In one of our previous posts, we had written about this project of dividing all the letters of Warren Buffett into six parts representing six decades of Buffett’s investment journey. We also wrote about our learnings from the letters of Warren Buffett in the first decade (1957-1966).
This post is on our learnings from his letters in the second decade (1967-1976). For our readers’ convenience, just like the last time, we’ve put together an illustrated version of the letters. Please click here to download it.
Here are the eight big learnings from the second decade of Warren Buffett’s investment journey.
1. An admission that the performance will not be repeated is a big foresight
Apart from the technical skills of understanding businesses, industries and the ability to read and understand financial numbers, a very important aspect of investing is about having a rational mind and setting right expectations for your investments. Buffett is the perfect example of that. After a phenomenal investment performance in the initial ten years, he could sense the difficulty in repeating it the next. This is what he says:
A keen mind working diligently at interpreting the figures on page one could come to a lot of wrong conclusions. The results of the first ten years have absolutely no chance of being duplicated or even remotely approximated during the next decade. They may well be achieved by some hungry twenty-five-year-old working with $105,100 initial partnership capital and operating during a ten-year business and market environment which is frequently conducive to successful implementation of his investment philosophy. They will not be achieved by a better fed thirty-six-year-old working with our $54,065,345 current partnership capital who presently finds perhaps one-fifth to one-tenth as many really good ideas as previously to implement his investment philosophy. (Jan, 1967)
When you set the right expectations at the start for yourself and for the clients whose funds you are managing, you automatically liberate yourself from managing clients’ perception during volatile times. It not only prepares the clients for the road ahead but also gains you an immense trust.
“Promising less and delivering more” always works well in the long term.
2. Focus on the Long Run
One of the biggest traits of Buffett is to have an uncanny ability to focus only on long term performance. And for that, he is always prepared for periods of substantial underperformance. And not only that, but he also prepares his clients for those periods by effectively communicating to them through his letters. Below is an excerpt from one of his letters:
Personally, within the limits expressed in last year’s letter on diversification, I am willing to trade the pains (forget about the pleasures) of substantial short term variance in exchange for maximization of long term performance. However, I am not willing to incur risk of substantial permanent capital loss in seeking to better long term performance. To be perfectly clear – under our policy of concentration of holdings, partners should be completely prepared for periods of substantial underperformance (far more likely in sharply rising markets) to offset the occasional over performance such as we have experienced in 1965 and 1966, and as a price we pay for hoped-for good long term performance. (Jan, 1967)
These things are easier said than done. We often hear from many investors about their philosophy of investing for the long term, but when we look at their portfolio, we see something completely different. But Buffett has been someone who has always walked his talk. And that is all that has made the difference.
3. Great Business Vs Undervalued Securities
While the focus on long term performance has never changed for Buffett over the years. We noticed a subtle change from the first decade to the second in how he thought about building his portfolio. In the first decade, he was more focused on finding undervalued securities. This is what he wrote in the 1958 letter:
I make no attempt to forecast the general market – my efforts are devoted to finding undervalued securities. However, I do believe that widespread public belief in the inevitability of profits from investment in stocks will lead to eventual trouble. Should this occur, prices, but not intrinsic values in my opinion, of even undervalued securities can be expected to be substantially affected.
If you notice above, there is no mention of the quality of business here, the only focus is to find undervalued securities.
Now look at what he writes in his 1975 letter:
Our equity investments are heavily concentrated in a few companies which are selected based on favorable economic characteristics, competent and honest management, and a purchase price attractive when measured against the yardstick of value to a private owner. When such criteria are maintained, our intention is to hold for a long time. (1975 Letter)
Here he is talking about the importance of having favorable economics, quality management, and attractive price. You may note that he has not yet started talking about the word MOAT or competitive advantage. The word Moat has now become so famous that we often don’t realize that Buffett association with the same came a lot later in his career.
4. Business Performance over Stock Market Fluctuation
Here is an excerpt from his 1975 letter:
Stock market fluctuations are of little importance to us—except as they may provide buying opportunities—but business performance is of major importance. On this score we have been delighted with progress made by practically all of the companies in which we now have significant investments. (1975 Letter)
Now, everyone knows about this. We all say that business performance matters in the long run. If a company does well, the stock price will eventually follow. In reality, however, when the stock price of the company, we are invested in, drops by 20-30% we start getting nervous. All our investment hypothesis goes haywire. This is where Buffett differentiates himself from most investors. And this is what one has to learn from him.
5. Quantitative Vs Qualitative
Buffett writes in the Oct 1967 Letter:
Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess – I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight”. This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side – the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions. Such statistical bargains have tended to disappear over the years. (Oct, 1967)
This gives a fair idea of how Buffett could spot the changes in the investment environment. Notice how he says in the end that statistical bargains have been disappearing over the years. So, even though he made most of his money by investing in statistical bargains in the first decade, having the ability to evolve and look for the qualitative aspects when the environment started changing is a must trait to have for any investor. So, if you are an investor and you just blindly try to copy what has worked in the past, you will find it tough. You must adapt to the changing environment and fine-tune your investment process accordingly.
