The Essays of Warren Buffett (Third Edition) - critical summary review

In October 2008, a USA Today article noted a staggering fact: there were 47 books in print with Buffett’s name in the title. There are many more today. Even so, “The Essays of Warren Buffett” is the only book with Buffett’s name listed as the author as well. It’s also Buffett’s favorite one.

Described by Buffett himself as “a coherent rearrangement of ideas” from his annual report letters, “The Essays of Warren Buffett” is a carefully edited and organized selection of “the Wizard’s” letters to the shareholders of Berkshire. So, get ready to get inside the mind and money-managing practices of the most successful investor in history, and remind yourself why following investing trends is never as smart as value investing.

Warren Buffett and Berkshire Hathaway

Buffett was already a millionaire when he bought Berkshire Hathaway, a textile manufacturing company, in 1964. Back then, its book value per share was $19.46. Today, more than half a century later, it is around $100,000 – and its intrinsic value even higher. Compounded annually, the growth rate in book value per Berkshire share under Buffett’s management is about 20%.

Berkshire’s most important business is insurance – it owns Geico Corporation, one of the largest auto insurers in the United States and General Re Corporation, one of the largest reinsurers in the world. Aside from insurance, Berkshire also owns and operates a few large energy companies, and, since 2010, the Burlington Northern Santa Fe Corporation, one of the largest railroads in North America. 

But these are not the only great companies Berkshire possesses: Lawrence Cunningham, the editor of Buffett’s essays, remarks in the book’s introduction that eight of its subsidiaries would be included in the Fortune 500 if they were stand-alone companies! “Berkshire is now a holding company engaged in 80 distinct business lines,” Cunningham writes further, listing just a few of them: food, clothing, building materials, tools, equipment, newspapers, books, transportation services, and financial products. 

Berkshire also owns large equity interests in major corporations, such as American Express (17.6%), Wells Fargo (10%), Coca-Cola (about 10%), and Apple (5.2%). No wonder Buffett himself said once that “when you are looking at Berkshire, you are looking across corporate America.” But how did he do it? How did he manage to get so good at the stocks game and become one of the world’s wealthiest people? And how did he turn a failing textile company into one of the ten largest public companies in the world? 

Owner-related business principles: Berkshire’s owner manual

There’s probably no better place to look for preliminary answers to these questions than Berkshire’s owner manual. First outlined by Buffett in 1979 but then heavily revised through the 1980s, the owner’s manual is annually distributed to Berkshire’s shareholders ever since 1988. Its 15 principles are the following:

1. Partnership, not corporate. “Although our form is corporate,” writes Buffett, “our attitude is partnership.” In other words, Buffett and Charlie Munger, the vice chairman of Berkshire Hathaway, see themselves as managing partners and think of their shareholders as owner-partners.
2. Eating your own cooking. Virtually all of Buffett’s net worth – and about 9/10 of Munger’s – is in Berkshire stock. This way, they make or lose money only when the shareholders do – and in precisely the same proportion. 
3. Per-share progress. Berkshire doesn’t measure its success in terms of size or share price – but in terms of per-share progress. The company’s long-term goal is “to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis.”
4. Direct ownership. Berkshire prefers to grow through direct ownership of a diversified group of business “that generate cash and consistently earn above-average returns on capital.” Buying parts of a similar business is a second choice.
5. Ignoring consolidated numbers. Buffett and Munger don’t care about Berkshire’s consolidated reported earnings – and they advise their shareholders to do the same. The important numbers are the earnings of each individual major business – and these are always transparently shared with the shareholders in an annual report.
6. Ignoring accounting consequences. When acquisition costs are similar, Buffett prefers purchasing “$2 of earnings that is not reportable […] than to purchase $1 of earnings that is reportable.” Put simply, Berkshire’s goal is to maximize its intrinsic value – even if certain investments don’t show up under standard accounting practices.
7. Avoid using excessive debt. Even if an opportunity looks appealing, Berkshire tends to avoid using excessive debt. This conservatism has penalized the company’s results in the past, but Buffett would always prefer comfort to chance and risk, writing – “To finish first, you must first finish.”
8. Putting shareholders first. Buffett and Berkshire’s managers will only do with their shareholders’ money what they would do with theirs. Meaning, they will never diversify by purchasing entire businesses at control prices from some managerial “wish list” while ignoring long-term economic consequences to their shareholders.
9. Five-year tests. Even the noblest intentions should be checked periodically against results. Buffett’s five-year tests comprise only two questions:
   - Did book value growth exceed the S&P 500's performance?
   - Did Berkshire’s stock consistently sell at a premium to book value (meaning, “every $1 of retained earnings was always worth more than $1”)? 
10. Issuing stocks. Berkshire is always very careful when it comes to issuing stock. In Buffett’s experience, whether for acquisitions, public offerings, stock options, or else, issuing stock is often dilutive.
11. Good business. Regardless of price, Berkshire has no interest in selling any good businesses it owns. Even if this would result in a big gain.
12. Radical business transparency. The fundamental guideline followed by Buffett and his team is to be always honest with their shareholders, telling them the business facts they would want to know if positions were inverted. To this end, they also try to give their shareholders as much information as is reasonably possible. 
13. Investing secrets. As candid as Buffett is in terms of management and business, he is notoriously silent when it comes to his investing strategies. “Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are,” he writes. So, there’s no point in sharing them with anyone.
14. Intrinsic business value. The goal of Berkshire is to keep the company’s stocks reasonably priced, so they never become under or overvalued.  By aiming for the company’s stock price to move proportionally to its intrinsic value over time, Berkshire makes sure to attract the proper kind of long-term investors.
15. Outpacing the yardstick. Berkshire regularly compares the gain in the company’s per-share book value to the performance of the S&P 500, aiming to outpace it. “Otherwise, why do our investors need us?” Buffett asks. He notes, however, this doesn’t happen every year. Moreover, because of the company’s conservative strategy, he expects Berkshire to “outperform the S&P in lackluster years for the stock market and underperform when the market has a strong year.” “So, when the market plummets,” he points out in a somewhat tongue in cheek manner, “neither panic nor mourn. It’s good news for Berkshire.”

