1996
Click here to read the letter.🧠 Key Takeaways
In the long run, the share price will follow the company’s earnings and free cash flow, because that’s what ultimately drives the intrinsic value of the business.
At the end of the day, what’s most important are the returns you earn over the long term, not how smooth they come along the way.
When it comes to investing, sitting still is often the best thing you can do. Investing should be boring, and if you own great companies, what else is there to do besides sit on them?
Trimming your winners just for the sake of maintaining a certain level of diversification doesn’t actually improve your portfolio. All it does is reallocate capital away from the stocks that have proven themselves toward stocks that haven’t been as successful.
Industries and businesses that are resilient to change are more predictable—and so are their cash flows. That predictability makes it a lot easier to forecast whether the business, and its competitive advantages, will still be around and thriving ten or twenty years from now.
If management can stay focused on the company’s core operations—and consistently devote their energy to expanding the main thing—that’s a great sign. On the other hand, if management starts drifting away from the core business—like when Coca-Cola once decided to grow shrimp, which obviously has nothing to do with selling soda—that’s a major red flag.
As investors, we will have our natural strengths in some areas, and that’s where we should focus. Those are the areas where we’ll have an actual advantage.
If you want to become a successful investor, you should focus all your time on just two things: how to value a business, and how to think about share prices.
This is the essence of investing boiled down to its simplest form: look for reasonably priced businesses you understand, whose earnings and free cash flow are likely to be higher in the future than they are today. If you can build a collection of businesses like that—and have the patience to hold them over time—your portfolio’s value will follow suit.
✍️ Memorable Quotes
“Of course, the longer a shareholder holds his shares, the more bearing Berkshire’s business results will have on his financial experience - and the less it will matter what premium or discount to intrinsic value prevails when he buys and sells his stock. That’s one reason we hope to attract owners with long-term horizons.”
What Warren is saying here about Berkshire applies to all stocks and companies.
This definitely isn’t true in the short term, but over time, a company’s share price growth is ultimately tied to its financial growth—no more, no less. In the long run, the share price will follow the company’s earnings and free cash flow, because that’s what ultimately drives the intrinsic value of the business.
“Gyrations in Berkshire’s earnings don’t bother us in the least: Charlie and I would much rather earn a lumpy 15% over time than a smooth 12%. (After all, our earnings swing wildly on a daily and weekly basis - why should we demand that smoothness accompany each orbit that the earth makes of the sun?)”
So much can happen in the short term that impacts a stock’s share price that it’s practically impossible for a stock to grow in a clean, consistent, straight line. There are always going to be ups and downs—driven by news, investor emotions, and all kinds of random noise—that have little to do with the actual fundamental performance of the business.
Warren and Charlie are perfectly fine with that because they know that volatility just comes with the territory of owning stocks. Rather than trying to avoid it, they accept it.
At the end of the day, what’s most important are the returns you earn over the long term, not how smooth they come along the way.
“Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses? The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.”
One of the great things about investing is that you really don’t need to do much.
Sure, there’s a lot of upfront research involved when you’re deciding whether or not to invest in a company, but once you make that decision, your job mostly shifts to monitoring. You’re just keeping tabs on whether the company’s fundamentals are still intact and growing over time.
The problem is, the inactivity that comes with investing runs completely contradictory to how we think about success in almost every other part of life. In most pursuits, the more effort you put in, the more you get out. But in investing, less is more.
This traditional mindset of getting out what you put in is part of what gets investors into trouble. It makes people feel like they always need to be doing something—constantly keeping up with news, looking at the charts, trading in and out of positions, etc.
But most of that activity isn’t worth doing. A lot of the time, you’re just doing something for the sake of doing something—because you’re conditioned to believe it’s better than nothing.
The truth is, when it comes to investing, sitting still is often the best thing you can do. Investing should be boring, and if you own great companies, what else is there to do besides sit on them?
“When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio. This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.”
There’s a Peter Lynch quote that sums up what Warren is describing here. He says: “Don’t pull out your flowers to water your weeds.”
Basically, it doesn’t make sense to trim your best-performing stocks just because they’ve grown to represent a larger portion of your portfolio. If anything, that’s exactly what you should want—to have more money invested in your best ideas.
Trimming your winners just for the sake of maintaining a certain level of diversification doesn’t actually improve your portfolio. All it does is reallocate capital away from the stocks that have proven themselves toward stocks that haven’t been as successful.
