Diversification

Wide diversification is only required when investors do not understand what they are doing.

- Warren Buffett

What to look for in a business

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to 'be fruitful and multiply' is one we take seriously at Berkshire.)

There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.

Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.

Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.

Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.

To sum up, think of three types of "savings accounts". The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

- Warren Buffett on Berkshire Hathaway 2007 AR

Don't leverage

I do know that the economy, over a period of time, will do very well, and people who own a piece of it will do well. But they shouldn't own it on leverage.

- Warren Buffett

Winner

Here is an old but interesting story of two friends who went to a jungle. They saw a hungry lion there. As soon as they saw the beast, they understood that they are going to be history. One of those guys took a pair of brand new shoes and started wearing them. His friend was surprised at his action and asked him, "Do you think that you can run faster than the lion with those shoes on?" This guy replied him, "Dude, I need not run faster than the lion. I just need to run faster than you!

Wall Street people

Wall Street people learn nothing and forget everything.

- Benjamin Graham

Investment opportunities

Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised.

- Warren Buffett

Holding period

Our favourite holding period is forever.

- Warren Buffett

Speculative counterparts...

Where the company has the highest credit rating because both its past record and future prospects are most impressive, we find that the stock market tends more or less continuously to introduce a highly speculative element into the common shares through the simple means of a price so high as to carry a fair degree of risk.

- Benjamin Graham

One formula.. doesn't work

People always want a formula – but it doesn’t work that way – you have to estimate total cash generated from now to eternity, and discount it back to today. Yardsticks such as P/Es are not enough by themselves.

– Warren Buffett

Ignorance with leverage

When you combine ignorance with leverage, you get some pretty interesting results.

- Warren Buffett

Satisfactory investment results

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

- Benjamin Graham

How to become rich

I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.

- Warren Buffett

Qualitative Vs Quantitative decisions

The really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

- Warren Buffett

Bear Market

A bear market is a financial cancer that spreads. Intermediate rallies (occasionally very strong ones) keep the hopes of investors alive. Furthermore, by continuously publishing bullish reports, brokers and economists, like good nurses, keep the flame of hope from burning out. But after 18 to 36 months of continued losses, total capitulation usually sets in and a major low occurs.

- Marc Faber

Invest in companies you like

Why not invest your assets in the companies you really like? As Mae West said, Too much of a good thing can be wonderful.

– Warren Buffett

What is not simple is speculative

Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics, the more uncertain and speculative are the conclusions we draw therefrom.

- Benjamin Graham

Market doesn't beat...

The market does not beat them. They beat themselves, because though they have brains they cannot sit tight.

- Jesse Livermore

Temperament

The most important quality for an investor is temperament, not intellect... You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.

- Warren Buffett

Wait

We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely.

- Warren Buffett

Judging investment risks

By confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.

- Benjamin Graham

Right or wrong

You are neither right nor wrong because people agree with you. You are right because your facts and reasoning are right.

- Benjamin Graham