Berkshire Hathaway Letters to Shareholders, 2012

1. Focus on intrinsic business value, not short-term market fluctuations

"We prefer a concept of 'economic' earnings that includes all undistributed earnings, regardless of ownership percentage."

Long-term value creation. Buffett emphasizes the importance of focusing on the intrinsic value of a business rather than short-term market fluctuations. This approach involves looking at the underlying economics of a company, including its ability to generate cash flow and grow over time.

Accounting vs. economic reality. The letter highlights the difference between reported earnings and true economic value. Buffett argues that investors should look beyond accounting figures to understand the real earning power of a business. This includes considering factors such as the quality of earnings, the sustainability of competitive advantages, and the potential for future growth.

• Key factors in assessing intrinsic value:
  • Cash flow generation
  • Growth potential
  • Competitive position
  • Quality of management

2. Invest in businesses with strong economic characteristics and competent management

"We much prefer businesses that dazzle us with their economic characteristics to those that dazzle us with their growth potential."

Exceptional businesses. Buffett seeks out companies with strong economic characteristics, such as high returns on capital, sustainable competitive advantages, and the ability to grow without requiring significant additional investment.

Quality management. The importance of competent and honest management is emphasized throughout the letters. Buffett looks for managers who think like owners and have a track record of making rational business decisions.

• Characteristics of desirable businesses:
  • High returns on capital
  • Strong market position
  • Ability to grow without significant capital investment
  • Competent and shareholder-oriented management

3. Maintain a long-term perspective and patience in investment decisions

"Our favorite holding period is forever."

Long-term outlook. Buffett advocates for a long-term investment horizon, emphasizing the benefits of holding onto great businesses for extended periods. This approach allows investors to benefit from compounding and avoid unnecessary transaction costs.

Patience in decision-making. The letters stress the importance of waiting for the right opportunities rather than feeling pressured to act. Buffett is willing to hold cash for long periods if attractive investments are not available.

• Benefits of a long-term perspective:
  • Compounding of returns
  • Reduced transaction costs
  • Ability to benefit from long-term business growth
  • Less focus on short-term market noise

4. Prioritize capital allocation and rational business practices

"The heads of many companies are not skilled in capital allocation, and... it is not surprising because most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics."

Efficient capital allocation. Buffett emphasizes the critical role of capital allocation in creating long-term value. He argues that many CEOs are not skilled in this area, leading to suboptimal decisions that can destroy shareholder value.

Rational business practices. The letters advocate for making business decisions based on economic reality rather than accounting conventions or short-term market reactions. This includes avoiding wasteful acquisitions, sensible dividend policies, and share repurchases when appropriate.

• Key aspects of effective capital allocation:
  • Reinvesting in the core business when returns are attractive
  • Making value-creating acquisitions
  • Returning capital to shareholders through dividends or share repurchases
  • Avoiding empire-building or ego-driven decisions

5. Seek businesses with sustainable competitive advantages

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage."

Moats and competitive advantages. Buffett places great emphasis on identifying businesses with durable competitive advantages, often referred to as "moats." These advantages allow companies to maintain high profitability and fend off competition over long periods.

Durability of advantages. The letters stress the importance of not just identifying current competitive advantages but also assessing their sustainability in the face of technological change, shifting consumer preferences, and competitive threats.

• Types of competitive advantages:
  • Brand strength
  • Network effects
  • Cost advantages
  • Regulatory barriers
  • Intellectual property

6. Embrace a value-oriented approach to investing

"Price is what you pay. Value is what you get."

Margin of safety. Buffett advocates for buying businesses at prices significantly below their intrinsic value, providing a margin of safety against errors in valuation or unforeseen negative events.

Market inefficiencies. The letters highlight opportunities that arise from market inefficiencies, where prices can deviate significantly from underlying value due to short-term thinking, emotional reactions, or institutional constraints.

• Key principles of value investing:
  • Focus on intrinsic value rather than market price
  • Look for a significant margin of safety
  • Be patient and wait for attractive opportunities
  • Understand the business thoroughly before investing

7. Understand the importance of corporate culture and managerial integrity

"Managers who want to expand their domain at the expense of owners might better consider a career in government."

Alignment of interests. Buffett emphasizes the importance of managers who think and act like owners, aligning their interests with those of shareholders. He seeks out businesses where management has a significant ownership stake or compensation structures that encourage long-term value creation.

Integrity and honesty. The letters stress the critical role of managerial integrity in creating long-term value. Buffett is wary of managers who engage in aggressive accounting practices, empire-building, or self-serving behavior.

• Indicators of strong corporate culture:
  • Management with significant ownership stakes
  • Rational compensation structures
  • Transparent communication with shareholders
  • Track record of ethical behavior

8. Recognize the power of compounding and retained earnings

"Over the long term there has been a more consistent relationship between Berkshire's market value and business value than has existed for any other publicly-traded equity with which I am familiar."

Compounding returns. Buffett highlights the extraordinary power of compounding over long periods, emphasizing how seemingly small differences in annual returns can lead to vast differences in wealth creation over decades.

Retained earnings. The letters discuss the importance of businesses that can reinvest their earnings at high rates of return, allowing for compounding within the business itself. Buffett prefers companies that can grow without requiring significant additional capital.

• Factors contributing to successful compounding:
  • High returns on invested capital
  • Long reinvestment runway
  • Rational capital allocation
  • Sustainable competitive advantages

9. Be cautious of accounting practices and focus on economic reality

"Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable."

Accounting limitations. Buffett warns about the limitations of accounting figures in reflecting economic reality. He emphasizes the need to look beyond reported earnings to understand the true economics of a business.

Economic vs. accounting earnings. The letters discuss the differences between economic and accounting earnings, particularly in areas such as depreciation, amortization, and the treatment of subsidiaries.

• Areas to scrutinize in financial statements:
  • Treatment of depreciation and capital expenditures
  • Acquisition accounting
  • Off-balance sheet liabilities
  • Non-recurring items and adjustments

10. Maintain financial strength and flexibility in operations

"We will reject interesting opportunities rather than over-leverage our balance sheet."

Conservative financial management. Buffett emphasizes the importance of maintaining a strong balance sheet and avoiding excessive leverage. This approach provides flexibility during economic downturns and allows Berkshire to capitalize on opportunities when others are constrained.

Operational flexibility. The letters discuss the benefits of a decentralized operating structure, allowing individual business units to adapt quickly to changing market conditions while benefiting from the financial strength of the parent company.

• Benefits of financial strength:
  • Ability to weather economic downturns
  • Capacity to seize opportunities during market dislocations
  • Lower cost of capital
  • Reduced risk of financial distress

Last updated: October 10, 2024