Intelligent “value” investing

First formulated by Benjamin Graham and David Dodd, Buffett’s teachers, his conservative investing strategy can be roughly summed up in a single sentence: instead of trying to beat the market by buying “hot stocks” – just try to ignore it and buy “good companies” instead.

In essence, markets fail because, at a certain point, the discrepancy between the inherent value of a company and its stock prices is just too enormous to hold up. You can try to be a maverick and base your investment strategy on profiting from these discrepancies in the short run, but – as history has taught us – you’re bound to make a mistake or two eventually, and some of them may be very costly.

Although it will not make you rich overnight, Warren Buffett’s commonsense approach is much safer and should earn you just enough money in the long run. According to Buffett, you should only buy shares in companies that have an inherent value and only expect returns in the long run. “If you aren’t willing to own a stock for ten years,” he writes, “don’t even think about owning it for ten minutes.” That’s intelligent investing: everything else is just luck and charlatanism. “According the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic,” Buffett remarks memorably.

Buffett was never interested in running businesses: he made his fortune by purchasing promising businesses and assigning talented managers to operate them. Even so, he was only buying businesses he understood, continuously emphasizing that there’s no essential difference between buying a business and investing in one. Diversification is pointless in itself if you’re not investing in businesses you actually understand. 

Buffett writes: “I cannot understand why an investor […] elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.’”

Assessing risk: the five most important factors

So, in essence, when you happen upon a headline such as “Investors lose as market falls,” you should edit it in your mind to “Disinvestors lose as market falls – but investors gain.” Because real investors are not hopeful of great results – but certain of good ones. And they are much more interested in buying wonderful companies at a fair price than fair companies at a wonderful price.” But how do you distinguish between the two? In one of his shareholder letters, Buffett presents the five factors that one should consider when assessing an investment’s risk. As formulated by him, these are:

1. The certainty with which the long-term economic characteristics of the business can be evaluated.
2. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows.
3. The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to itself.
4. The purchase price of the business.
5. The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

Although “unbearably fuzzy” and barely quantifiable, these factors are exceptionally important when assessing the risk of a prospective buy. Remember: it’s not necessary to calculate these with engineering precision but to be able to estimate them with a useful degree of accuracy.

Final Notes

Often described as “the gold standard of its genre,” “The Essays of Warren Buffett” is extraordinary – not merely because of Buffett’s excellent writing style and stature, but also because of Lawrence Cunningham’s exceptional introduction and just as laudable editing expertise. As a Financial Times review stated upon the book’s original publication: “A classic on value investing and the definitive source on Buffett.” Five editions since, it still is both.

12min Tip

Don’t buy stocks you don’t understand – no matter what the professionals say.