TL;DR: Warren Buffett, the legendary "Oracle of Omaha," has been an investing icon for over half a century, offering nuggets of wisdom through his annual Berkshire Hathaway shareholder letters. We harnessed the analytical capabilities of ChatGPT to distill 45 years of Buffett's insights into 10 seminal investing rules. These include fundamental tenets like "Invest in What You Know," emphasizing the importance of understanding one's investments, and the principle of "Intrinsic Value / Margin of Safety," underscoring the essence of discerning a company's true worth. Buffett's long-term investment horizon, his penchant for quality businesses, and his unflinching honesty even in the face of investment errors are all dissected. The takeaway? While the world of finance offers myriad complex investment strategies, the time-tested, straightforward principles championed by Buffett often prove to be the most effective.
Image courtesy of New Zealand National Library - Artist: Murray Webb.
The Buffett Letters.
Warren Buffett stands as the most successful and renowned investor of our time. Even at the impressive age of 93, he exhibits no signs of slowing down. For over 50 years, Buffett has penned annual letters to the shareholders of Berkshire Hathaway, the conglomerate through which he conducts numerous investments. These letters are replete with invaluable insights on investing and personal finance.
This week, leveraging the analytical prowess of ChatGPT, we’ve distilled the past 45 years of Warren’s wisdom (from the publicly available letters dated 1977-2022) into 10 straightforward rules, enriched with insightful quotes from the “Oracle of Omaha” himself.
N.B. Each quote will be referenced according to the fiscal year of the corresponding letter, regardless of the fact that these letters are typically written in the subsequent year. For example, a quote from the letter for fiscal year 1985 was penned in 1986; the letter for ‘86 was composed in ‘87; ‘87 in ‘88, and so forth.
1. Invest in What You Know.
Buffett is famed for his unique value investing approach, symbolized by the maxim “Invest in what you know,” alternatively termed the “circle of competence.” This fundamental principle advises investors to allocate resources to industries and companies with which they are familiar or have profound understanding. By doing so, investors minimize risk and enhance the likelihood of achieving consistent returns.
In his 1977 letter, Buffett articulated his entire investment philosophy through a concise, step-by-step method:
We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.
Variations of this process have been echoed in every letter since, and across all of Buffett’s writings, it becomes abundantly clear that he possesses extensive knowledge of his businesses. This means he can assess their performance, management, and processes with pinpoint accuracy.
2. Calculate Intrinsic Value / Margin of Safety.
Intrinsic Value represents the actual or “true value” of a company, based on underlying fundamentals. For Buffett, “Intrinsic Value” is the discounted value of the cash that can be extracted from a business during its remaining life. It serves as an estimate rather than an exact figure, illuminating the real worth of a company. If the intrinsic value of a company exceeds the current stock price, it may present a favorable investment opportunity.
Margin of Safety is the discrepancy between the intrinsic value of a stock and its market price. Investing when there is a substantial margin of safety enables investors to mitigate downside risk while maximizing the potential for upside return.
In his 1978 letter, Buffett implicitly discussed the significance of intrinsic value of firms while addressing insurance companies in his portfolio, without stating it overtly. Insurance has been one of Buffett's most prolific and enduring sources of profit:
We continue to find for our insurance portfolios small portions of really outstanding businesses that are available, through the auction pricing mechanism of security markets, at prices dramatically cheaper than the valuations inferior businesses command on negotiated sales.
Once more, in 2008, Buffett emphasized his stance on intrinsic value, referencing his mentor Benjamin Graham’s most celebrated quote on value (Bolded):
The market value of the bonds and stocks that we continue to hold suffered a significant decline along with the general market. This does not bother Charlie and me. Indeed, we enjoy such price declines if we have funds available to increase our positions. Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.
Buffett values intrinsic value primarily because it provides a mathematical framework that assists investors in avoiding overpayment for overvalued companies. As he expressed in 1982:
The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.
However, Buffett has also conceded, as exemplified in his 2005 letter, that intrinsic value can be variable and imprecise:
My goal in writing this report is to give you the information you need to estimate Berkshire’s intrinsic value. I say “estimate” because calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base.
3. Invest Long-Term.
Buffett’s investment philosophy is distinctly defined by a long-term investment perspective. He frequently jokes that his preferred holding period is "forever," seeking companies with the potential for indefinite retention. Buffett prioritizes the lasting quality and viability of a business over transient price variations. For instance, he has steadfastly maintained holdings in companies like Coca-Cola and See’s Candies for decades (since 1988 and 1972, respectively). When acquiring new investments, it's apparent that the intention is to retain them for as lengthy a period as possible.