6. Stay with your Strengths, Don’t fall for things you do not understand
This is one of his best advice:
I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean foregoing large and apparently easy profits to embrace an approach which I don’t fully understand, have not practiced successfully and which possibly, could lead to substantial permanent loss of capital. (Oct 1967)
We, investors, are often offered luring baits all along our investment journey. Some are produced by the market, while some are the products of other participants. The challenge always for us is to continue on our path not getting distracted. However, at times, it becomes too tempting for us and we give in to the short-term gain and deviate from our process. People like Buffett who have been successful over long periods of time have this important trait of character. They say “No” to almost everything. And then focus on only the thing they truly understand and like. All investors should strive for that.
7. Investing in Textile Business- One of the biggest mistake
Originally, Buffett wanted to stay in the textile business, reduce capital spending and use all excess funds to expand the rest of his empire. In the following excerpts, you will notice that he is always defending why he wants to continue with the textile operation even though he realizes.
This is what he writes in the 1969 letter:
If we are not getting a good return on the textile business of Berkshire Hathway Inc, why do we continue to operate it? I don’t want to liquidate a business employing 1100 people when the management has worked hard to improve their relative industry position, with reasonable results, and as long as the business does not require substantial additional capital investment. I have no desire to trade several human dislocations for a few percentage points additional return per annum. Obviously, if we faced material compulsory additional investment or sustained operating losses, the decision might have to be different, but I don’t anticipate such alternatives. (Dec, 1969)
And this in 1971:
We, in common with most of the textile industry, continued to struggle throughout 1971 with inadequate gross margins. Strong efforts to hammer down costs and a continuous search for less price‐sensitive fabrics produced only marginal profits. However, without these efforts we would have operated substantially in the red. (1971 letter)
And this in 1976:
Our textile division was a significant disappointment during 1976. Earnings, measured either by return on sales or by return on capital employed, were inadequate. In part, this was due to industry conditions which did not measure up to expectations of a year ago. But equally important were our own shortcomings. Marketing efforts and mill capabilities were not properly matched in our new Waumbec operation. Unfavorable manufacturing cost variances were produced by improper evaluation of machinery and personnel capabilities. Ken Chace, as always, has been candid in reporting problems and has worked diligently to correct them. He is a pleasure to work with—even under difficult operating conditions. (1976 Letter)
Notice, that even after sustained below-par performance of the Textile business, Buffett continues to own it. That shows that even bests make mistakes. He later realizes this mistake and the following quote from his 1985 letter is very famous today which says:
Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
8. A superb performance of the Insurance Business
In the last section, we covered what did not work for Buffett. In this section, we want to highlight what worked phenomenally for him. And that is his investments in the insurance business. Have a look at some of his commentary year after year:
This he writes in 1970 letter
Jack Ringwalt and his outstanding management group turned in new records in just about every department during 1969. During another year in which the fire and casualty insurance industry experienced substantial underwriting losses, our insurance subsidiaries achieved significant adjusted underwriting profits. (April 1970)
In the 1971 letter he writes this:
We set no volume goals in our insurance business generally—and certainly not in reinsurance—as virtually any volume can be achieved if profitability standards are ignored. When catastrophes occur and underwriting experience sours, we plan to have the resources available to handle the increasing volume which we will then expect to be available at proper prices. (1971 Letter)
1972 letter:
We were most fortunate to experience dramatic gains in premium volume from 1969 to 1971 coincidental with virtually record‐high interest rates. Large amounts of investable funds were thus received at a time when they could be put to highly advantageous use. Most of these funds were placed in tax‐exempt bonds and our investment income, which has increased from $2,025,201 in 1969 to $6,755,242 in 1972, is subject to a low effective tax rate. (1972 Letter)
And finally this in the 1973 letter:
Our traditional business, specialized auto and general liability lines conducted through National Indemnity Company and National Fire and Marine Insurance Company, had an exceptionally fine underwriting year during 1973. We again experienced a decline in volume. Competition was intense, and we passed up the chance to match rate‐cutting by more optimistic underwriters. There currently are faint indications that some of these competitors are learning of the inadequacy of their rates (and also of their loss reserves) which may result in easing of market pressures as the year develops. If so, we may again experience volume increases. (1973 Letter)
The biggest learning from Buffett’s success in the insurance business is that the success of an investor or an investment manager is not only dependent on how efficiently he/she manages the investment portfolio but also on the ability to constantly put in large amounts of capital.
We all have the performance of Warren Buffett in front of us. We look at it with awe and respect. But we often miss one important part.
Have you ever thought, how he would have performed if had not started the insurance business?
Of course, he would have still compounded his capital at the same rate.
But, without the steady incoming premiums of his insurance subsidiaries, Buffett would have been left to manage a lot less capital over the years. Hence, the Berkshire of today would not have been possible minus the insurance business.
So, as an investor our performance over a period is determined by two factors:
- How much returns we generate over our investible period.
- How much money we put in our portfolio.
For most of us, even if we achieve lesser long term returns than what Buffett has achieved, we can do really well for ourselves.
Hence, setting the right expectation is very important.
But while striving for the best returns, we must not forget to look for the float. Buffett had that float in the form of insurance premiums. Asset managers have that float in the form of access to other people’s money. Different investors find their float in different ways.
If you are curious to know what is float, wait for our next post on Buffett letters.
We have compiled an illustrated version of Buffett’s letter. You can download it from here.
