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Learning from Warren Buffet Series – Part 1

What is this series about?

We have all heard a lot about the ace investor Warren Buffet. But how many of us have really read through his letters? So here we are, launching a learning series where our expert Mr. Kshitiz Jain summarizes the learning from each of his letters and connects it to what it means for us. So whether you invest in stocks or mutual funds, do takeaway some key learning for investing in general!

Also, participate in sharing the knowledge. So do Comment / Share / Like.

Berkshire Hathaway Shareholder letter – 1977

Characteristics of Good Management : Buffet letters gives us a lot of insight on this matter
  1. Buffet prefers to give his shareholders bad news first, followed by good news. There are various evidences throughout the letters. This is a hallmark of good management, while reading annual reports look for these characteristics.
  2. Good Management will readily accepts its mistake and instead of finding excuses looks to either cut losses or keep their shareholders well informed about their mistake and learning from it. Buffet accepts that Textile business has not been working well and explains in detail the reason why they are continuing with the business.
  3. Good management will give clear guidance and instead of being just overly optimistic, good management will manage shareholder expectations honestly.
  4. Managerial Discipline even in the wake of industry wide malpractices.
Investing gyaan: Buffet gives us a unique insight in his style of investing
  1. While investing in stocks evaluate as if you are buying ownership of the company and not just looking to earn short term gains.
  2. Buffet defines the type of business, one should invest in:
    1. One that we can understand,
    2. With favorable long-term prospects,
    3. Operated by honest and competent people
    4. Available at a very attractive price.
  3. Long term investment horizon and ignoring short term volatility  – “Most of our large stock positions are going to be held for many years and the scorecard on our investment decisions will be provided by business results over that period and not by prices on any given day.”
  4. Invest in companies or industries where the industry scenario is favorable, this gives the company scope to make mistakes, learn and move on – “One of the lessons your management has learned – and, unfortunately, sometimes re-learned – is the importance of being in businesses where tailwinds prevail rather than headwinds.”
  5. Stock market gives you opportunities to buy outstanding businesses at discounts which will not be available, if you are looking to acquire entire companies – “Our experience has been that pro-rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies. Consequently, bargains in business ownership, which simply are not available directly through corporate acquisition, can be obtained indirectly through stock ownership.  When prices are appropriate, we are willing to take very large positions in selected companies, not with any intention of taking control and not foreseeing sell-out or merger, but with the expectation that excellent business results by corporations will translate over the long term into correspondingly excellent market value and dividend results for owners, minority as well as majority.”
My two cents

Buffet helps us to answer two of the most important question that an investor needs to answer. I have tried to extend these learning further for mutual fund investors.

Where to invest?

Invest in good quality well managed businesses that you understand and are available at attractive prices. This is one of the most important learning that investors should always try to invest in quality business, even if they may not be the flavor of the month. A good quality well managed business that is currently out of favor is the best thing that can happen for an investor. Similarly, good quality mutual funds managed by fund managers with long term track records may under perform for short periods in between but will give higher returns in the long term.

How to identify good management?

Management that is honest, manages shareholders expectations with clear guidance, readily accepts mistakes and disciplined. Similarly, a mutual fund manager who has a disciplined approach to investing and does not waver from his investing style and fund mandate even in tough market situations would be someone to entrust your investments with.

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Do you get attracted by market forecasts?

“Bullish on market, see Sensex at 32000 by December 2016″ – Citi Jan 13, 2016

“Citi’s December 2017 Sensex target at 31500, implies 5% upside”- May 05, 2017

We often come across news headlines such as above. The “expert” forecaster’s ever changing goal posts.

Forecasts are everywhere. The financial markets are inundated with forecasts by the so called “experts” either on TV or in print media. This is not an article against any single forecaster. I am just trying to show how wrong the so called experts can go while predicting the financial market’s movement.

We as human beings by nature look for certainty, in an uncertain future. This is the reason, unfortunately as investors we tend to give far greater weight to these “predictions” in print or on TV. As Howard Marks of Oaktree Capital wrote in his memo to clients on the same topic “The opinions of experts concerning the future are accorded great weight . . . but they’re still just opinions.”

Many of my friends and relatives come up to me and ask questions like “Is the Sensex going to touch 35000 by Dec 2017?”, Or “Is RIL stock going to cross 2000 this month?” My answer to all such questions is unequivocally “I don’t know”.

I would always advise everyone to not invest on basis of forecasts. Always do your own due diligence before making an investment decision. As per a legend, one of the top bankers in the world, JP Morgan when asked about what stock market will do, replied, “It will fluctuate”. If one of the top bankers in the world doesn’t know, we better avoid falling into that trap.

