FORTUNE -- "Investment is most intelligent when it is most businesslike." --Benjamin Graham
, The Intelligent Investor
It
is fitting to have a Ben Graham quote open this essay because I owe so
much of what I know about investing to him. I will talk more about Ben a
bit later, and I will even sooner talk about common stocks. But let me
first tell you about two small nonstock investments that I made long
ago. Though neither changed my net worth by much, they are instructive.
This
tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an
explosion in farm prices, caused by a widespread belief that runaway
inflation was coming and fueled by the lending policies of small rural
banks. Then the bubble burst, bringing price declines of 50% or more
that devastated both leveraged farmers and their lenders. Five times as
many Iowa and Nebraska banks failed in that bubble's aftermath as in our
recent Great Recession.
In 1986, I purchased a 400-acre farm,
located 50 miles north of Omaha, from the FDIC. It cost me $280,000,
considerably less than what a failed bank had lent against the farm a
few years earlier. I knew nothing about operating a farm. But I have a
son who loves farming, and I learned from him both how many bushels of
corn and soybeans the farm would produce and what the operating expenses
would be. From these estimates, I calculated the normalized return from
the farm to then be about 10%. I also thought it was likely that
productivity would improve over time and that crop prices would move
higher as well. Both expectations proved out.
I
needed no unusual knowledge or intelligence to conclude that the
investment had no downside and potentially had substantial upside. There
would, of course, be the occasional bad crop, and prices would
sometimes disappoint. But so what? There would be some unusually good
years as well, and I would never be under any pressure to sell the
property. Now, 28 years later, the farm has tripled its earnings and is
worth five times or more what I paid. I still know nothing about farming
and recently made just my second visit to the farm.
In
1993, I made another small investment. Larry Silverstein, Salomon's
landlord when I was the company's CEO, told me about a New York retail
property adjacent to New York University that the Resolution Trust Corp.
was selling. Again, a bubble had popped -- this one involving
commercial real estate -- and the RTC had been created to dispose of the
assets of failed savings institutions whose optimistic lending
practices had fueled the folly.
Here, too, the analysis was simple.
As had been the case with the farm, the unleveraged current yield from
the property was about 10%. But the property had been undermanaged by
the RTC, and its income would increase when several vacant stores were
leased. Even more important, the largest tenant -- who occupied around
20% of the project's space -- was paying rent of about $5 per foot,
whereas other tenants averaged $70. The expiration of this bargain lease
in nine years was certain to provide a major boost to earnings. The
property's location was also superb: NYU wasn't going anywhere.
I
joined a small group -- including Larry and my friend Fred Rose -- in
purchasing the building. Fred was an experienced, high-grade real estate
investor who, with his family, would manage the property. And manage it
they did. As old leases expired, earnings tripled. Annual distributions
now exceed 35% of our initial equity investment. Moreover, our original
mortgage was refinanced in 1996 and again in 1999, moves that allowed
several special distributions totaling more than 150% of what we had
invested. I've yet to view the property.
Income from both the farm
and the NYU real estate will probably increase in decades to come.
Though the gains won't be dramatic, the two investments will be solid
and satisfactory holdings for my lifetime and, subsequently, for my
children and grandchildren.
I tell these tales to illustrate certain fundamentals of investing:
- You
don't need to be an expert in order to achieve satisfactory investment
returns. But if you aren't, you must recognize your limitations and
follow a course certain to work reasonably well. Keep things simple and
don't swing for the fences. When promised quick profits, respond with a
quick "no."
- Focus on the future productivity of the asset you
are considering. If you don't feel comfortable making a rough estimate
of the asset's future earnings, just forget it and move on. No one has
the ability to evaluate every investment possibility. But omniscience
isn't necessary; you only need to understand the actions you undertake.
- If
you instead focus on the prospective price change of a contemplated
purchase, you are speculating. There is nothing improper about that. I
know, however, that I am unable to speculate successfully, and I am
skeptical of those who claim sustained success at doing so. Half of all
coin-flippers will win their first toss; none of those winners has an
expectation of profit if he continues to play the game. And the fact
that a given asset has appreciated in the recent past is never a reason
to buy it.
- With my two small investments, I thought only of what
the properties would produce and cared not at all about their daily
valuations. Games are won by players who focus on the playing field --
not by those whose eyes are glued to the scoreboard. If you can enjoy
Saturdays and Sundays without looking at stock prices, give it a try on
weekdays.
