How to invest like Warren Buffett – 7 lessons from Warren Buffett’s annual shareholder letters

Warren Buffet is much admired for his investing prowess. This guide summarises seven easy-to-learn lessons from Buffett’s investment strategy so that you can start to achieve returns like Berkshire Hathaway.

The first port of call in analysing Berkshire’s investments is to examine the Buffett’s annual shareholder letters (website). These letters are a goldmine for investors because they are provocative and persuasive, and contain a wealth of sound advice. The latest letter (published 26 Feb) is no different.

As we approach the forty-fifth edition of the shareholder letter, we distill some lessons for readers in constructing and managing equity portfolios, backed by the examples found in these letters. Here are seven things you can learn from Berkshire Hathaway’s portfolio.

Lesson 1: Equity portfolios change dynamically over time

As philosopher Heraclitus pointed out centuries ago, ‘change is the only constant in life.’ So does an equity portfolio.

The reasons are many. New sectors emerge; while new technology renders some industries obsolete (think Kodak). Macro conditions evolve. The global economy progresses over time. Just recently, war breaks out suddenly in eastern Europe which upended the global energy market. Therefore, your equity portfolio must change too, to reflect – and capture – the upside of these changes.

Looking back at the shareholder letters, it is a myth that Buffett never sells his stocks. He buys and sells – all the time.

Now compare Berkshire’s equity portfolio from these decade-wide time points: 2021, 2011, and 2001. The changes in holdings were dramatic.

Berkshire Hathaway 2021 Portfolio

Berkshire Hathaway 2011 Portfolio

Berkshire Hathaway 2001 Portfolio

Source: Berkshire Hathaway (2021 letter, 2011 letter, 2001 letter)

Yes, there are some stocks he kept far longer than average investors. But he held onto these stocks because of the superiority of the management of the company and the strength of the sector.

The key point here is that due to changes in the economy and market, your portfolio has to stay relevant and nimble.

Lesson 2: Learn to sell well

The second important lesson Warren Buffett has taught us over the years is learn how to sell. Much ink has been spilled about what and how he bought; a great deal less was written about why he sold the stakes.

The ‘Sage of Omaha’ only sells his equity stakes for three reasons:

• Great price – ‘Mr Market’ (or a buyer) offers him an excellent price for the stock. So its time to cash out
• Investments mistakes – Prices have gone south over time (e.g. Berkshire lost $444 million in Tesco (TSCO)).
• Unexpected negative catalysts – such as a pandemic or management scandal (e.g., Berkshire sold its Wells Fargo (WFC) stake after 30 years due to persistent mismanagement)

Take a look at one of Buffett’s best trades in the oil stock Petrochina (PTR). Berkshire bought into the company’s ADR in 2003 for $488 million. So huge was the stake that Berkshire owned at one point more than 10% of the entire free float. Guess when Buffett sold the entire $3.3 billion stake? October 2007 – right at the peak of the bubble. If he hadn’t, he would have lost 50% of the equity value soon after. The lesson is clear: Next time you’re offered an excellent price for an investment, take it.

What about a losing investment? When should you book the loss? This question is actually easier to answer: When you reach your ‘pain point’.

For example, when you’re buying shares at $10, do a quick scenario testing. What do you do when prices drop to $8, $4 or $1? At which price point would you panic? And do you believe in the company? If you really believe in the company, be prepared to invest for the long haul and look to add more shares at lower prices. If not, take the loss at the earliest opportunity. As they say, “the first loss is the best loss.”

Sometimes, the pain point is not about losing – it is about missing the opportunity in other sectors or stocks. Buffett, for instance, dumped his 7-year investment in IBM (IBM) because he found Apple (AAPL) more attractive.

There is another point here worth mentioning: Price volatility itself is not a signal to sell. A violent reaction in prices is often a blessing because you can buy wonderful companies at far cheaper prices.

Lesson 3: Ditch home bias and go global

Globalisation of the world economy has created opportunities outside the US equity market in the last few decades. The integration of many economies resulted in ‘win-win’ developments for many countries.

Warren Buffett has been deploying capital outside the US market since 2001. To him, there is a clear reason to store assets in foreign markets, as articulated in the Fortune magazine (2003):

“Through the spring of 2002, I had lived nearly 72 years without purchasing a foreign currency. Since then Berkshire has made significant investments in–and today holds–several currencies. I won’t give you particulars; in fact, it is largely irrelevant which currencies they are. What does matter is the underlying point: To hold other currencies is to believe that the dollar will decline.”

He anticipated that US will have low interest rates, low savings, and high trade deficits. Taken together, the US Dollar will depreciate – a fact highlighted again in his 2011 shareholder letter:

…in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time.

The trend to invest globally coincided with the popularity of “BRIC”, a collection of large and high-growth economies like Brazil, Russia, India, & China. (Note: BRIC was coined by Goldman Sachs – see original paper here). Buffett believes he could achieve higher returns by buying fast-growing foreign assets. As a result, Berkshire invested over the years in places like:

• China (e.g. Petrochina)
• Hong Kong (e.g. BYD)
• UK (e.g. Tesco),
• South Korea (e.g., POSCO),
• Israel (e.g., Iscar – subsequently fully owned), and
• Europe (e.g., Sanofi), among others.

For UK investors, this point is particularly pertinent because many world-class companies are listed in foreign exchanges. You need to diversify and capture some of this strong international growth. Do not be afraid of venturing outside the home market. You can either do this via exchange-traded funds, investment trusts, or buying individual shares.

Compare the returns from the FTSE 100 (proxied by ETF – ISF) against that of FTSE World Market (proxied by the ETF VWRL). The latter vastly outperforms UK blue-chips.

Lesson 4: Lock core holdings away for a long time

In following Berkshire’s equity portfolio over time, it is clear that the conglomerate has a set of core holdings that Warren Buffett seldom touched. For example, he held American Express (AXP) and Coca-Cola (KO) for more than two decades.

The reasons are three-fold:

1. These stocks were bought at a bargain price and he is letting these vast profits run.
2. These companies are profit machines. They continue to generate huge earnings for shareholders and it would be very difficult to replace these stocks at good prices.
3. These companies pay good dividends and sometimes shrink the number of shares via huge buybacks.

I believe that an investor should emulate Berkshire’s approach by holding a few ‘forever stocks’.

Surely, you know a few good companies – companies with steady earnings growth, good management, and are not highly indebted. Some of them are global consumer-related stocks.

Once you found them, wait to buy them at a fair price and then hold them for years. Entry prices are important it gives you more options, as Howard Marks quipped, ‘well bought are half sold.’

Another important point to bear in mind is that you need to understand the company’s cyclicality and profitability. Knowing this gives you the strength to hold the stock during bad times.

Once you acquire these stocks at a good price, do not be in a hurry to sell them – unless you find much better opportunities elsewhere. The ‘cost of replacement’ is huge. These core holdings will anchor your portfolio during the bad times.

Lesson 5: Take a few ‘blue-sky’ bets to juice up returns

Sometimes, you will see a few surprising new additions to Berkshire’s portfolio. In 2008, