1987
Click here to read the letter.🧠 Key Takeaways
The best returns are usually achieved by companies that have been doing the same thing successfully for many years.
Look for companies with an average return on equity (ROE) of over 20% over the past 10 years, and ensure their ROE hasn't dipped below 15% during that period.
When Buffett and Munger buy stocks, they go through the process as if they are purchasing a piece of a private business. This means they focus on the long-term potential and fundamentals of the business, rather than merely buying a ticker symbol that goes up and down. As a result, they do not make their decisions based on short-term market predictions. Nor do they base their investment decisions on macroeconomic forecasts or technical analysis.
In the short run, the market operates as a "voting machine," where prices are influenced by news cycles, investor sentiment, and often erratic behavior. When these things converge, it can create some noticeable volatility that doesn’t necessarily reflect the underlying fundamentals of a company. On the other hand, over the long term, the market functions as a "weighing machine." This means that eventually, a company's stock price will reflect its true intrinsic value based on its fundamental performance.
Cheap stocks might seem appealing (because we all love a good discount), but often, the low price reflects fundamental issues with the underlying business. Instead of focusing solely on finding cheap stocks, aim to invest in wonderful businesses that are trading at a sensible price.
✍️ Memorable Quotes
“Severe change and exceptional returns usually don’t mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today’s business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be. Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.”
Essentially, stability and consistency often yield better long-term returns than chasing after the latest and flashiest business trends, which can be all but stable and consistent.
This runs counter to how many investors behave, as they often get excited about companies that promise significant and rapid changes, hoping these will translate into high profits. As a result, they tend to place the highest value (price-earnings ratios) on businesses with exotic and promising prospects, rather than on established companies with stable, proven business models. This excitement is based on the potential for future profitability, rather than the actual performance and fundamentals of the business today (what might happen versus what is happening).
Overall, the best returns are usually achieved by companies that have been doing the same thing successfully for many years. These companies have a proven track record and are more predictable, which reduces the risk of substantial mishaps.
“The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000 companies met two tests of economic excellence - an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.”
Some interesting insight on how to find marketing beating companies: Look for those with an average return on equity (ROE) of over 20% over the past 10 years, and ensure their ROE hasn't dipped below 15% during that period.
“The Fortune champs may surprise you in two respects. First, most use very little leverage compared to their interest-paying capacity. Really good businesses usually don’t need to borrow. Second, except for one company that is “high-tech” and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane. Most sell non-sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.”
Here are two key observations Warren made about the 24 market-beating stocks mentioned in the Fortune article:
First, these companies used very little debt compared to their EBITDA or FCF, and the interest on their minimal debt is easily covered. Warren believes that truly strong businesses don’t need to borrow much. In my portfolio, examples like Williams-Sonoma and Visa come to mind.
Second, these businesses are "boring," which aligns with Warren’s earlier message in his letter. Look for companies doing the same thing today as they were 5 or 10 years ago, as this consistency indicates a winning business model.
Such mundane businesses — like KO or PG — tend to be more resilient to change, reducing investment risk and offering more opportunities for sustainable, long-term returns.
“Whenever Charlie and I buy common stocks for Berkshire’s insurance companies (leaving aside arbitrage purchases, discussed later) we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. we do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts.”
When Buffett and Munger buy stocks, they go through the process as if they are purchasing a piece of a private business. This means they focus on the long-term potential and fundamentals of the business, rather than merely buying a ticker symbol that goes up and down.
They see themselves primarily as analysts of the businesses they invest in. This means they focus on understanding the business itself—its operations, competitive position, and growth prospects.
Along with that, they do not make their decisions based on short-term market predictions. Nor do they base their investment decisions on macroeconomic forecasts or technical analysis.
“Following Ben’s teachings, Charlie and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.”
In the short run, the market operates as a "voting machine," where prices are influenced by news cycles, investor sentiment, and often erratic behavior. When these things converge, it can create some noticeable volatility that doesn’t necessarily reflect the underlying fundamentals of a company.
On the other hand, over the long term, the market functions as a "weighing machine." This means that eventually, a company's stock price will reflect its true intrinsic value based on its fundamental performance.
The speed at which this occurs is less important than the fact that it will happen if the company's fundamental performance continues to shine. It’s also important to note that it rarely happens in your desired timeline — stay patient!
“Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better.”
While Warren Buffett’s favorite holding period is forever, these are some instances in which he would sell a stock.
“We really don’t see many fundamental differences between the purchase of a controlled business and the purchase of marketable holdings such as these. In each case we try to buy into businesses with favorable long-term economics. Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price. Charlie and I have found that making silk purses out of silk is the best that we can do; with sow’s ears, we fail.”
Cheap stocks might seem appealing (because we all love a good discount), but often, the low price reflects fundamental issues with the underlying business. Instead of focusing solely on finding cheap stocks, aim to invest in wonderful businesses that are trading at a sensible price.