- Forming macro opinions or listening to the macro or
market predictions of others is a waste of time. Indeed, it is dangerous
because it may blur your vision of the facts that are truly important.
(When I hear TV commentators glibly opine on what the market will do
next, I am reminded of Mickey Mantle's scathing comment: "You don't know
how easy this game is until you get into that broadcasting booth.")
My
two purchases were made in 1986 and 1993. What the economy, interest
rates, or the stock market might do in the years immediately following
-- 1987 and 1994 -- was of no importance to me in determining the
success of those investments. I can't remember what the headlines or
pundits were saying at the time. Whatever the chatter, corn would keep
growing in Nebraska and students would flock to NYU.
There
is one major difference between my two small investments and an
investment in stocks. Stocks provide you minute-to-minute valuations for
your holdings, whereas I have yet to see a quotation for either my farm
or the New York real estate.
It
should be an enormous advantage for investors in stocks to have those
wildly fluctuating valuations placed on their holdings -- and for some
investors, it is. After all, if a moody fellow with a farm bordering my
property yelled out a price every day to me at which he would either buy
my farm or sell me his -- and those prices varied widely over short
periods of time depending on his mental state -- how in the world could I
be other than benefited by his erratic behavior? If his daily shout-out
was ridiculously low, and I had some spare cash, I would buy his farm.
If the number he yelled was absurdly high, I could either sell to him or
just go on farming.
Owners of stocks, however, too often let the
capricious and irrational behavior of their fellow owners cause them to
behave irrationally as well. Because there is so much chatter about
markets, the economy, interest rates, price behavior of stocks, etc.,
some investors believe it is important to listen to pundits -- and,
worse yet, important to consider acting upon their comments.
Those
people who can sit quietly for decades when they own a farm or apartment
house too often become frenetic when they are exposed to a stream of
stock quotations and accompanying commentators delivering an implied
message of "Don't just sit there -- do something." For these investors,
liquidity is transformed from the unqualified benefit it should be to a
curse.
A
"flash crash" or some other extreme market fluctuation can't hurt an
investor any more than an erratic and mouthy neighbor can hurt my farm
investment. Indeed, tumbling markets can be helpful to the true investor
if he has cash available when prices get far out of line with values. A
climate of fear is your friend when investing; a euphoric world is your
enemy.
During the extraordinary financial panic that
occurred late in 2008, I never gave a thought to selling my farm or New
York real estate, even though a severe recession was clearly brewing.
And if I had owned 100% of a solid business with good long-term
prospects, it would have been foolish for me to even consider dumping
it. So why would I have sold my stocks that were small participations in
wonderful businesses? True, any one of them might eventually
disappoint, but as a group they were certain to do well. Could anyone
really believe the earth was going to swallow up the incredible
productive assets and unlimited human ingenuity existing in America?
When
Charlie Munger and I buy stocks -- which we think of as small portions
of businesses -- our analysis is very similar to that which we use in
buying entire businesses. We first have to decide whether we can
sensibly estimate an earnings range for five years out or more. If the
answer is yes, we will buy the stock (or business) if it sells at a
reasonable price in relation to the bottom boundary of our estimate. If,
however, we lack the ability to estimate future earnings -- which is
usually the case -- we simply move on to other prospects. In the 54
years we have worked together, we have never forgone an attractive
purchase because of the macro or political environment, or the views of
other people. In fact, these subjects never come up when we make
decisions.
It's
vital, however, that we recognize the perimeter of our "circle of
competence" and stay well inside of it. Even then, we will make some
mistakes, both with stocks and businesses. But they will not be the
disasters that occur, for example, when a long-rising market induces
purchases that are based on anticipated price behavior and a desire to
be where the action is.
Most investors, of course, have
not made the study of business prospects a priority in their lives. If
wise, they will conclude that they do not know enough about specific
businesses to predict their future earning power.
I have good news
for these nonprofessionals: The typical investor doesn't need this
skill. In aggregate, American business has done wonderfully over time
and will continue to do so (though, most assuredly, in unpredictable
fits and starts). In the 20th century, the Dow Jones industrial index
advanced from 66 to 11,497, paying a rising stream of dividends to boot.
