Some years ago, I had lunch with one of the best Lloyd’s underwriters, a gentleman who retains an enviable track record of successfully weathering the rigours of the insurance cycle. In the highly cyclical industry of internationally traded insurance this is some achievement.
As we ate in the modest surroundings of the Lloyd’s dining room — the luxury of the Captain’s Room was even then long gone — he explained the key to successful underwriting: patience. This was the virtue, prized above all others, which allowed him to stand aside while other underwriters were filling their boots with unprofitable business.
I was reminded of this lesson by what I found in this year’s letter from Warren Buffett.
The world’s most famously successful investor
To remind you, Warren Buffett is the Chairman of Berkshire Hathaway, a company he took over during the 1960s, when it was a troubled, northeast American textile company. Over the years, he transformed the company by using its cash flows to purchase other attractive investments. In the 1970s, Buffett merged Berkshire with Charlie Munger’s investment holding company, Blue Chip Stamps, to form what today is one of the world’s largest holding companies. Each year, as Chairman of the Board (and its largest shareholder), Buffett writes a letter to his fellow shareholders.
Buffett’s observations into how businesses should be run are always insightful. This year, Buffett addressed certain topics that are particularly important for us all to consider.
Market timing
"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."
Many investors, Buffett points out, achieve disastrous returns simply by forgetting to invest only when good value is offered to them. Instead, they deal too frequently on the basis of fads — "rather than on thoughtful, quantified evaluation of businesses" — and adopt a stop-go approach of entering and exiting the market.
As Buffett explains, in 2004 Berkshire Hathaway built up a large cash mountain of some $43bn because he and Charlie Munger had not found anything they thought right to invest in. ‘Mr Market’ had offered them nothing at the right price; in these circumstances it was right to stand on the sidelines, complete no deals and wait patiently for times to change.
Stay with simple propositions
Another of Buffett’s precepts which investors can, and should, make their own is to only invest in businesses that they understand. This sounds obvious, but is not always adhered to — even by Buffett.
In September last year, the electricity utility company MidAmerica — 80.5% of which is owned by Berkshire — wrote off a project to extract zinc from brine, which is a by-product of its California geothermal operations. The project’s downfall was that there were too many key variables.
"If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if 10 independent variables need to break favourably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many."
Indeed, the principle of ‘staying with simple propositions’ is one of Buffett’s conditions for buying businesses.
Berkshire is only interested in owning companies that have demonstrated consistent earning power, and that have earned good returns with little debt. ‘Turnaround’ situations are eschewed and earnings projections are irrelevant. Berkshire also has no interest in businesses with lots of technology — "...We won’t understand it".
Make the business your own
One of Buffett’s most important investment principles is that the managers of the business must treat it as if they owned it personally and would expect to own it for the foreseeable future. This ensures that they avoid ‘short-termism’. Berkshire has a number of investments in quoted stocks, including American Express, Coca Cola, Gillette, Moody’s and Wells Fargo. And these have been held for many years.
As Buffett says: "Some people look [at the stocks owned by Berkshire] and view it as a list of stocks to be bought and sold based upon chart patterns, brokers’ opinions, or estimates of near-term earnings. Charlie [Munger] and I ignore such distractions and instead view our holdings as fractional ownerships in businesses."
Often, delving into a company’s financials is the only way to find undervalued investment opportunities with long-term potential. Investors, unlike speculators, are characterised by a commitment to research.
Following the Buffett way
All investors can follow Warren Buffett’s investment strategy of patience when seeking value. Investors need to focus on the intrinsic value of what they buy or own, and compare it to the prices offered by Mr Market. Often the right thing to do is to wait patiently for something attractive to present itself.
Indeed, Buffett’s approach to investment can actually be seen as the application of the successful strategy in the volatile and cyclical insurance industry: only write business at a price high enough to ensure an underwriting profit.
Once a Senior Research Fellow of the Institute of Economic Affairs, Robert C.B. Miller is now one of the leading independent consultants in the country. He was one of the main men behind the launch of LIFFE and a senior consultant for the London Commodity Exchange
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