you have no more insight than other investors.
In assessing the soundness of their reinsurance protection, insurers must therefore apply a stress test to all participants in the chain, and must contemplate a catastrophe loss occurring during a very unfavorable economic environment. After all, you only find out who is swimming naked when the tide goes out. At Berkshire, we retain our risks and depend on no one. And whatever the world’s problems, our checks will clear.
Page 10, Paragraph 2 of 2001 Letter to Shareholders
I’ve always liked this quote and it applies in many ways to personal finance. Take 1999 when even a fool could make some money until everything failed during the tech crash. If a stock had anything to do due with the internet it went up regardless of fundamentals. Heck, even Coca-Cola got over priced at a 50 PE in this timeframe.
If you are taking too much risk and the economy goes into a recession (or worse), that’s when you find out which stocks are buy and hold forever stocks. When the Feds are flooding the economy with trillions of dollars it can be hard to determine which company is solid until they turn off the facet. Those with too much debt or poor cashflow are exposed and the true quality companies rise to the top. Those are the ones you want to find and own.
I’ve told the story in the past about the fellow traveling abroad whose sister called to tell him that their dad had died. The brother replied that it was impossible for him to get home for the funeral; he volunteered, however, to shoulder its cost. Upon returning, the brother received a bill from the mortuary for $4,500, which he promptly paid. A month later, and a month after that also, he paid $10 pursuant to an add-on invoice. When a third $10 invoice came, he called his sister for an explanation. “Oh,” she replied, “I forgot to tell you. We buried dad in a rented suit.”
Page 11, Paragraph 7 of 2001 Letter to Shareholders
This reminds me to always get to know the deep dark secrets of the companies you have in your portfolio. There’s nothing worse than buying a stock on it’s way down only to find out 1-year later that there is an asbestos liability that’s been sitting on the books for 10-years making it’s way through the court system.
Don’t be blindsided … do your due diligence as best you can. Read the annual reports and listen to the quarterly earnings call because analysts will usually ask relevant questions. It’s our job as do-it-yourself investors to find out everything we can about our companies. Look for reasons not to buy something. Remember, protect your capital and don’t make dumb mistakes.
Charlie and I believe that American business will do fine over time but think that today’s equity prices presage only moderate returns for investors. The market outperformed business for a very long period, and that phenomenon had to end. A market that no more than parallels business progress, however, is likely to leave many investors disappointed, particularly those relatively new to the game.
Page 15, Paragraph 3 of 2001 Letter to Shareholders
When stocks are at all-time highs and things could be described as too enthusiastic, then future returns will likely be disappointing. I liken this to today’s market and think many stocks are too rich and are borrowing from future returns. Finding value in today’s market is difficult. When you can’t find value it might be best to build up your cash position and wait for a better opportunity.
Buffett will famously sit on $125B+ until he finds the right opportunity. Does it hurt short-term returns sitting on that much cash? Of course! But we are long-term investors so stick to your game plan and only buy stocks that fit your strategy. Patience is critical when buying stocks. I’ve been known to have an “itchy” buying impulse when I’m sitting on some cash but I’ve gotten better over time.
The scariest thing I’ve seen is when investors chase high-yield or start buying stocks that are already up 300% in 1 year. The fear of missing out is a real thing and people can lose real money chasing performance. Again, stick to your plan, be patient, and don’t be afraid to build-up your cash while you wait for better opportunities.
Despite these dangers, we periodically find a few – a very few – junk securities that are interesting to us. And, so far, our 50-year experience in distressed debt has proven rewarding. In our 1984 annual report, we described our purchases of Washington Public Power System bonds when that issuer fell into disrepute. We’ve also, over the years, stepped into other apparent calamities such as Chrysler Financial, Texaco and RJR Nabisco – all of which returned to grace. Still, if we stay active in junk bonds, you can expect us to have losses from time to time.
Page 15, Paragraph 6 of 2001 Letter to Shareholders
Junk bonds, junk stocks, junk strategies … don’t confuse dumb luck with superior intellect. If you continue to play with fire you will get burned. I’ve lost lots of money doing things I’d never do today. I learned those lessons the hard way but I wish someone had taught me that before I lost my money.
This kind of goes back to the don’t make dumb mistakes and protect your capital. Buffett is smarter than us and he has a team of very smart people around him. Like I’ve said earlier, stay in your lane. As Dirty Harry (Clint Eastwood) told the Mayor of San Francisco, “A good man knows his limitations.” Know your limitations, know your investment approach, and choose your opportunities carefully. If you can’t do this then just buy an index fund and be done with it.
Final Thoughts
From my viewpoint, here’s a simple summary of these 10 lessons:
- Determine how to comparatively measure your portfolio’s success.
- Since most gains come from only a handful of your companies, don’t hold too many stocks in your portfolio. To quote Buffett, “We need “elephants” to make significant gains now – and they are hard to find.”
- Fallen companies can rebound and even the greatest of companies can fail. Don’t ever get too confident in any stock that you own.
- Owning stocks (or just about any investment) comes with risk. Even when the risks of something appear to be very, very low the risk is never zero. Have a plan to address these risks and don’t be blindsided.
- Predicting something doesn’t mean anything if you don’t take action. For example, if a stock goes up 125% and you are thinking about reducing your position then do it. If suddenly the stock drops by 50% that’s real money and your “prediction” means nothing because you didn’t take action.
- You can produce outstanding long-term results primarily by avoiding dumb decisions, rather than making brilliant ones. Perfection is never the goal with investing … just try not to be stupid.
- You only find out who is swimming naked when the tide goes out, which means all stocks going up in good times is easy. How will your portfolio do in a recession or hard economic times? That’s when you find out who is taking too much risk or chasing high-yield dividends.
- Most companies have dark secrets buried in their past and it’s your job to find them. Don’t be blindsided by them …. do your due diligence, read the annual report, listen to the quarterly analyst calls to really learn about your company.
- A stock (or even the market) must parellell actual business results. If a stock (or the market) gets ahead of itself then future returns will be impacted (flat or negative). If you have cash to invest and those conditions exist then be patient and wait for value to appear.
- Finally, if you play with junk stocks long enough you will get burned. Junk is junk and eventually it’s true colors will be revealed with poor performance (or worse). Stick to quality and what you know and the probability that you succeed goes up.
Seriously, you have to read the letter to truly understand the analogies and concepts because I didn’t do them justice. I’m sure I could read them again and come up with a slightly different understanding of how his words relate to my investing.
We can learn much from the gurus. I mean, Buffett is 90 years old and he’s forgotten more than I’ll ever know about investing. What I really like about Buffett is he is transparent and learns from his mistakes. And as important, he actually recognizes and acknowledges his mistakes and does what he can to correct them.
Thanks for reading!
Mr. TLR