Selecting Stocks Investments
Jun 12th, 2007 by Martin Lee
Berkshire Annual Letter 1996 (Part 6)
The portfolio of Berkshire shows little change compared to the previous year.
Warren Buffett considers inactivity as intelligent behaviour.
He will never trade highly-profitable subsidiaries just because of a small change in some economic indicator. Neither will he do so because some Wall Street expert changes his views on the market.
In fact, this principle applies to his minority positions as well. In both cases, you want to acquire at a reasonable price, a business with excellent economics and able, honest management.
Any monitoring is done to ensure that these qualities are present.
Using this strategy, it is likely that a person will end up having a few shares of companies representing a very large portion of his portfolio. There is nothing to be alarmed of.
Consider this analogy.
An investor purchases an interest in 20% of the future earnings of a number of outstanding college basketball stars. A few of these people will eventually become NBA stars, and the investor’s returns from these few will dominate his royalty stream.
Would he sell off these portions just because their income have come to dominate his portfolio? of course not!
Stability
Warren Buffett likes business and industries that are unlikely to experience major changes. He wants to be able to tell that a company will maintain it’s enormous competitive strength even ten or twenty years later.
This does not mean that Warren does not welcome change. Innovation is good and leads to a better standard of living. It’s just that as an investor, he prefers something more predictable.
Even though the businesses that Warren Buffett buy will change to a certain extent as time goes by, the underlying economics doesn’t really change much.
For example, See’s Candy is very much different from twenty years ago. The products, the distribution channels, machinery, etc are all different. But the reasons why people buy boxed chocolates and choose See rather than someone else are still the same.
Companies like Coca-cola and Gillette give Warrren Buffett the certainty of a good result unlike companies in high-tech or embryonic industries which give him hope of a great one.
It is difficult to find companies like Coca-Cola and Gillette. Even companies that seem to enjoy long periods of invincibility like General Motors, IBM and Sears still suffer from major shocks in the end.
Thus, for every company like Gillette, there are dozens of impostors. Companies which are currently riding high but are vulnerable to competitive attacks.
Having said all these, even if a truly great company is found, there is always a risk of overpaying for the investment. Making purchases at a high price will extend the time for the value of the company to catch up with the purchase price.
Another more serious problem occus when the management of a great company sidetracks and starts to buy other so-so or worse businesses. Even Gillette got into this mess (exploring for oil) decades ago.
This loss of focus is something that Warren Buffett and Charlie Munger considers heavily when they think of investing in companies that in general look outstanding.
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