AuthorRohit Chauhan

just read the 1969 partnership letter. This was the year when buffet shocked his partners by deciding to close his partnership. That was highly unusual for a money manager , especially if the preceeding year had been as good as it had been for buffet and on top of that if the market was in a bull phase. But buffet rationally decided that there were no bargains to be found and it was better to quit the game than set yourself up for failure.
what struck me in the letter were two points
a) buffet in 1969 clears says that considering the situation then, the conventional wisdom that stocks are a better investment than bonds did not hold true and an investor could expect the same level of return from both. As a result an investor would be better off holding bonds instead of stocks. now this is important as most of the people equate buffet with ‘buy and hold’ which has now become buy and hold ( irrespective of the valuations). This letter clearly shows buffet’s thinking in this matter. Hold you stock till one has rational and well thought out reasons that the stock is not grossly overvalued
b) the second point is mainly buffet’s recommendation of bill ruane to his investor and his very rational and sound assesment of bill ruane’s past performance and ethics. He logically explains and sets the right expectations for his investor and also gives some pointers of how to evaluate a money manager. i found this very enlighting

I read the article below and found it to be very interesting. Makes you think on the importance of free cash flow v/s earnings (on which analysts are fixated).
If free cash flow is important, then what should be the value of companies like – moser baer, some of the cement companies, steel companies which make a lot of money (at least in the upcycle ) , but need buckets of cash to invest in new plant, R&D , working capital etc.
One would see analyst getting excited with the huge earnings growth and the low PE. I would temper my expectations because
a) earnings are high as demand and pricing is strong
b) PE are low in a cyclical stock during an upcycle
c) earnings are ignoring the impact of Capex ( which is high in these companies)

article taken from wallstraits.com
BUFFETT: FOLLOW RETAINED EARNINGS
In the 1934 edition of Security Analysis, Ben Graham introduces his readers to Edgar Lawrence Smith, who in 1924 wrote a book on investing entitled Common Stocks As Long-Term Investments (Macmillan, 1924). Smith put forth the idea that common stocks should in theory grow in value as long as they earn more than they pay out in dividends, with the retained earnings adding to the company’s net worth. In a representative case, a business would earn a 12% return on equity, pay out 8% in dividends, and retain 4% to surplus. If it did this every year, the stock value should increase with its book value, at a rate of 4% compounded annually.
With this in mind, Smith explains the growth of asset values through the reinvestment of a corporation’s surplus earnings in the expansion of its operations. Graham, however, warns us that not all companies can reinvest their surplus earnings in expansion of their business enterprise. Most, in fact, must spend their retained earnings on simply maintaining the status quo through the replenishment of expiring plants and equipment. Predicting future earnings of any enterprise can be very difficult and given to great variance. This means that making a future prediction of earnings can be fraught with potential disaster.
Warren Buffett concluded that Graham’s assessment of Smith’s analysis was correct for a great majority of businesses. However, he found that under close analysis some companies were an exception to the rule. Buffett found that these exceptions over a long period of time were able to profitably employ retained earnings at rates of return considerably above the average. In short, Buffett found a few businesses that didn’t need to spend their retained earnings upgrading plant and equipment or on new-product development, but could spend their earnings on acquiring new businesses or expanding the operations of their already profitable core enterprises.
We want to invest in businesses that can retain their earnings and haven’t committed themselves to paying out a high percentage of their profits as dividends. This way the shareholders can benefit from the full effects of compounding, which is the secret to getting really rich.
Capital Spending for Maintenance vs Growth
One of our key stock screens for our WS8 Portfolio, as our Intelli-Vest members are well aware, is to think carefully about how management allocates capital. How much is paid as cash dividends? How much is required to be invested in maintaining or replacing plants and equipment just to maintain current levels of sales and profits? How much is spent on expanding production to create new business, new sales and new profits? To understand the investment merit of any business, we must be able to answer these capital allocation questions.
Making money is one thing, retaining it is another, and not having to spend it on maintaining current operations is still another. Buffett found that in order for Smith’s theory to work he had to invest in companies that (1) made money, (2) could retain it, and (3) didn’t have to spend those retained earnings on maintaining current operations.
Buffett discovered that the capital requirements of a business may be so demanding that the company ends up having little or no money left to increase the fortunes of its shareholders.
Let me give you an example. If a business makes $1 million a year, and retains every cent, but every other year it has to spend $2 million replacing plant and equipment that were expended in production, the company really isn’t making any money at all; the business is only breaking even. The perfect business to Buffett would be one that earns $2 million and spends zero on replacing plant and equipment.
Buffett used to teach this lesson when he conducted a night class on investing at the University of Nebraska at Omaha Business School (image enrollment demand if he still taught such a class today!). He would lecture on the capital requirements of a company and the effect that it had on shareholder fortunes. He would do this by showing his students the past operating records of AT&T and of Thomson Publishing.
Buffett would demonstrate that AT&T, before it was broken up, was a poor investment for shareholders, because though it made lots of money, it had to plow even more money than it made into capital requirements — research and development and infrastructure. The way that AT&T financed the expansion was to issue more shares and to sell lots of debt.
But a company like Thomson Publishing, which owned a bunch of newspapers in one-newspaper towns, made lots of money for its shareholders. This was because once a newspaper had built its printinig infrastructure it had little in the way of capital needs to such away the shareholders’ money. This meant that there was lots of cash to spend on buying more newspapers to make its shareholders richer.
The lesson is that one business grew in value without requiring more infusions of capital and the other business grew only because of the additional capital that was invested in it.
Warren Buffett decided he wanted to search for a few businesses businesses that seldom required replacement of plant and equipment and didn’t require ongoing expensive research and development. He wanted a few companies that produced a product that never became obsolete and was simple to produce and had little competition: the only newspaper in town, a candy bar manufacturer, a chewing gum company, a razor blade producer, a soda pop business, a brewery — basic businesses with products that people never want to see essentially change. Predictable product, predictable profit. And he found a few, and he became the richest man on the planet!

