Rules of wealth creation: 7 takeaways from Warren Buffett’s letter to shareholders

1 share of Berkshire Hathaway Inc. costed $302,000 as of closing on February 22 on the New York Stock Exchange. In terms of Indian currency, the cost is over Rs 2 crore for one equity share (assuming exchange rate at Rs 71/USD).

Here is a list of top 7 takeaways from Warren Buffett's newsletter to shareholders:

Diversification of business:

This is one age-old principle which is relevant for all businesses that are looking for growth. Investors who evaluate Berkshire sometimes obsess on the details of many diverse businesses, also known as economic “trees”, as quoted in the newsletter.

Analysis of that type can be mind-numbing, given that Berkshire owns a vast array of specimens, ranging from twigs to redwoods. Buffett in the newsletter said that a few of our trees (referring to diversity in business) are diseased and unlikely to be around a decade from now, but many others, though are destined to grow in size and beauty.

Apart from equity portfolio, Berkshire held $112 billion at year end in US Treasury bills and other cash equivalents, and another $20 billion in miscellaneous fixed-income instruments.

Berkshire considers a portion of that stash to be untouchable, having pledged to always hold at least $20 billion in cash equivalents to guard against external calamities.

Buy 'ably-managed' businesses:

Even for Indian markets, most analysts focus on the management pedigree which is the most important ingredient of any company which could give consistent returns or creates value over a period of time. Consistency is the key to wealth creation.

Buffett also highlighted that Berkshire looks to buy ably-managed businesses, in whole or part, that possess favorable and durable economic characteristics. “We also need to make these purchases at sensible prices. Sometimes we can buy control of companies that meet our tests,” quoted the letter.

Charlie and I (Buffett) believe that companies in which they have invested offer excellent value, far exceeding that available in takeover transactions.

Investment horizon:

If you are looking to create wealth then patience as well as stock selection is the key. Berkshire’s equity investments were worth nearly $173 billion at year-end, an amount far above their cost.

If the portfolio had been sold at its year-end valuation, federal income tax of about $14.7 billion would have been payable on the gain. In all likelihood, we will hold most of these stocks for a long time, the note to shareholders quoted.

Our investees paid us dividends of $3.8 billion last year, a sum that will increase in 2019. Far more important than the dividends, though, are the huge earnings that are annually retained by these companies.

Blindly buying an overpriced stock is value destructive:

Warren Buffett was one of the key individuals who promoted the concept of value investing. In his letter, he said blindly buying an overpriced stock is value destructive, a fact lost on many promotional or ever-optimistic CEOs.

When a company says that it contemplates repurchases, it’s vital that all shareholder-partners be given the information they need to make an intelligent estimate of value.

“We do not want a partner to sell shares back to the company because he or she has been misled or inadequately informed,” he said.

If it’s okay for the boss to cheat a little, it’s easy for subordinates to rationalize similar behavior:

Warren Buffett always emphasized in value both in terms of quantitatively as well as qualitatively. Berkshire does not give estimates or give heat to what Street is expecting because this is one step which could result in unethical behavior.

Over the years, Charlie and I have seen all sorts of bad corporate behavior, both accounting and operational, induced by the desire of management to meet Wall Street expectations, as was highlighted in the letter to shareholders.

What starts as an “innocent” fudge in order to not disappoint “the Street” – say, trade-loading at quarter-end, turning a blind eye to rising insurance losses, or drawing down a “cookie-jar” reserve – can become the first step toward full-fledged fraud.

“Playing with the numbers “just this once” may well be the CEO’s intent; it’s seldom the end result. And if it’s okay for the boss to cheat a little, it’s easy for subordinates to rationalize similar behavior,” added the letter.

Looking for elephant size acquisition, but no target:

That disappointing reality is that 2019 will likely see Berkshire again expanding their holdings of marketable equities. “We continue, nevertheless, to hope for an elephant-sized acquisition. Even at our ages of 88 and 95 – I’m the young one – that prospect is what causes my heart and Charlie’s to beat faster,” the note added.

Magical metal was no match for the American mettle:

Those who believe in theories and gloom and doom would have bought gold but that might not have resulted in value creation. Hence, investors should look for stocks instead of gold.

“Those who regularly preach doom because of government budget deficits might note that our country’s national debt has increased roughly 400-fold during the last of my 77-year periods. That’s 40,000%!,” Warren Buffett said in the letter.

“Suppose you had foreseen this increase and panicked at the prospect of runaway deficits and a worthless currency. To “protect” yourself, you might have eschewed stocks and opted instead to buy 31⁄4 ounces of gold with your $114.75,” he explains.

And what would that supposed protection have delivered?

“You would now have an asset worth about $4,200, less than 1% of what would have been realized from a simple unmanaged investment in American business. The magical metal was no match for the American mettle,” he concludes.

“Over the next 77 years, however, the major source of our gains will almost certainly be provided by The American Tailwind. We are lucky – gloriously lucky – to have that force at our back,” Warren Buffett said.