The 21st century will witness further gains, almost certain to be
substantial. The goal of the nonprofessional should not be to pick
winners -- neither he nor his "helpers" can do that -- but should rather
be to own a cross section of businesses that in aggregate are bound to
do well. A low-cost S&P 500 index fund will achieve this goal.
That's
the "what" of investing for the nonprofessional. The "when" is also
important. The main danger is that the timid or beginning investor will
enter the market at a time of extreme exuberance and then become
disillusioned when paper losses occur. (Remember the late Barton Biggs's
observation: "A bull market is like sex. It feels best just before it
ends.") The antidote to that kind of mistiming is for an investor to
accumulate shares over a long period and never sell when the news is bad
and stocks are well off their highs. Following those rules, the
"know-nothing" investor who both diversifies and keeps his costs minimal
is virtually certain to get satisfactory results. Indeed, the
unsophisticated investor who is realistic about his shortcomings is
likely to obtain better long-term results than the knowledgeable
professional who is blind to even a single weakness.
If
"investors" frenetically bought and sold farmland to one another,
neither the yields nor the prices of their crops would be increased. The
only consequence of such behavior would be decreases in the overall
earnings realized by the farm-owning population because of the
substantial costs it would incur as it sought advice and switched
properties.
Nevertheless, both individuals and institutions will
constantly be urged to be active by those who profit from giving advice
or effecting transactions. The resulting frictional costs can be huge
and, for investors in aggregate, devoid of benefit. So ignore the
chatter, keep your costs minimal, and invest in stocks as you would in a
farm.
My
money, I should add, is where my mouth is: What I advise here is
essentially identical to certain instructions I've laid out in my will.
One bequest provides that cash will be delivered to a trustee for my
wife's benefit. (I have to use cash for individual bequests, because all
of my Berkshire Hathaway (BRKA)
shares will be fully distributed to certain philanthropic organizations
over the 10 years following the closing of my estate.) My advice to the
trustee could not be more simple: Put 10% of the cash in short-term
government bonds and 90% in a very low-cost S&P 500 index fund. (I
suggest Vanguard's. (VFINX))
I believe the trust's long-term results from this policy will be
superior to those attained by most investors -- whether pension funds,
institutions, or individuals -- who employ high-fee managers.
And now back to Ben Graham. I learned most of the thoughts in this investment discussion from Ben's book
The Intelligent Investor, which I bought in 1949. My financial life changed with that purchase.
Before
reading Ben's book, I had wandered around the investing landscape,
devouring everything written on the subject. Much of what I read
fascinated me: I tried my hand at charting and at using market indicia
to predict stock movements. I sat in brokerage offices watching the tape
roll by, and I listened to commentators. All of this was fun, but I
couldn't shake the feeling that I wasn't getting anywhere.
In
contrast, Ben's ideas were explained logically in elegant,
easy-to-understand prose (without Greek letters or complicated
formulas). For me, the key points were laid out in what later editions
labeled Chapters 8 and 20. These points guide my investing decisions
today.
A couple of interesting sidelights about the
book: Later editions included a postscript describing an unnamed
investment that was a bonanza for Ben. Ben made the purchase in 1948
when he was writing the first edition and -- brace yourself -- the
mystery company was Geico. If Ben had not recognized the special
qualities of Geico when it was still in its infancy, my future and
Berkshire's would have been far different.
The 1949 edition of the
book also recommended a railroad stock that was then selling for $17 and
earning about $10 per share. (One of the reasons I admired Ben was that
he had the guts to use current examples, leaving himself open to sneers
if he stumbled.) In part, that low valuation resulted from an
accounting rule of the time that required the railroad to exclude from
its reported earnings the substantial retained earnings of affiliates.
The
recommended stock was Northern Pacific, and its most important
affiliate was Chicago, Burlington & Quincy. These railroads are now
important parts of BNSF (Burlington Northern Santa Fe), which is today
fully owned by Berkshire. When I read the book, Northern Pacific had a
market value of about $40 million. Now its successor (having added a
great many properties, to be sure) earns that amount every four days.
I can't remember what I paid for that first copy of
The Intelligent Investor.
Whatever the cost, it would underscore the truth of Ben's adage: Price
is what you pay; value is what you get. Of all the investments I ever
made, buying Ben's book was the best (except for my purchase of two
marriage licenses).
Warren Buffett is the CEO of Berkshire Hathaway. This essay is an edited excerpt from his annual letter to shareholders.
This story is from the March 17, 2014 issue of Fortune.