In practical terms, this philosophy reflects a profound belief in the businesses and is inseparably connected to the Intrinsic Value and Margin of Safety mentioned in the preceding lesson. Here he is in 1982, elucidating this long-term view and expressing indifference to immediate market fluctuations (unless they denote a price drop, presenting an opportunity to acquire more of the company’s shares):
We look forward to substantial future gains in underlying business value accompanied by irregular, but eventually full, market recognition of such gains. Year-to-year variances, however, cannot consistently be in our favor. Even if our partially-owned businesses continue to perform well in an economic sense, there will be years when they perform poorly in the market. At such times our net worth could shrink significantly. We will not be distressed by such a shrinkage; if the businesses continue to look attractive and we have cash available, we simply will add to our holdings at even more favorable prices.
4. Buy Quality Businesses.
Buffett gives precedence to investing in “quality businesses,” honing in on companies with robust brand recognition, competitive advantages, adept management, and a history of profitability and growth. Allocating resources to such companies usually ensures more reliability and a higher probability of long-term success.
Throughout all of Buffett’s writings, he consistently discusses the business and management while explaining to Berkshire Hathaway investors the rationale behind his optimistic outlook on a particular acquisition. Here he is in 1977, delineating his perspective on Capital Cities Communications, Inc. (the entity that would eventually acquire ABC—a company four times its size—and subsequently be acquired by Disney):
Capital Cities possess both extraordinary properties and extraordinary management. And these management skills extend equally to operations and employment of corporate capital. To purchase, directly, properties such as Capital Cities owns would cost in the area of twice our cost of purchase via the stock market, and direct ownership would offer no important advantages to us. While control would give us the opportunity - and the responsibility - to manage operations and corporate resources, we would not be able to provide management in either of those respects equal to that now in place. In effect, we can obtain a better management result through non-control than control. This is an unorthodox view, but one we believe to be sound.
Understanding a quality business, however, is as much about acknowledging mistakes as it is celebrating successes. In 1979, Buffett had to do just that while reviewing his ownership of Waumbec Mills:
Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment. By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing. But the purchase was a mistake. While we labored mightily, new problems arose as fast as old problems were tamed. Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.
5. Find Economic Moats.
Buffett is distinguished for investing in companies possessing a formidable economic moat. An economic moat denotes a business's capacity to sustain competitive advantages over its rivals to defend its long-term profits and market share from competing entities. Possessing a broad moat enables a company to ward off competition and preserve its position and profitability over time.
In 1998, while discussing Berkshire’s stake in NetJets, Buffett expounded on why NetJets had a substantial moat relative to their competitors:
Being the leader in this industry is a major advantage for all concerned. Our customers gain because we have an armada of planes positioned throughout the country at all times, a blanketing that allows us to provide unmatched service. Meanwhile, we gain from the blanketing because it reduces dead-head costs. Another compelling attraction for our clients is that we offer products from Boeing, Gulfstream, Falcon, Cessna, and Raytheon, whereas our two competitors are owned by manufacturers that offer only their own planes. In effect, NetJets is like a physician who can recommend whatever medicine best fits the needs of each patient; our competitors, in contrast, are producers of a “house” brand that they must prescribe for one and all.
At times—particularly in highly regulated sectors—moats may be attributed to a few, or even a singular differentiator, as is the case with insurance. From Buffett’s 1977 letter:
Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition. It is commonplace, in corporate annual reports, to stress the difference that people make. Sometimes this is true and sometimes it isn’t. But there is no question that the nature of the insurance business magnifies the effect which individual managers have on company performance. We are very fortunate to have the group of managers that are associated with us.
However, moats can also vanish. When the Airline Industry underwent deregulation in 1978, a gradual transformation of the industry unfolded as newer, budget-friendly carriers emerged, diminishing the competitive advantage and business models of several existing airlines. In 1994, Buffett conceded that he had overlooked this shift in industry dynamics:
Before this purchase, I simply failed to focus on the problems that would inevitably beset a carrier whose costs were both high and extremely difficult to lower. In earlier years, these life-threatening costs posed few problems. Airlines were then protected from competition by regulation, and carriers could absorb high costs because they could pass them along by way of fares that were also high. When deregulation came along, it did not immediately change the picture: The capacity of low-cost carriers was so small that the high-cost lines could, in large part, maintain their existing fare structures. During this period, with the longer-term problems largely invisible but slowly metastasizing, the costs that were non-sustainable became further embedded. As the seat capacity of the low-cost operators expanded, their fares began to force the old-line, high-cost airlines to cut their own. The day of reckoning for these airlines could be delayed by infusions of capital (such as ours into USAir), but eventually a fundamental rule of economics prevailed: In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction. This principle should have been obvious to your Chairman, but I missed it.
