Monday, March 24, 2014

Buffett on Farms, Real Estate, and Stocks

From Warren Buffett's 2013 Berkshire Hathaway (BRKa) shareholder letter:

"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."

Buffett's use of his farm to explain the partial ownership of a business helps illustrate a simple but important point: that is, the shares of a good business need not be thought of any differently than his farm. He also provides another good example: a New York retail property near NYU that he bought in 1993. Both non-stock investments provide a useful framework for thinking about the long-term ownership of common stocks. Whether an investor owns all or part of a business -- public or otherwise -- the lessons of those two non-stock investments can be very instructive.

In the farm example, he had someone capable that he trusts available to operate and harvest what is produced each year.

Before buying any business, whether reasonably capable management is in place is a qualitative judgment that must be made. The investor has to be able to have enough confidence that the management, like Buffett's son, has the capability (and integrity) to competently operate and "harvest" -- even if not literally -- for the owners. Much like Buffett's farm, a portion of the net proceeds earned can be paid out as dividends with the rest, if the management is doing their job, put to good use.

Now, consider that most business transactions, to this day, involve substantial frictional costs for buyers and sellers.
(Just think about all the commissions and related costs involved in most real estate transactions, for example.)

In contrast, buying part of a business that happens to trade publicly (i.e. a common stock) can be achieved at low cost and at great convenience via modern capital markets. So anyone with access to one of the many high quality brokerage accounts -- one with solid service and reasonable fees -- can own a piece of some very good businesses (and, of course, many not so great businesses); they can, at the same time, avoid the complexity and cost of most private transactions.

Based upon just about any metric becoming a part owner of a public company can be accomplished with comparative ease and reduced costs versus just about any private business.
(Whether a farm, piece of real estate, or any business that just happens to not trade publicly.)

So the inherent liquidity, convenience, and low cost of modern capital markets should be an advantage.

Yet that convenience and low cost, as it turns out, ends up being a two-edged sword.

It encourages behavior that often turns this inherent advantage into a disadvantage: excessive buying and selling.

This not only increases frictional costs, this also increases the chance for unnecessary errors. Errors will be made, of course, but a sound investment process should eliminate them where possible:

"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin

There's a tendency to be overly optimistic that the next buy or sell decision will lead to improved results. It's easy to focus too much on the upside of a particular action while not giving appropriate consideration of the downside. That can lead to big mistakes. It's a changeable behavior but, for some, the temptation to trade with great frequency is overwhelming.

Now, even if the temptation to trade hyperactively is kept in check, the equity investor still has to know what to buy within his/her own limits.

The equity investor still has to know the appropriate price to pay (i.e. what price represents a plain discount to value based upon conservative assumptions).

The equity investor still has to learn to mostly ignore the daily quoted prices.*

Those that can't do these things, on a consistent basis, most likely should not be buying and selling stocks.

Somewhat strangely, one of the great advantages of owning a farm, some real estate (or, for that matter, a private business of any kind) happens to be -- though logically it shouldn't be an advantage -- that there is no frequently quoted price to distract the owner. That lack of distraction makes it more easy to put the focus of the owner where it should be: on what the underlying business assets can produce over the long haul.

For stocks the focus should be no different.

There are no doubt exceptions** but, for most participants, it's best to avoid the folly of excessive trading and focus, instead, on what the underlying assets of things they understand can produce -- not what they sell for on any given day -- over longer time horizons. This may not be easiest thing to do but, then again, it's also not exactly impossible with some work, discipline, and awareness of limits.

Those who, within their limitations, know how to judge business value and possess some price discipline (i.e. always operate with a nice margin of safety) have, at their disposal, the incredible convenience and low cost of modern capital markets. They simply need to overcome the temptation to transform the investment process into various forms of speculation and gambling.

There's just no good reason to be cut by the wrong side of that two-edged sword.

Nothing can guarantee good outcomes in an uncertain world but the principles used, and process in place, should be as robust as possible.

In the letter, Buffett provides his thoughts on investing fundamentals and uses his two non-stock investments to help illuminate "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 making 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."

Buffett's advice is no doubt wise but I suspect that won't stop many from trying to profit from near-term (and, for that matter, even intermediate-term) price action.

As Buffett points out there's nothing improper about speculating; it's just that it's too often not very lucrative.


Long position in BRKb established at much lower than recent prices

* Fund investors, in order to prevent becoming their own worst enemy, similarly need to know when to ignore quoted prices even if they're not required to make sound judgments on individual securities.
** I'm just guessing but odds seem reasonably good that there are more who think they're the exception than actually who are the exception.
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