One of the things warren buffet repeats across his letter is his focus on limiting the downside to his portfolio. He considers a performance of -10% v/s -20 % of Dow better than a +20% v/s +10% of the dow. This clearly demonstrates the fact (which he has pointed out too ) that the portfolio was unconventional but also had a lower risk.
Warren buffet had put this approach in the inital letters and made it one of the key objectives in managing the portfolio.
The above approach bring to mind the quote from buffet –
rule 1 – Dont lose money
Rule 2 – dont forget rule 1

This is a very powerful approach to manage a portfolio. If one is convinced that the stock market would do well over the long term , and can limit the downside of the portfolio during bear markets , then as even buffet acknowldeged ,even if one cannot match the market on the upside , one should come out fine.

I have been reading the letters further and have read till the 1965 letter. After initial formal / fact driven style of letters, the latter ones are more informative and one can see the buffet humor in those letter coming through. These letters are closer to the BRK letter from the chairman and i was quite surprised to find example, quotes which buffet has repeated later through his BRK letters.

He discusses the ‘joys of compounding’ in the latter letters and stresses on the importance of compounding at a higher than average rate and the impact on one’s terminal networth.

There is a section on taxes (which has appeared later in the BRK letters) which discusses the importance of focussing on the post tax returns and focussing on investing based on this measure. Buffet points out to the folly of trying to minimise taxes at the cost of the post tax returns. He stresses on focussing on post tax returns and if the course of action enables the investor to save taxes , then thats added benefit. however the ‘means’ should not be confused with the ‘end’.

In addition buffet discusses about a workout (arbitrage) situation as an example. These workout enable buffet to post a great performance during the down markets. The second category is ‘generals’ which is mainly the undervalued stocks and this was the highest proportion of the partnership most of the times.

The third portion is the control situation and buffet has discussed about dempster mills in detail and how he was able to extract value out of it . The point he makes several times is the focus on buying at a such a good price that a mediocore sale is good enough. He even states that buying is 90 % of the task and selling the balance 10%. This is illuminating !!!

i am enjoying reading the letters