Buffett?s Latest Letter: Nuggets of Wisdom (Market Forcecast by Joe Chumbler)

Once again the “Sage of Omaha” did not disappoint readers of his annual letter to Berkshire Hathaway shareholders. I recommend going to www.berkshirehathaway.com and reading not only the 2007 letter, but also each of the archived letters written since 1977.

Here I’m going to highlight a few of the nuggets of wisdom investors can glean from Buffett’s latest letter. We will see why the greatest investor of all time favors stocks over mutual funds, his definition of a great business, and how he made a lot of money investing in Internet pure-play Amazon.com.

How To Beat The Market

To the dismay of thousands of brokers and financial planners who claim that asset allocation is more important than investing in good individual companies at reasonable prices, Warren Buffett posted yet another impressive investment result in 2007. During the year, the book value of his company, Berkshire Hathaway, increased 11 percent (after-tax) compared to the increase in the S&P 500 of 5.5 percent (pre-tax, including dividends). Berkshire’s book value increases when the value of its investment portfolio grows ($141 billion of stocks, bonds and cash at the end of 2007) and also when the myriad businesses it owns generate increased earnings.

In case you are wondering, 2007 was no fluke. Over the last 43 years, Buffett and partner Charlie Munger have grown the per-share book value of Berkshire Hathaway at a compound annual growth rate of 21.1 percent, compared to the S&P 500 growth rate of 10.3 percent. I know of no mutual fund or ETF that even comes close to this type of market outperformance even over a short time period.

Yet Buffett’s recipe is no secret. It doesn’t require finding the hottest mutual fund or having a certain amount of money invested internationally or in real estate or hedge funds. Simply put, it requires identifying good-to-great businesses and investing in them at attractive prices.

Anatomy of a Great Business

It’s not rocket science, in fact it’s almost 3rd grade math. As described on page 6 of the 2007 letter, Buffett likes to invest in businesses he understands with favorable long-term economics and able and trustworthy management — all at a sensible price. Acquired more than 30 years ago, See’s Candies exemplifies his idea of a dream company.

Since being acquired by Berkshire in 1972, the boxed-chocolates company’s sales volume has increased at a rate of only 2 percent per year from 16 million pounds of chocolate to 31 million pounds in 2007. This type of slow-growth business is not the kind that can enable a stockbroker to generate hefty commissions through “hot stock tips,” but how sweet it is. Since purchasing See’s for $25 million, Buffett has seen its profits steadily grow from $5 million to $82 million. More importantly, since See’s sells chocolate for cash (no receivables) and doesn’t have a lot of money tied up in inventory, Berkshire has been able to extract $1.35 billion of profits over its 35-year holding period. See’s low capital requirements enabled Berkshire to keep these profits and reinvest them.

A Few Good Stocks

In addition to buying entire great businesses like See’s Candies, Buffett buys stocks as well. But he doesn’t invest through mutual funds; rather he researches and invests in just a handful of carefully selected individual stocks.

At the end of 2007, Berkshire’s stock portfolio totaled about $75 billion, $67 billion of which was invested in only 18 stocks. He noted that three of his largest holdings performed well in 2007, citing 12 percent to 14 percent earnings growth for American Express, Coke, and Procter & Gamble. It’s instructive to note that he did not discuss the share price performance of each of these companies, rather the financial performance and competitive position of each.

The lesson here, of course, is to research and invest in individual stocks just as one would buy an entire business outright, and focus on the performance of the company rather than the vagaries of the stock market when assessing investment merits.

Buffett Goes Dotcom

With well over 2,000 titles referencing “Warren Buffett” for sale at Amazon.com, the online book retailer has certainly made money on his success. Buffett reciprocated by earning a handsome return on an investment in Amazon.com made in 2001 and 2002. Regular readers of the Berkshire Hathaway Chairman will find this somewhat surprising, given his scorn for rapidly changing technology and irrationally high valuations.

But at the ripe old age of 70, Buffett was clearly thinking outside the box when he bought Amazon.com bonds denominated in Euros at a steep discount of 57 percent of par value (like “junk” bonds). In 2001 and 2002 when the Euro was trading at 95 cents, Berkshire Hathaway invested a total of $169 million in these bonds. Here is the math: 310 million Euro face value times a 57 percent discount to face value is 177 million Euros; with a 95 cent exchange rate, the bonds cost $169 million US dollars.

I decided to look back at Amazon’s income statement, balance sheet and cash flow statements in 2001 and 2002 to see what gave Buffett the confidence to invest in these “junk” bonds. In 2002, Amazon.com had finally swung to an operating profit after losing money for several years. More importantly, the company had over $1 billion in cash and marketable securities and generated $174 million in cash from operations, while necessary capital expenditures were only $39 million. Clearly Amazon.com was not a company in financial distress that warranted its debt to trade at nearly 50 cents on the dollar.

And Buffett’s willingness to research the company and invest when others were fearful has paid off. In the last couple of years Amazon.com has redeemed some of Buffett’s bonds for 102 percent of face value. And with the Euro now trading at $1.47, his $169 million original investment is poised to be worth over $400 million.

Adding the 6.87 percent annual coupon payment he received, his total return is about 21 percent per year over the 7-year holding period. Appropriately, he observes in his letter that markets are still inefficient, even if some of the top business schools are teaching that they are not.

The See’s Candies investment teaches us that great investments can come in small, boring packages. And his Amazon.com buy is proof that the public stock and bond markets remain joyfully inefficient.

(Joe Chumbler, chartered financial analyst, is a partner in Boston Mountain Money Management in Fayetteville. He may be reached at [email protected].)