Stock markets usually go up

The 2009 letter shows a table of the annual performance of the S&P 500 from 1965 to 2008. In three-quarters of those years, a gain was made. Warren Buffett surmised that a similar proportion of the next 44 years would also be positive. However, he stressed that he cannot predict which years will be winners and which will be losers in advance. Therefore, when times are good or bad in the markets, he and his partner, Charlie Munger, focus on four goals for their portfolio:

1. Buy quality stocks with good liquidity and solvency positions that generate plenty of cash
2. Invest in businesses that have and can maintain a competitive advantage, i.e., they have a “moat”
3. Find businesses with outstanding management teams, develop and support them
4. Keep buying quality stocks of businesses with competitive advantages with great management behind them when they are available for a great price

This investment approach does not change whether the market is up or down. What does change is the number of stocks available for a great price.

Mr Market

The 1987 letter to the Shareholders of Berkshire Hathaway references a story told by Warren Buffett’s friend and mentor, Benjamin Graham. Mr Market is a capricious fellow. He turns up every day to offer to buy and sell stocks to you. Sometimes he quotes wildly high prices, sometimes, his mood is low, and he quotes rock-bottom prices. His prices often don’t seem to chime with the quality of what he is selling or buying. The trick is to realise that Mr Market can be sent away without transacting with him.

An investor needs not to be led by Mr Market’s ticker tape. Investors should determine a price they would be happy to buy a quality, comparatively advantaged stock with great management. If Mr Market turns up one day and offers to sell such a company below that price, he will get his hand bitten off, and if not, well, Mr Market will be back tomorrow.

Warren Buffett is greedy…sometimes

The most famous quote from one of the world’s greatest investors is probably:

Be fearful when others are greedy, and greedy when others are fearful.

Warren Buffet, Berkshire Hathaway, Inc. Chairman’s Letter, 1986

This quote means that the time to load up and greedily feast on stocks in fantastic businesses is exactly when others are panicking, and the market is tanking. That is when Mr Market is likely to offer prices below a business’s intrinsic price, which is calculated based on its long-term potential.

So, Warren Buffett probably does not do anything different when the market is crashing compared to when it is booming. But he might do a little more. That’s because market crashes are an opportunity to buy stocks he wants to own for a lower price.

As a result, I have more money in Berkshire Hathaway (NYSE:BRK.B) than any other business. Having a lot of money in one business brings risk, but it’s a situation that I’m very happy with. 

It’s not just Buffett that I think makes Berkshire a great investment. It’s the way the company is run and the competitive advantage it has.

Investing like Warren Buffett

A lot of the time, investing like Warren Buffett is about working out which stocks to buy. It’s well known that the Berkshire Hathaway CEO has distinctive criteria for identifying stock opportunities.

Copying the Oracle of Omaha is difficult, though. There are two main reasons for this. 

First, Buffett has (in my view) some unique attributes. Chief among these is his patience and temperament.

The secret behind Buffett’s investment success, as I see it, is his ability to wait for the best opportunities. That’s difficult for investors like me who haven’t been investing for 60 years.

Second is the fact that Buffett has access to a unique source of investment capital. The key to Berkshire’s success is the way that its insurance business generates cash.

Insurance

Berkshire Hathaway owns a number of insurance businesses. These work by collecting premiums in exchange for providing cover against risks. 

One way for insurers to make money is by paying out less in claims than they make in premiums. But this isn’t their main source of income.

Insurance companies also invest the premiums they take in. This way they can generate returns before paying claims.

This means that its insurance operations give Berkshire access to capital to invest. When the insurance business collects premiums, Buffett can invest these to generate returns.

Berkshire’s big advantage

This structure is true of insurance companies in general. So why is Berkshire Hathaway so special?

Unlike other insurers, Berkshire invests its insurance premiums in common stocks and businesses. Other insurers typically invest most of their premiums in bonds.

Since stocks and businesses typically produce higher returns than bonds, this means that Berkshire outperforms its insurance competitors.

The next question is why Berkshire’ competitors don’t invest their premiums in stocks and businesses, rather than bonds? The answer is that they can’t. 

Berkshire is able to maintain a big stock portfolio because of the huge cash reserves that protect its underwriting. Other insurance companies just don’t have this and it’s hard for them to generate it.

In order to build a big cash base, an insurer needs to take in a lot of premiums and invest them well. But in order to do that, they need a big cash base to protect themselves from losses.

This is why Berkshire Hathaway has such a big advantage over its competitors. There is risk associated with owning stocks over bonds and there’s risk of overpaying to acquire a business, but I think that Berkshire’s competitive position is unrivaled and it’s why I’m happy to invest a significant sum in the business.