The Berkshire Hathaway Letter: 5 Investing Lessons

If Warren Buffett had a big, flowy, white beard, my view of the release of Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) annual letter as a second Christmas would be complete.

My fellow Fool Morgan Housel has already done a great job hitting the overall highlights of the letter, including Buffett's views on the economy. I drilled 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 realizing 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 I find myself 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. To be sure, Buffett doesn't spend a lot of time talking about Coca-Cola (NYSE: KO  ) CEO Muhtar Kent, even though it's Berkshire's largest public holding. And after the kerfuffle over the Cadbury deal, Buffett may not have a glowing review of Kraft's (NYSE: KFT  ) Irene Rosenfeld, even though Berkshire still owns a substantial stake after he sold a significant chunk.

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? I think the answer is actually 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. As far as 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 (NYSE: JNJ  ) managed 32%.

This can be a good starting point for finding good investments. Here are a few non-Buffett holdings with impressive returns on tangible equity.


Return on Unlevered Tangible Equity

Philip Morris International (NYSE: PM  ) 137%
IBM 65%
United Technologies 56%
Oracle 41%
Abbott Laboratories (NYSE: ABT  ) 39%

Source: Capital IQ, a Standard & Poor's company, and author's calculations.

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.                                      

I'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.

Are there really stocks that Buffett only wishes he could buy? My fellow Fools think so and you can find out what they are in this free special report.

Berkshire Hathaway, Johnson & Johnson, and Coca-Cola are Motley Fool Inside Value picks. Berkshire Hathaway is a Motley Fool Stock Advisor choice. Philip Morris International is a Motley Fool Global Gains recommendation. Johnson & Johnson and Coca-Cola are Motley Fool Income Investor picks. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Berkshire Hathaway, Coca-Cola, International Business Machines, Johnson & Johnson, Oracle, and Philip Morris International. Motley Fool Alpha owns shares of Abbott Laboratories and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, Philip Morris International, Johnson & Johnson, and Abbott Labs, but does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Read/Post Comments (8) | Recommend This Article (38)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 01, 2011, at 5:32 PM, chamir wrote:

    This was a good read. Great job hitting those bullet points from his letter.

  • Report this Comment On March 01, 2011, at 5:53 PM, TMFKopp wrote:

    Thanks chamir!


  • Report this Comment On March 02, 2011, at 8:28 AM, midnightmoney wrote:

    Have I got this right: "management is important when it's important"? Sounds like an odd cross between a prosaic dr suess and football commentary to me.

  • Report this Comment On March 04, 2011, at 6:30 AM, hochwald wrote:

    Item 3 in the above list is just Buffett's way of saying again (what he has always said) that a good business is more important than good management, or that good managers on a bad business will ultimately be brought down by the bad business.

    But even a good business can be ruined by bad managers, so might as well have good managers.

  • Report this Comment On March 05, 2011, at 8:59 PM, vaidybala wrote:

    How does one make money on BRK A or B shares which are pricey? So much is written and talked about in the media.

  • Report this Comment On March 11, 2011, at 5:00 PM, racchole wrote:


    Buy fewer shares.

  • Report this Comment On March 27, 2011, at 11:35 PM, hoangquocanh wrote:


    Could you pls explain how to calculate the return on unleverage tangible assets? Especially how can we come up with unleverage tangible asset figure?


  • Report this Comment On April 20, 2011, at 6:50 PM, jeffgreen123 wrote:

    I also have had trouble replicating the numbers as they were calculated for this article. Could you please step through a sample calculation?



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