6. Finance Conservatively.
Buffett’s investment philosophy accentuates conservative financing. He typically prefers companies that do not heavily depend on debt to drive growth and can produce sufficient earnings to meet interest payments with ease. Such companies, given their prudent financial approach, are generally perceived as less risky due to their diminished likelihood of encountering financial difficulties or insolvency.
Here he is discussing this stance in the letter for 2017—a time characterized by notably low-cost debt:
The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed. At Berkshire, in contrast, we evaluate acquisitions on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual business would generally be fallacious… Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need.
In alignment with his conservative outlook, Buffett also tends to avoid excessively complicated deals or unconventional financial products, as these can obscure valuation assessments and hinder returns. In 2005, he clarified this viewpoint while discussing the preference for acquiring companies through cash, not equity:
When a management proudly acquires another company for stock, the shareholders of the acquirer are concurrently selling part of their interest in everything they own. I’ve made this kind of deal a few times myself – and, on balance, my actions have cost you money.
And here he is in 1989, dismissing the contemporary enthusiasm for the—at the time controversial but popular—Zero-Coupon Bonds:
The satirical nonsense of the bezzle is dwarfed by the real-world nonsense of the zero-coupon bond. With zeros, one party to a contract can experience "income" without his opposite experiencing the pain of expenditure. In our illustration, a company capable of earning only $100 million dollars annually - and therefore capable of paying only that much in interest - magically creates "earnings" for bondholders of $150 million. As long as major investors willingly don their Peter Pan wings and repeatedly say "I believe," there is no limit to how much "income" can be created by the zero-coupon bond.
7. Be Cost Conscious.
Buffett assigns immense value to cost consciousness in both his personal life and investment choices. He appreciates companies that effectively manage operational costs, operate with efficiency, and consequently, optimize profitability. This focus on thrift and efficiency is mirrored in the management approaches and operational methodologies of the companies he selects for investment, as well as in his own preference for a frugal lifestyle.
In 1978—while Buffett was appraising the particularly economical management of a bank leader whose bank was owned by Berkshire—he remarked:
Our experience has been that the manager of an already high-cost operation frequently is uncommonly resourceful in finding new ways to add to overhead, while the manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors.
Perhaps there is merit to the age-old saying, “If you want something done, ask a busy person”—only, in this context, it could be “if you want something done economically, ask a frugal person.” Cost consciousness is a consistent theme across all their businesses; for instance, Geico employs a direct-to-consumer model, bypassing costs related to agents and transferring the savings to consumers in the form of reduced premiums.
8. Manage Risk.
Buffett underscores risk management within his investment philosophy, adhering to principles and strategies designed to minimize potential loss while maximizing opportunities for gain. Besides emphasizing intrinsic value, competitive advantage, and quality of management, Buffett also focuses on ensuring his businesses operate with a robust internal margin of safety and remain forward-looking, avoiding an overreliance on past successes.
In 1982, he conveyed this mindset, indirectly reminding his investors of the timeless investment wisdom: “Past performance is NOT indicative of future results”:
Future profitability of the industry will be determined by current competitive characteristics, not past ones. Many managers have been slow to recognize this. It’s not only generals that prefer to fight the last war. Most business and investment analysis also comes from the rear-view mirror.
In 2015, he detailed how the prudent banking practices of Berkshire’s investments were fortifying them against a potential future rate hike—a hike that did indeed later challenge numerous US banks (you may remember SVB, Signature, and First Republic from earlier this year), but not those in Buffett’s portfolio:
Normally, it is risky business to lend long at fixed rates and borrow short as we have been doing at Clayton. Over the years, some important financial institutions have gone broke doing that. At Berkshire, however, we possess a natural offset in that our businesses always maintain at least $20 billion in cash-equivalents that earn short-term rates.
However, Buffett is not infallible, and unprecedented events, such as those that transpired on 9/11, caught even him by surprise. But, unlike many managers who might claim “no one could have predicted this,” Buffett candidly acknowledges where Berkshire would take on losses, and where it would remain strong:
Why, you might ask, didn't I recognize the above facts before September 11th? The answer, sadly, is that I did — but I didn't convert thought into action. I violated the Noah rule: Predicting rain doesn't count; building arks does. I consequently let Berkshire operate with a dangerous level of risk — at General Re [Insurance Corporation] in particular. I’m sorry to say that much risk for which we haven't been compensated remains on our books, but it is running off by the day… The bottom-line today is that we will write some coverage for terrorist-related losses, including a few non-correlated policies with very large limits. But we will not knowingly expose Berkshire to losses beyond what we can comfortably handle. We will control our total exposure, no matter what the competition does.
9. Ignore Market Fluctuations.
Buffett’s investment philosophy incorporates a thoroughly articulated approach to market fluctuations. He perceives the oscillations in the market as inevitable and avoids engaging in attempts to time the market or forecast its movements. Instead, he is resolute in his strategy to invest in quality companies with robust fundamentals and retain them over the long term, undistracted by transient market fluctuations. He adheres to the mindset of “be greedy when others are fearful and fearful when others are greedy.”
