This is fourth in the series of lessons from Warren Buffet’s annual letters to shareholders – a bible for many of us to follow for sound investment and business practices. Learn from the Sage of Omaha on the timeless principles for investment, business management and pitfalls to watch out for.

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This is fourth in the series (the last one was published in 2015) of the lessons from Warren Buffet’s annual letters to shareholders,. You can read Part 1, Part 2 and Part 3 here.

Investing

• It is much better to own a non-controlling but substantial portion of a wonderful business than owning 100% of a so-so business.
• An investment portfolio must contain a combination all three forms of capital allocation – owning & operating businesses, passive non-controlling stakes and finally portfolio of marketable securities.
• It is important that serious investors understand the true nature of tangible assets of a company they are investing in, though the accounting rules treat all of them equally. A few tangible assets truly deplete in value over time (e.g. software) whereas others do not lose value (e.g. customer relationships).
• Many times depreciation charge falls far short of capital outlays required to just run the operations smoothly (e.g. railroads). So watch out when pre-depreciation figures are quoted as a valuation guide in asset intensive businesses. The reported earnings, in those cases, are higher than true economic earnings
• Keep a note when ‘adjusted-per-share earnings’ are being highlighted by companies. The real costs in reported numbers may be hidden in these cases
• It is not always good when companies acquire businesses by issuing stock and increasing outstanding shares. When the rest of the parts of the company perform better than those businesses acquired, it is a net loss for the shareholders
• Investments for an extended period in a collection of large, conservatively financed companies will almost certainly do well
• Over a period of 10 years, around 100 hedge funds in aggregate have under performed low-cost index fund, after adjusting for the fees. Carefully evaluate actively managed funds before investing
• Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence but instead an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.
• Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that this objective won’t be attained. By that standard, supposedly “risk-free” long-term bonds are often far riskier investment than a long term investment in common stocks. Risky investments are not an answer to inadequate interest rates.
• Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. However, investors must carefully evaluate that the retained earnings are reinvested in creating productive operational assets
• Track return on net tangible equity capital required to run the business of a company when investing
• There are 3 ways a conglomerate increase value to their share holders
  • Increase long time earning power of the controlled businesses
  • Buy non-controlling part interests in great businesses
  • Repurchase shares
• Stock repurchases are to be avoided when businesses need all the cash they got for managing and expanding operations (or) when there is an investment opportunity with far greater intrinsic value than the undervalued shares
• The intrinsic value of the business is not always captured in the book value. The carrying value of the ‘losers’ is reduced by writing down the economic good will. But ‘winners’ are not revalued upwards. Intrinsic value can be close to market value of business but diverges often

Business Performance

• A sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does (3) set a premium that, on average, will deliver a profit; and (4) be willing to walk away if the appropriate premium can’t be obtained.
• When book value of an insurer is calculated the float is deducted as a liability. In reality, it should be treated as a revolving fund as long as the insurer is able to write new contracts matching up to the old claims that are paid out from the float
• Utilities, that are offering essential service on exclusive basis has recession-resistant earnings. It is even better if these utilities have diverse revenue streams so they are not seriously harmed by a single regulatory body.
• Lending long at fixed rates and borrowing short term on floating rates is a risky business
• The key qualities to look for in stand-alone businesses : durable competitive strengths, competent management, good returns on the net tangible assets, opportunities for internal growth at attractive returns; and, finally, a sensible purchase price
• Often, companies use their overvalued stock to acquire target companies at far more value than they are worth. Such acquisitions do not add any value to the investors of acquirer.