In other words, diversification just for the sake of diversification isn’t a good enough reason to start liquidating your top performers. When you have a “Michael Jordan” in your portfolio, you don’t trade him away—you build around him.
“In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.”
It’s pretty simple: industries and businesses that are resilient to change are more predictable—and so are their cash flows.
That predictability makes it a lot easier to forecast whether the business, and its competitive advantages, will still be around and thriving ten or twenty years from now. And that’s exactly why Warren and Charlie prefer to invest in these kinds of companies.
To paint more of a picture, let’s think about two businesses: Republic Services Group (RSG) and Clear Secure (YOU), which is one of the newer additions to my portfolio.
Republic Services is in the waste management and trash collection business. And as much as I’ve tried, I can't think of anything that's going to disrupt the garbage industry anytime soon. Human beings will always produce trash, and someone will always need to pick it up.
On top of that, waste management tends to be a local monopoly—once a company like RSG secures contracts with a municipality, it’s rare for competitors to pop up. Here in Las Vegas, for example, I believe RSG is the only company around.
These two factors—permanent demand and limited competition—make the business extremely predictable. I’d be hard-pressed to believe that RSG won’t still be doing its thing, with even more customers, ten or twenty years down the road.
Clear Secure, on the other hand, operates in a relatively new industry. It’s growing fast, and that’s exciting—but fast growth usually means fast change. This doesn’t make it a bad business, it’s just much less predictable.
As Warren points out, fast-moving industries might offer huge wins—but they’re also a bigger gamble, which makes them less reliable investments. It’s just so much harder to see what the future looks like for companies in these industries.
“A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged. Unfortunately, that is precisely what transpired years ago at both Coke and Gillette. (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette? Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding. All too often, we’ve seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.”
This is a key insight into how Warren and Charlie gauge a company’s management team.
If management can stay focused on the company’s core operations—and consistently devote their energy to expanding the main thing—that’s a great sign. On the other hand, if management starts drifting away from the core business—like when Coca-Cola once decided to grow shrimp, which obviously has nothing to do with selling soda—that’s a major red flag.
It usually signals one of two things: either management is getting bored and feels the need to do something just for the sake of being busy, or they’re becoming overconfident in their ability to deploy capital and are venturing into random areas that have nothing to do with the company’s core business.
In either case, it’s a bad sign. A lack of focus can lead to wasted time and money, stagnant growth, and as Warren puts it, a lot of “suffering of investors.”
“What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
This is probably one of the most important quotes from any of the letters I’ve read so far. Here, Warren really drives home the importance of staying within your Circle of Competence.
It’s a great reminder for us as investors that we don’t need to understand every business out there. In fact, there’s no way we could be experts in every field—or even familiar with every field, for that matter.
But we will have our natural strengths in some areas, and that’s where we should focus. Those are the areas where we’ll have an actual advantage.
“To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.”
According to Warren, the world of finance and investing is often made way more complicated than it needs to be. A lot of the stuff you’d learn in business school—while it might sound fancy and intellectually impressive—isn’t actually worth knowing.
In fact, Warren says you’re often better off not learning it at all. Things like beta, modern portfolio theory, and efficient markets are mostly noise.
Instead, if you want to become a successful investor, Warren says you should focus all your time on just two things: how to value a business, and how to think about share prices—and the two go hand in hand.
Learning how to think about share prices isn’t about trying to predict where a stock will go next—which is impossible—it’s about understanding human psychology and behavior. Once you pick up on that, you’ll realize that share prices often move for reasons that have nothing to do with a company’s actual fundamental performance, at least in the short-term.
Just like the academic theories, Warren would argue that most day-to-day share price movement should be ignored. What really matters is the intrinsic value of the business, which is tied to the cash flows it will produce over time.
If you can learn how to confidently calculate that—and anchor your decisions to it—you can tune out a lot of the noise and focus on what actually matters.
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
This is the essence of investing boiled down to its simplest form: look for reasonably priced businesses you understand, whose earnings and free cash flow are likely to be higher in the future than they are today. If you can build a collection of businesses like that—and have the patience to hold them over time—your portfolio’s value will follow suit.
Memorable quotes and key takeaways from the 2001 Berkshire Hathaway shareholder letter.