Value Hunting in a Changed Market: Essential Lessons from Buffett's 1985 Letter
In 1985, Warren Buffett, the Oracle of Omaha, penned his annual letter to Berkshire Hathaway shareholders. It wasn't a mere financial report; it was a treasure trove of investment wisdom, delivered with his signature clarity and wit.
Let’s dive into some of the key insights from Buffett's 1985 letter and explore how they can be applied to your investment strategy in the 21st century.
The Fading Bargain: Recognizing Market Valuation
One of the most striking observations Buffett makes in the 1985 letter is about the changing market landscape. He laments the scarcity of deeply undervalued opportunities, a stark contrast to the fertile ground of the preceding decades.
"Today we cannot find significantly-undervalued equities to purchase for our insurance company portfolios. The current situation is 180 degrees removed from that existing about a decade ago, when the only question was which bargain to choose."
Explanation: Buffett's point is simple: the market, in its collective wisdom (or lack thereof), had started to recognize and price in the value of good companies. This meant fewer opportunities for the kind of "cigar butt" investing, where one finds a company trading far below its intrinsic value and squeezes out the last few puffs of profit.
Real-World Application: Today, with information spreading faster than ever, the market often reacts quickly to news and potential opportunities. This doesn't mean bargains are extinct. It means you need to be more diligent. It also highlights the importance of understanding a company's intrinsic value, using methods like discounted cash flow analysis, instead of relying solely on readily available metrics like P/E ratios.
Modern Context: The proliferation of ETFs and passive investing strategies has arguably exacerbated this trend. As more money flows into index funds, valuations across the board can get inflated, making it harder to find truly undervalued companies. This underscores the importance of active, fundamental analysis to identify companies that are truly mispriced.
The Weight of Size: Growth's Inherent Limitations
Buffett also addresses a challenge that Berkshire Hathaway itself was starting to face: the impact of size on investment returns.
"The second negative factor, far more telling, is our size. Our equity capital is more than twenty times what it was only ten years ago. And an iron law of business is that growth eventually dampens exceptional economics."
Explanation: As a company's capital base grows, finding enough high-return investment opportunities to maintain the same rate of growth becomes increasingly difficult. It’s like trying to find a small pool of water when you have an ocean to fill.
The Importance of Economic Goodwill: Intangible Value Drivers
Buffett stresses the importance of "economic goodwill," which he clarifies in previous letters. In the 1985 Letter, he hints at it by focusing on successful business that require little capital reinvestment to sustain profits.
"The dramatic growth in earning power of these three businesses, accompanied by their need for only minor amounts of capital, illustrates very well the power of economic goodwill during an inflationary period (a phenomenon explained in detail in the 1983 annual report)."
Explanation: Economic goodwill refers to a company's intangible assets, such as brand reputation, customer loyalty, and strong management. These assets allow a company to generate consistently high returns on capital without needing to constantly reinvest large amounts of money. Buffett has a preference for businesses with strong brand recognition and a competitive moat.
Management Matters: Aligning Interests for Long-Term Value
Buffett consistently emphasizes the crucial role of management in creating long-term value. He lauds exceptional managers like Kay Graham of The Washington Post Company and critiques compensation structures that reward mediocrity.
"The extra $160 million or so we gained through ownership of WPC came, in very large part, from the superior nature of the managerial decisions made by Kay as compared to those made by managers of most media companies. Her stunning business success has in large part gone unreported but among Berkshire shareholders it should not go unappreciated."
Explanation: Buffett believes that a talented and ethical management team, focused on creating long-term value for shareholders, is essential for a company's success. He also criticizes compensation plans that reward managers simply for retaining earnings, rather than for generating high returns on invested capital.
Practical Takeaways for Today's Investor
Based on Buffett's insights from the 1985 letter, here are some practical takeaways for today's investor:
- Embrace Value Investing, but Adapt: While deep bargains may be harder to find, value investing remains a sound strategy. Focus on understanding intrinsic value and be willing to look beyond traditional metrics.
- Recognize Growth Limitations: Understand that growth rates eventually slow down. Reassess your portfolio periodically and adjust your expectations accordingly.
- Prioritize Economic Goodwill: Focus on companies with strong brands, loyal customer bases, and valuable intellectual property.
- Evaluate Management Teams: Carefully assess a company's leadership, ensuring that they are talented, ethical, and aligned with your interests.
- Be Patient and Think Long-Term: Investing is a marathon, not a sprint. Embrace patience and focus on building a portfolio of high-quality companies that can generate sustainable returns over the long run.
- Continuously Learn and Adapt: The market is constantly evolving. Stay informed, challenge your assumptions, and be willing to adapt your investment strategy as needed.