Timely Investing Wisdom from Warren Buffett

Jim Steffen |

Warren Buffett’s annual letter to shareholders was released last weekend. For me, it is one of the most refreshing things to read every year. In my opinion, Mr. Buffett’s views about investing are more cogent than any other investor in history. Like no one else, he has a way of cutting through the jungle of “noise” and focusing on what really matters. This may be his greatest genius.

As it happens, on the Monday following the letter’s release, the stock market took its sharpest fall in two years on fears of the spreading coronavirus. Buffett happened to be on CNBC that morning for three hours taking questions from the hosts and those submitted by viewers. The timing couldn’t have been better as the American public watched headlines such as, “Dow drops 1000 points.”

Cool as ever, Buffett reminded viewers what stocks really are, fractional ownership in businesses. As always, he went on to make the point that if you bought a rental property, farm, or McDonalds franchise, you wouldn’t spend your days watching the headline news to gauge how things are going. What really matters is the earnings power of that asset over time.

This way of thinking is perfectly illustrated in Buffett’s annual letter to shareholders where he spends virtually no time talking about Berkshire Hathaway’s stock price. Instead, he goes to great lengths breaking down the underlying companies Berkshire owns and the change in their profits. For example, Berkshire’s two biggest subsidiaries (Burlington Northern Santa Fe and Berkshire Hathaway Energy) earned a combined $8.3 billion in 2019, an increase of 6% over the previous year. At the end of the day, this is what really matters.

Imbedded Compounding

Buffett also dedicated a segment of his letter explaining a simple concept related to investing in stocks. There are many publicly traded companies that pay no dividends (Berkshire Hathaway being one example). What happens to the profits of a company that are not paid out to its owners? In most cases, a large percentage are reinvested in the business. When you have a company that earns high returns on capital, the reinvestment can create a very powerful compounding effect.

For example, imagine opening a coffee shop with a special blend that everyone wants to have. To get set-up, you buy a building, equipment and inventory with $500,000 cash. Therefore, you’ve invested $500,000 of capital to get your business going. At year end, after all the bills were paid, assume you earned a $100,000 profit. This means your business generated a 20% return on invested capital ($100,000/$500,000 = 20%).

Instead of taking your $100,000 profit, you decide to reinvest to expand your business. Now with $600,000 of capital, assuming your profitability stays the same, you could expect to generate $120,000 of profit ($600,000 x 20%). If you reinvested again to expand your capital base to $720,000, your expected income would be $144,000 and so-on.

This effect largely explains why stocks have historically generated better returns than bonds. In essence, it’s built-in compounding. This contrasts to bonds which pay a fixed amount for a specified period of time and reinvest nothing.

To be sure, not every company earns great returns on invested capital. But, as Buffett points out in his annual letter, in a world where government bonds pay under 2%, a business that can reinvest its earnings at 10% or more looks very attractive. The challenge, of-course, is investors must be able to keep their wits when financial markets get choppy. The biggest price to capturing the returns stocks have historically generated is putting up with significant market volatility.

The market is there to serve you, not guide you.

Warren Buffett’s mentor, Benjamin Graham, famously wrote the parable about “Mr. Market” in his book, The Intelligent Investor. The purpose was to help investors conceptualize market swings.

Graham suggested that investors think about the stock market as an acquaintance who shows up at your door every day with either an offer to buy company stock you own, or conversely, sell you stock that he owns. Unfortunately, this acquaintance, Mr. Market, is manic depressive. Some days he is flying high and willing to pay a high price for the stock you own. Other days, Mr. Market is quite depressed and willing to sell his stock for a bargain price. The good news is Mr. Market will show up at your door every day regardless of whether you take his offer and will never exhaust his resources. Your job as an investor is to recognize when Mr. Market is being overly optimistic or pessimistic and take advantage of the opportunities as they come your way.

This is a critical concept for investors to grasp especially as we view the market reaction to the spreading coronavirus. There will always be events like this that shake confidence. It’s part of the game. But, it also creates opportunity for those with the knowledge and understanding of market psychology. This is why we have long favored managers, like Mr. Buffett, who are willing to accumulate cash when Mr. Market is feeling rosy, and put it to work when he is full of fear.