2007
Click here to read the letter.🧠 Key Takeaways
Warren prefers investment opportunities where resilience is high and the range of possible outcomes is relatively narrow.
We all want to invest in great businesses. But if what makes a business great is solely the people running it, then the reality is that the business itself probably isn’t all that great.
Some businesses you own for their ability to drive organic growth, and subsequently, higher returns. Others you own because—even without rapid growth—they generate a ton of cash that can be redeployed into those higher-growth opportunities.
No business—even the truly great ones—can grow at a high rate forever. Every company eventually reaches an inflection point where growth slows and it inevitably transitions into the the steady cash generator. It’s just part of the corporate circle of life.
There are certain businesses that can grow their sales and earnings without needing to invest large amounts of capital back into the business. And those are the best kinds of businesses to own.
Warren really doesn’t base the success of his investment decisions on what the share price does in any given year. In such a short time period, it’s a pretty meaningless metric for gauging progress, since prices are largely driven by human emotion and sentiment.
What Warren cares about are the operational outcomes of his businesses. Are they growing their sales? Are they growing their earnings and free cash flow? And importantly, is their competitive position (AKA their moat) expanding over time, or starting to dwindle?
✍️ Memorable Quotes
“Our criterion of ‘enduring’ causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s ‘creative destruction’ is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.”
In just a few sentences, Warren is saying a lot here. The essence of the quote is that he seeks out investment opportunities where resilience is high and the range of possible outcomes is relatively narrow.
This is a big reason he avoided investing in technology companies for so long. Because the industry is, by design, constantly changing and evolving, the variability of outcomes tends to be much higher than in more predictable industries like railroads or consumer staples.
“Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses. But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.”
The key sentence in the quote is this: “If a business requires a superstar to produce great results, the business itself cannot be deemed great.” That really says it all.
We all want to invest in great businesses, no doubt about that. And of course, we want those businesses to be run by competent and trustworthy managers.
But if what makes a business great is solely the people running it, then the reality is that the business itself probably isn’t all that great.
And because of that, whatever success it’s experiencing is likely temporary, which is not an ideal quality to look for in a long-term investment.
“Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.”
There’s a lot of good insight packed into this quote. But reading between the lines, what I take away is that different businesses can play different roles within a portfolio.
Some businesses you own for their ability to drive organic growth, and subsequently, higher returns. Others you own because—even without rapid growth—they generate a ton of cash that can be redeployed into those higher-growth opportunities.
In other words, some businesses drive the growth, while others provide the fuel for it.
And importantly, no business—even the truly great ones—can grow at a high rate forever. Every company eventually reaches an inflection point where growth slows and it inevitably transitions into the the steady cash generator. It’s just part of the corporate circle of life.
“ A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.”
As the saying goes, it takes money to make money. But what Warren is pointing out here is that this isn’t always the case.
There are certain businesses—like Microsoft, Alphabet, and others in the tech space—that can grow their sales and earnings without needing to invest large amounts of capital back into the business. And those are the best kinds of businesses to own.
Looking at Microsoft as an example, when they add another subscriber to their software, they don’t have to physically produce anything. The product is digital, so it can be delivered instantly without creating another copy.
That’s very different from a business like an automaker. If Ford wants to sell more cars, they have to build more cars. And to do that, they need to spend money on more materials, factories, and labor. It’s a much more capital-intensive process than selling another copy of Excel.
“I should emphasize that we do not measure the progress of our investments by what their market prices do during any given year. Rather, we evaluate their performance by the two methods we apply to the businesses we own. The first test is improvement in earnings, with our making due allowance for industry conditions. The second test, more subjective, is whether their ‘moats’ - a metaphor for the superiorities they possess that make life difficult for their competitors - have widened during the year. All of the ‘big four’ scored positively on that test.”
This quote distills so much about how to think about long-term investing.
For starters, Warren really doesn’t base the success of his investment decisions on what the share price does in any given year. In such a short time period, it’s a pretty meaningless metric for gauging progress, since prices are largely driven by human emotion and sentiment.
As Ben Graham said, in the short term the market is a voting machine, but in the long term it’s a weighing machine—which brings us to what really matters.
What Warren cares about are the operational outcomes of his businesses. Are they growing their sales? Are they growing their earnings and free cash flow? And importantly, is their competitive position (AKA their moat) expanding over time, or starting to dwindle?
If the business fundamentals are improving over time, then the share price will eventually catch up. But in the short term, it’s important to remember that the share price is not always reflective of the business.
Memorable quotes and key takeaways from the 2007 Berkshire Hathaway shareholder letter.