Having said that, there is a difference in forecasting and making a probability based judgment. Judgment based on proper due diligence is far better than opinion of experts. We as investors should avoid the noise surrounding us. We should try to focus on our own analysis of important and relevant information to do our investments.

I would close this article with an excerpt from the Howard Marks’ Memo titled “Expert Opinion” which is a huge inspiration for this article, and, also because I could not have put it any better.

One of the most powerful things we can do as a human being in our hyper connected, 24/7 media world is say: “I don’t know.” Or more provocatively, “I don’t care.”

Not about everything, of course –just most things. Because most things don’t matter, and most news stories aren’t worth tracking

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Frequent changes to your investment portfolio can be detrimental

The list of top performing stocks or mutual funds keeps changing frequently. This is of course obvious as the performance depends on various factors and some of these factors are not completely in control of the company’s management. Even good companies with sound management will face ups and downs. There is one obvious question that comes to every investor’s mind – Do we keep churning our portfolio frequently to exit the underperformer and buy the outperformer? My answer to this is overwhelming ‘No’. I believe churning of your portfolio too frequently will do more harm than good.

Let me try to explain further. During the last 15 years, Nifty (including dividend) has grown at an annual rate of 16.7%, to put it in simple terms, Rs. 100 invested 15 years back has now grown to more than 10 times. But, having said that, equity as an asset class is known to be volatile in short periods (see chart below). So, while investing in equity for short term may be tricky, the odds of making money in the long term are quite high.

Now, let us come back to ‘Power of Compounding’, which we had touched briefly in my last article (Read here). This has to be one of the most important financial lessons of all time. As the great Albert Einstein said “Compound interest is the eighth wonder of the world. He, who understands it, earns it … he who doesn’t … pays it”.

Here, we will see how holding your portfolio for the long term helps power of compounding play its magic in the most unusual way. If you hold your portfolio for long term, the winners in your portfolio will tend to become dominant, and the losers will become insignificant. The positive impact of the winners will significantly outweigh the negative contribution and your portfolio will compound significantly. Not sure, right? I can understand your circumspection.

Let me explain this by taking a simple two stock portfolio. Stock ‘A’ is a winner, gives 25% annual return over a period of 15 years, while Stock ‘B’ is declining by 25% annually. How has your portfolio performed? I would say good, rather great. Your portfolio has given an annual return of 19.4%. This example demonstrates the power of compounding.

This magic can also work for you. You just have to be patient and give your money long enough time to grow.

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Planning to fail in your golden years?

Yet again, a discussion with few friends on a Sunday afternoon has brought me here today. We were discussing about our future plans and each one of us wanted to retire early and retire rich. No surprises there. What surprised me is that my friends only have a vague idea, no concrete plans about how they are going to achieve this goal. This is true for most of us. With rising cost of living and increasing life expectancy, the need to plan for one’s golden years is absolutely necessary.

Lack of a concrete plan for retirement may lead to problems just when you are least prepared for it. As one of the founding father of the United States, Benjamin Franklin, so succinctly put “If you fail to plan, you are planning to fail”.

Most of us tend to underestimate the retirement corpus. If you need Rs. 50,000 for monthly expenses today, will you need the same after 30 years, when you retire? The answer is no. You will need Rs. 2.2 lakhs every month, assuming just 5% inflation. There it is, now I have your attention. Inflation leads to reduction in purchasing power, by slowly but steadily eating up your money. Learn more about it here.

Let me tell you one more thing. With increasing life expectancy, the non-earning period in an individual’s life is expanding. Someone retiring at age 60 after working for 30 years could live on for another 25 years or more. Assuming your current age of 30 years, current monthly expense of Rs. 50,000, inflation of 5% and retirement age of 60 years, the amount of retirement corpus one needs for 25 years after retirement is Rs 5.3 cr and for 30 years after retirement is Rs. 6.1 crore. These are not small sums by any measure. If you do not start to plan now, there is a high probability to fall short.

Are you now thinking when to start investing for retirement? The answer is as EARLY as possible. If you do that, your money gets more time to grow. Each rupee gained generates further returns. This is called “power of compounding”, and this helps you get rich… and richer over time.

Let us take the above example, say you start investing at age of 30 years and continue to do so for next 30 years. To achieve a corpus of Rs. 5.3 cr at retirement, assuming 12% return on your investment, you will have to invest Rs. 15,391 per month. If you delay the investment by even 5 years, the same monthly installment doubles itself to Rs. 28,630.

Don’t feel overwhelmed by all the numbers shown above, you can take help from your financial advisor for this. The key is to start early, invest regularly and choose the right products for your investments.