In the opening paragraph of this letter, there’s already a lesson. When looking at the operating earnings of any company, do not take into account the capital gains/losses of its holdings. We will want to evaluate a company based on the earnings from it’s underlying operations.
In the long run however, the aggregate gains or losses will of course be significant.
Another thing is about earnings. Most companies define record earnings as a new high in earnings per share. The point to note is that there is nothing fantastic about higher earnings if the equity base is higher! Even a dormant savings account can do the same because of compounding.
Thus, a more appropriate measure of managerial ability is the return on equity capital.
The third lesson is in the choosing of companies in correct industries. The textile operations continued to struggle even with good management while the insurance business continued to thrive even though a few major mistakes were made.
There was an interesting comment by Warren that the only products of insurance companies are promises. The policies can be copied by anyone, and there’s very little consumer differentiation to protect against competitors. In such a business, the individual managers have a greater effect on the company’s performance.
Warren also spells out his criteria for buying over businesses. The business should be (1) one that you can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.
As most stocks would be held over the long term, do not be overly concerned with just near term earnings or recent trends in earnings when making your stock purchases. If you were buying a whole business, wouldn’t you be more concerned about the long term prospects?
Also, it makes no difference whether you are buying a minority stake or taking over the entire company. After all, you would want the present management to carry on with the wonderful job that they had been doing and not make any changes.
In fact, it is often the case that the stock market offers you chances to make your purchases at a very good (low) prices. If you were to try buying over the whole company, usually you would have to offer fair value (high price).