The latest lessons from Buffett

How you should really be measuring portfolio performance

Many investors eagerly scan Warren Buffett’s annual shareholder letters to find out what stocks the investing wizard’s firm Berkshire Hathaway bought or sold in the recent past. But the far more valuable insights in his annual letter usually come from Buffett’s (and his partner Charlie Munger’s) native wisdom on how to evaluate businesses and investments.

Here are some of the takeaways for Indian investors from Berkshire’s 2017 newsletter, which was out this week.

Bank on book value

In the 53 years of its existence, the growth of Berkshire Hathaway’s stock market capitalisation has been much more impressive than the growth in its assets. From 1965, when Buffett acquired control of the company until 2017, Berkshire Hathaway’s market capitalisation has grown at a 20.9 per cent CAGR. Its book value per share has grown at a somewhat lower 19.1 per cent.

But in his annual newsletters, Buffett always uses the growth in the company’s book value and not market capitalisation to update shareholders on the progress of the company.

2017 was a rare year in which Berkshire’s book value (up 23 per cent) grew faster than its stock market value (21 per cent). But the newsletter kicks off with the disclaimer that of the $65 billion gain in total book value this year, $29 billion was a windfall from US government’s new tax code, which had nothing to do with ‘anything we accomplished at Berkshire’. It also criticises the new GAAP rule asking companies to account for unrealised portfolio gains in their profits, though this move may actually benefit Berkshire.

Buffett’s approach offers three takeaways for Indian investors. One, track the book value per share of the companies in your portfolio to evaluate how they are faring over the years, more closely than their EPS (earnings per share) or stock price returns. Book value is a wider measure than EPS because it captures how well the company is deploying its retained earnings to build new assets. Two, stick to a single metric to evaluate a company’s performance over the years, instead of constantly shifting the goalposts.

Finally, stick to companies whose top managers actively ignore its stock price performance. Look for managers who obsess over operations and assets instead.

Be sceptical of ‘synergies’

Berkshire Hathaway is a company that has built up its book value brick-by-brick through acquisitions. Over the years, starting out with two struggling textile mills, the company has grown to its mammoth size of $242 billion in revenues, by snapping up general insurers, railroads players, power companies, auto part makers, ketchup makers and lately, real estate brokerages. The company follows a no-dividend policy and often sits on large piles of cash waiting for new takeover opportunities to crop up.

You, therefore, have to take Buffett very seriously when he warns that the merger ‘synergies’ that companies tout at the time of an acquisition, almost never materialise. He says that company CEOs are often chosen for their can-do spirit and these aggressive types often like to build large empires. To justify their empire-building, they often forecast large ‘synergies’, cheered on by investment bankers.

So that’s a few more lessons for investors. Don’t buy a stock on acquisition news, or expectations of an EPS boost from ‘synergies’. When evaluating a company’s track record, see if its acquisitions have been made at high or low points in the business cycle — the latter are always better. Be wary of debt-funded M&As, and evaluate any acquisition as if it were equity-funded.

Never borrow to invest

It is not just in buying out businesses that Buffett has a healthy distaste for debt. He cautions investors never to use borrowings to fund their own stock market investments either. In a strong paragraph on short-term investing, he writes — “Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their chart patterns, target prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful, our investments will be successful as well. Sometimes the pay-offs to us will be modest. Occasionally, the cash register will ring loudly. And sometimes I will make expensive mistakes.”

Keep it simple

In short, if someone’s plugging a complicated investment idea that sounds sophisticated or cool, ignore it. A good broad-market low-cost index fund may be a far better bet. Making money is more important than looking smart!

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