Addressing investors’ concerns about a potential market downturn in his 1978 letter, Buffett articulated:
We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do.
A year later he affirmed the same idea:
We very much like the companies in which we have major investments, and plan no changes to try to attune ourselves to the markets of a specific year.
And again after the 2008 financial crisis:
In 75% of [previous] years, the S&P stocks recorded a gain. I would guess that a roughly similar percentage of years will be positive in the next 44. But neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.
10. Beware the Incentives of Others.
Lastly, a pivotal aspect of Warren Buffett’s philosophy is a considerable emphasis on independent analysis, often resulting in a discernible skepticism towards external sources and their counsel. He typically shuns suggestions from investment bankers, financiers, and accountants, who might lean towards short-term gains and personal benefits, choosing instead to rely on his own analysis. While receiving advice from external parties isn’t inherently detrimental, Buffett prompts us to consider the motivations driving the advice-givers and to factor that in when evaluating their recommendations.
Here he is in 1982:
The acquirer’s manager will find ample rationalizations for such a value-destroying issuance of stock. Friendly investment bankers will reassure him as to the soundness of his actions. (Don’t ask the barber whether you need a haircut).
This notion—“Don’t ask the barber if you need a haircut”—recurs frequently in Buffett’s discourses as he assesses the motives and incentives behind actions and advice. In his 1998 examination of multiple accounting fraud instances, he reiterated this principle:
Though auditors should regard the investing public as their client, they tend to kowtow instead to the managers who choose them and dole out their pay. (“Whose bread I eat, his song I sing.”)
Furthermore, in his pointed 2015 analysis of the 2008 financial crisis, he highlighted how proficient financial experts are at devising intricate illusions to mislead average investors into ill-advised ventures, leading to devastating outcomes:
Mortgage-origination practices are of great importance to both the borrower and to society. There is no question that reckless practices in home lending played a major role in bringing on the financial panic of 2008, which in turn led to the Great Recession. In the years preceding the meltdown, a destructive and often corrupt pattern of mortgage creation flourished whereby (1) an originator in, say, California would make loans and (2) promptly sell them to an investment or commercial bank in, say, New York, which would package many mortgages to serve as collateral for a dizzyingly complicated array of mortgage-backed securities to be (3) sold to unwitting institutions around the world. As if these sins weren’t sufficient to create an unholy mess, imaginative investment bankers sometimes concocted a second layer of sliced-up financing whose value depended on the junkier portions of primary offerings. (When Wall Street gets “innovative,” watch out!) While that was going on, I described this “doubling-up” practice as requiring an investor to read tens of thousands of pages of mind-numbing prose to evaluate a single security being offered. Both the originator and the packager of these financings had no skin in the game and were driven by volume and mark-ups. Many housing borrowers joined the party as well, blatantly lying on their loan applications while mortgage originators looked the other way. Naturally, the gamiest credits generated the most profits. Smooth Wall Street salesmen garnered millions annually by manufacturing products that their customers were unable to understand. (It’s also questionable as to whether the major rating agencies were capable of evaluating the more complex structures. But rate them they did.)
Despite enduring substantial personal losses of $25 billion and a downgrade to Berkshire’s credit rating, Buffett emerged from the financial crisis holding significant positions in two major investment banks and augmented stakes in several other Berkshire investments. His net worth saw a substantial increase, rising from $37 billion in 2009 to $82.5 billion in 2019.
Buffett’s investing career has been long and storied, but perhaps more captivating are the simplicity and enduring nature of the lessons gleaned from his investment strategies. Basic principles like “don’t buy what you don’t understand” or “tend to your finances, and they will tend to you” might seem self-evident, but in a landscape cluttered with investment advisors and strategies hinging on day-trading, intricate derivatives, and speculative ventures, it’s often easy to overlook the efficacy of a straightforward approach.
Certainly, sophisticated trading methods can be profitable, but seasoned investors who have withstood the test of time are seldom the daring, high-stakes gamblers. More often, they resemble Buffett, practicing caution, investing incrementally, and conducting thorough evaluations before committing their funds. Additionally, the teachings of Buffett reverberate through the ages, reflecting tenets so timeless that even Confucius, the Chinese philosopher from 500 BC, voiced comparable wisdom long before “Buffettisms” were coined: “He who will not economize will have to agonize.”
In conclusion, Buffett is but one figure in the vast tapestry of investment and commerce, yet the wisdom he shares remains impactful. Although navigating through his shareholder letters might appear overwhelming, we strongly recommend exploring the wealth of knowledge within them. You may discover the exact wisdom you are seeking, right when it’s most needed.