Saturday, March 3, 2007

2006 Berkshire Letter Review, Part 1: Why Don't We Evaluate or Stock Portfolios Like Warren Buffett Does?

Of all the topics discussed in Warren Buffett's 2006 annual letter to Berkshire Hathaway shareholders (warning: links to a .pdf document), the one that I think applies directly to most investors comes on page 15, under the section entitled "Investments." This is the section where Buffett talks about Berkshire's investment portfolio- the common stock investments that the company owns. You can compare this to your own investment portfolio, though I would be more than willing to bet you own many fewer shares of the companies than Berkshire does.

The letter breaks out the 17 different investments that Berkshire owns with a market value of more than $700 million. Buffett notes that there are 2 investments with market values over $700 million that were left off the list because Berkshire is still buying the shares and he doesn't want to tip the market off and drive up their share prices. Referring to these two mystery companies, he says "I could, of course, tell you their names. But then I would have to kill you."

Allthough the makeup of the portfolio is very interesting, (the usual suspects: American Express, Coke, Wal-Mart, Moodys, and some relative newcomers like PetroChina "H" shares and POSCO) that wasn't the part that interested me the most. What interested me most was the way Buffett described the performance of his portfolio, how it is fundamentally different than the way most people describe their own portfolios, and how much better off people would be if they took his approach. You'll see my point when you read what he had to say about his stock portfolio’s performance in 2006:

“We are delighted by the 2006 business performance of virtually all of our
investees. Last year, we told you that our expectation was that these companies,
in aggregate, would increase their earnings by 6% to 8% annually, a rate that
would double their earnings every ten years or so. in 2006 American Express,
Coca-Cola, Procter & Gamble and Wells Fargo, our largest holdings, increased
per-share earnings by 18%, 9%, 8% and 11%. These are stellar results, and we
thank their CEOs.”
Go back and read that again.

Did you find anything missing from that description?

What I found notably absent was a discussion of the price performance of the stocks Berkshire owns. The majority of investors would have talked about how their portfolio was up X% during 2006, with some stocks outperforming their peers or other benchmarks in terms of share price appreciation. Buffett, on the other hand, focuses on the performance of the underlying businesses, taking his world-famous business owner perspective on investing which I touched upon in my review of Mary Buffett’s book Buffettology (you can learn more about this perspective from that book).

Ninety percent of investors who own individual stocks take the wrong point of view when investing. They see stocks purely as pieces of paper or ticker symbols that fluctuate in value every day. Warren Buffett sees stocks for what they really are: pieces of ownership in the underlying business. He sees the earnings of the underlying business as being his, in proportion to the amount of shares he owns.

Because of this perspective, he evaluates the performance of the business underlying his investment, not the performance of the stock price. Buffett knows that stock prices will be subject to the whims of the markets, so they are not in themselves indications of how well his investment is performing.

If you own a portfolio of individual stocks, I challenge you to take this perspective. Set up a spreadsheet or make a paper listing a few key performance metrics for each of the companies you are invested in. It could be as simple as listing out revenues, net income, assets, liabilities, operating cash flow, and if you’re even more ambitious, free cash flow. Review the performance of your investments against these metrics once or twice a year. Think of yourself as an owner of the business, instead of as an owner of a ticker symbol that moves around with seemingly no rhyme or reason. Chances are you will start to see your portfolio in a whole different light.

Hopefully this exercise will at least shield you from using fluctuations in the market price of a stock as the only reason to buy or sell a stock. I am often amazed when I hear people saying they’re going to buy a stock “because the price keeps going up,” and using that as their sole criteria for making an investment. Or, deciding to sell a stock they own because “it is down 50% from where I bought it.” Don’t let the market tell you what to do. The market makes mistakes. People get fearful. People get greedy. In the short run, the market price will reflect the greed and fears of the day. In the long term, the market price will reflect the performance of the underlying business as indicated by the metrics I listed above, the most important one being the earnings of the business.

In a world of Jim Cramer’s Fast Money, all of the financial press, the talking heads on TV, the real-time stock quotes, heat maps, online trading, and all of the marketing dollars being thrown around in the investment world, investors often get caught up in the wrong things. They buy and sell stocks on whims, subjecting themselves to whipsaw, capital gains taxes, commissions, fees, penalties, and other investment performance killers that erode the value of their investments over the long term. If they took a step back, a deep breath, a long term outlook, and Warren Buffett’s business perspective of investing, they would do much better over the long run.

I’ll leave you with a final question. Pick any stock in your portfolio. Now without looking it up, can you tell me if its earnings were higher in 2006 than in 2005? If you can’t, I think you should be paying more attention to the companies you own.

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