Warren Buffett’s strategies and techniques have had a huge impact on millions of investors, including myself. Due to his humble beginnings, I think a lot of people find hope in his story – if he can do it, why can’t they? As well, he’s just a stand-up guy that I think has a lot of character, particularly considering his continuing frugality in the face of tremendous wealth. For all these reasons (and more!) I thought I would write a quick post on my opinion of Warren Buffett’s best lesson.
For those readers who are unfamiliar with Buffett, he’s arguably the most successful investor ever. In 1962, he began buying share of the failing textile business Berkshire Hathaway, until he eventually become the controlling shareholder and was appointed CEO. He expanded the business away from the failing textile business, and now Berkshire is an international conglomerate with significant presence in the insurance, restaurant, transportation, utilities, and even technology sectors.
Nowadays, his company is huge and his success is unquestioned. Berkshire Hathaway has a current market cap north of $350 billion and employs more than 320,000 people. They also have the most expensive stock price that I’ve ever seen, often quoted above $210,000. This is because Buffett opposes stock splits, as he believes it helps reduce price manipulation in Berkshire’s stock and it allows only serious investors with serious capital to invest in his company.
Enough background about Buffett. I’m sure you’re wondering what this post is all about, exactly! From Buffett’s teachings (often presented via his Berkshire Hathaway annual reports), I have learned the following important lesson:
One of the most important things that you should look for in a potential investment is smart, competent management that truly puts the shareholders’ interests first. This manifests itself in a variety of ways, which I will outline here.
Management has a huge impact on what I tend to think of as the “growth dynamic” or the “reinvestment dynamic” of companies. It isn’t actually the growth dynamic that concerns me as an investor, but rather the management’s reaction to it – sometimes the management doesn’t really have much control over the growth dynamic because of other forces.
What I mean by reinvestment dynamic is the ability for a company’s management to reinvest profits in their own company at above-average rates of return. If a company is unable to do this, there is typically two reasons why. The first is obvious – the company just isn’t successful, and likely should not be considered for investment in the first place. The second reason a company might not have a positive reinvestment dynamic is because they are simply at a mature stage of their development. As long as management is making smart decisions, this does not necessarily have to be a bad thing – there are alternatives! If a company does not have a strong reinvestment dynamic, there are typically there strategies that management can pursue to unlock shareholder value.
The first (and perhaps most well-known) technique that management will use to unlock shareholder value in a mature company is the payments of dividends. By paying out profits as dividends, they are essentially passing on the reinvestment decisions to the shareholders themselves. If the shareholders chose to reinvest in the company, so be it – they can purchase shares on the open market or perhaps enroll in a Dividend Re-Investment Plan (called a DRIP for short). If the shareholders agree with the management by saying there are better opportunities elsewhere, shareholders are free to invest outside of the company in question, whether this is in other stocks, bonds, or stuffing some cash in your sock under your bed.
Dividends pay a huge role in many investment strategies. For example, anyone who has read my post about investment in Dream Office REIT know that their healthy dividend yield, along with a generous DRIP, was a huge factor in my investment decision.
Another strategy that management can use to increase shareholder returns for a mature company is through shareholder buybacks. Essentially, what this means is that the company’s management buys shares of the company on the open market, with the intent to “cancel” them. This reduces the overall number of shares outstanding. This benefits the shareholders in two ways, the first obviously being the slight increase in the company ownership of each shareholder. Since every share repurchased reduces the number of shares outstanding, buybacks mean that all current shareholders hold a greater stake in the company after the buyback.
The second way that buybacks benefit shareholders is through dividend savings. If the company if paying a dividend and it reduces the number of shares outstanding through a buyback program, then it also doesn’t have to pay the dividends associated with those shares, resulting in some significant savings over the long run.
Now I’m sure many of you readers are thinking “I get that we need shareholder-friendly management. But how do we find companies whose management fits this criteria?”
How many readers here have a husband, wife, or other form of significant other? Recall for a moment the period you spent dating them, trying to decide if they were the right person to commit to for the long-term. How did you decide? Dating, obviously!
The whole point of dating isn’t to try that new restaurant in your city, or go skating, or see a movie at the cinema. It is to evaluate the other person’s personality, or more importantly, their character. And a similar approach should be taken when evaluating the management.
Implementing warren buffett’s best lesson
But through what technique do we “date” the management? Unless you run a multi-million dollar investment fund or have lots of money yourself, it’s not likely that you will be able to simply book an appointment with the upper management of a publicly-traded corporation. After all, these people have businesses to run and are definitely tremendously busy. So what’s the alternative?
Warren Buffett’s best lesson doesn’t just stop with placing a strong emphasis on management before making investments. He also has exemplified how we execute it. Buffett has historically been a huge consumer of information, known to read through many year of company’s annual reports before considering an investment. And that’s exactly the strategy that the individual investor should take as well.
Many of you might be thinking “but annual reports are boring!” Sadly, often that’s true. But if you want to consider yourself a serious investor, then you need to be willing to do your own due diligence. And that all starts in the annual report.
So do your research! With the Internet providing us access to unprecedented amounts of company filings and information, it’s important for us to capitalize and read everything we can about a company before we invest in it.
Readers, what did you think of my take on Warren Buffett’s Best Lesson? What other teachings do you think should be contenders for the crown of “best lesson”? Let me know in the comments!