WARREN BUFFETT’s INVESTING LESSONS

WARREN BUFFETT’s INVESTING LESSONS

The following is an excerpt from Warren Buffett’s latest annual letter to shareholders where he shares his thoughts on investing by narrating his experiences related to property purchases made by him in 1986 & 1993:

“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% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble’s aftermath than 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 $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%. 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 NYU 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%. But the property had been under managed by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant – who occupied around 20% of the project’s space – was paying rent of about $5 per foot, whereas other tenants averaged $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 that purchased the parcel. 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% of our original equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totalling more than 150% 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 the 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. 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.
  • 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 making 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.
  • 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.”)

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.”

KEY TAKEAWAYS:

Equity investors, on the whole, buy equities with a longer term perspective but tend to get influenced by the following factors resulting in them behaving irrationally:

  • Irrational behaviour of other equity investors in the market
  • Vast amount of information available about the markets, economy, interest rates, price movement of stocks etc.
  • Market ‘gyan’ shared by stock experts in leading newspapers and TV channels. The implied message being delivered to so-called rational investors is “don’t just sit there, do something.”

 A lot of times, just remaining passive and not doing something is the most sensible and beneficial (in the long run) course of action.

Warren Buffett’s latest newsletter is available on the Berkshire Hathaway’s website at the following link: http://www.berkshirehathaway.com/letters/letters.html

 FINANCIAL TRIVIA ON WARREN BUFFETT

  1.  The highest-price stock currently sold on the NYSE is Warren Buffett’s Berkshire Hathaway, Class A (NYSE: BRK-A), which sells for around $187,350 (as of March 31st, 2014). That means you can buy about 3097 shares of Facebook (Nasdaq: FB) ($60.49 as of March 31st, 2014) for the cost of one share of Berkshire Hathaway.
  2. The high price of the Berkshire stock is partly because they have never had a stock split and the company has paid only one dividend since Warren Buffett took over. The company prefers to retain corporate earnings on its balance sheet in a manner which is impermissible for private investors and mutual funds.
  3. Berkshire Hathaway was originally a textile manufacturing company that was founded in the nineteenth century. In 1962, Buffett started buying shares in the company because he thought the company was selling at a discount to its actual value. In 1964, he gained control of the company and fired its President, Seabury Stanton.
  4. Warren Buffett is paid a salary of $100,000 p.a. with no stock options. This is among the lowest salaries for CEOs of large companies in the United States.
  5.  2008 was Berkshire’s worst year in the 44 years that Buffett’s been its Chairman. Net worth fell by $11.5 billion that year, a decline that reduced per-share book value by -9.6%. The only other year that saw a decline was 2001, when Berkshire’s net worth fell by -6.2%.
  6. In the early 1950’s, Warren Buffett taught a night class called “Investment Principles” at the University of Nebraska-Omaha. The average age of his students was more than twice his own. Buffett was less than 25 years old then.
  7. In 2006, Warren Buffett announced that he will donate 85% of his wealth ($58.5 billion as of 2013) to the Bill & Melinda Gates Foundation. In 2010, he reiterated his intentions and pledged to donate 99% of his wealth to charity during his lifetime or at death.
  8. A Chinese investment executive by the name of Zhao Danyang of the Pureheart China Growth Investment Fund paid $2.1 million for having lunch with Warren Buffett in 2008. The money collected via a fundraiser auction was handed over to the Glide Foundation, which is renowned across the globe as an anti-poverty charity organization.

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