Two investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we cover the 1999 letter.
Common stock investments
In 1999, stock markets were in the midst of the dot-com bubble. Technology stocks in particular were extremely highly valued and the Nasdaq was volatile but in a strong bull market.
At the time, Buffett was being called a dinosaur as he refused to get sucked into the technology mania. In the 1999 letter, he spent a large amoun to time discussing his common stock portfolio and the reasoning behind Berkshire’s lack of investment in the technology sector. His predictions turned out to be correct, but it is the philosophy which is more interesting to me than his actual investment portfolio.
Several of the companies in which Berkshire had large investments had disappointing results in 1999. Nevertheless, Buffett said he believed these companies had “important competitive advantages that will endure over time.” This attribute, which Buffett said makes for good long-term investment results, is one Buffett and Munger believe they can occasionally identify. More often, however, Buffett warned, they cannot identify these opportunities with a high degree of conviction. This is the reason why Berkshire chose not to own stocks of technology companies, even though Buffett and Munger shared an overall view that society would be transformed by their products and services. The problem, said Buffett, is that the pair can't solve this “by studying up.” In other words, he admitted he had no insights into which participants in the technology sector really had “a truly durable competitive advantage.”
He wrote:
"Our lack of tech insights, we should add, does not distress us. After all, there are a great many business areas in which Charlie and I have no special capital-allocation expertise. For instance, we bring nothing to the table when it comes to evaluating patents, manufacturing processes or geological prospects. So we simply don't get into judgments in those fields."
On the other hand, Buffett said in a modest way, that their strength is “in recognizing when we are operating well within our circle of competence“ and “when we are approaching the perimeter.” Predicting the long-term economics of companies that operate in fast-changing industries is “simply far beyond” Buffett and Munger’s perimeter. Buffett is happy to let others with “predictive skill” in those industries put their bets to work in the market and Berkshire will happily abstain from playing in that sandbox. Instead, he emphasized that Berkshire’s mandate was to “just stick with what we understand.” More specifically, Buffett said:
"If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it's almost certain there will be opportunities from time to time for Berkshire to do well within the circle we've staked out. If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price."
This preference for a comfortable business over a comfortable price was a change in mindset for Buffett over the years, which was credited to Munger. When Buffett was closer to Ben Graham’s “cigar butt” strategy of deep value, he would buy anything that was dirt cheap. However, the success of this strategy seemed to fade somewhat overall and it was harder to find lower-risk, deep-value situations. Buffett, thanks to Munger’s advice, realized that over the long term it would be better to pay a reasonable price for higher-quality businesses, perhaps also influenced by the troubles at Berkshire’s textile business. A key reason was that a quality company with a quality management team could be left to its own devices and would throw off cash consistently, and management could be trusted to make sensible business decisions.
Don't party like it’s 1999
As Buffett wrote the 1999 shareholder letter in early 2000, he observed that equity investors seemed “wildly optimistic” in their expectations about future returns. This we know with the benefit of hindsight was a correct observation from Buffett. But interestingly, the guru, who usually stresses his inability to forecast macroeconomic variables, laid out his framework for growth in profits.
"We see the growth in corporate profits as being largely tied to the business done in the country (GDP), and we see GDP growing at a real rate of about 3%. In addition, we have hypothesized 2% inflation. Charlie and I have no particular conviction about the accuracy of 2%. However, it's the market's view: Treasury Inflation-Protected Securities (TIPS) yield about two percentage points less than the standard treasury bond, and if you believe inflation rates are going to be higher than that, you can profit by simply buying TIPS and shorting Governments."
Buffett went on to say that investor expectations would almost certainly become more realistic and the stock market adjustment would likely be severe, “particularly in sectors in which speculation has been concentrated.” This was a prescient forecast. His advice on the market environment at that time was truly sage and worth remembering. He concluded by writing:
"…If anyone starts explaining to you what is going on in the truly-manic portions of this 'enchanted' market, you might remember still another line of song: 'Fools give you reasons, wise men never try.'"
