Buffett's Letter: 5 Investing Lessons

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If Warren Buffett had a big, flowy, white beard, some people would view of the release of Berkshire Hathaway's annual letter as like having a second Christmas.

We've already listed the top 10 highlights of the letter, including Buffett's views on the economy. Here we drill down further to pick out five investment lessons baked into Buffett's letter.

1. Measure true earnings power

Net income may be the preferred measure on Wall Street, but as Buffett points out, it's not always the best measure to use when valuing a company.

In Berkshire's case, it's often a misleading measure. Thanks to fluctuating items like investment gains and losses and adjustments on derivatives, net income may look drastically different from year to year, even though the true earnings power of the business hasn't changed nearly as much.

At other companies, net income may be a more reasonable measure of profitability, but it's important to dig into the numbers to figure out whether that's really the case.

2. Keeping perspective

Managing emotions and keeping a realistic perspective are always a challenge when it comes to investing.

In the halcyon days at the peak of the dot-com bubble, maintaining perspective meant realising that no matter how many eyeballs a company was getting, it still needed to bring in cash to survive.

Today, Buffett believes that it means looking past the doomsayers:

The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential — a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War — remains alive and effective.

3. Management matters?

As plainspoken as Buffett is, there are definitely times when you might find yourself baffled by his comments.

In a recent interview with the Financial Crisis Inquiry Commission, Buffett said that he values the ability to raise prices more than good management.

However, in the annual letter, it's Buffett's custom to call out the capable managers at Berkshire. This year, that included Tony Nicely's long body of work at GEICO, Ajit Jain's brilliance at Berkshire Hathaway Reinsurance, Jim Issler's agility at H.H. Brown, and Dave Sokol's turnaround effort at NetJets.

So what gives? Is management important, or isn't it?

The answer may actually be so simple that it's easy to overlook: It's important when it's important. In cases like Coca-Cola or Kraft, where you have a business that has tremendous brand-driven pricing power, management isn't as big of a deal. On the other hand, at a big-catastrophe property and casualty reinsurer, top-notch management is a must.

4. The signal of a great business

When evaluating Berkshire's manufacturing, service, and retailing businesses, Buffett writes:

Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12%-20%.

This seems like a pretty straightforward way to identify excellent (or very good) businesses in those sectors. As far as Berkshire's public holdings go, Kraft earned nearly five times its unlevered tangible equity over the past 12 months, while Coca-Cola churned out a 28% return and Johnson & Johnson managed 32%.

This can be a good starting point for finding good investments, although, as Buffett acknowledges, even relying upon those metrics he has made some serious mistakes in capital allocation, because he misjudged the competitive strength of businesses or the future economics of their industries.

5. Be right even if you're not precise

Finally, when talking about Berkshire's derivatives exposure and the use of the Black-Scholes, Buffett pointed out the importance of being right over having a nice, tidy answer.

The markets' hatred of uncertainty and ambiguity can often create opportunities — or spell danger for those bent on always appearing to be precise.

We'll let Buffett take us out:

Part of the appeal of Black-Scholes to auditors and regulators is that it produces a precise number. … Our inability to pinpoint a number doesn't bother us: We would rather be approximately right than precisely wrong.

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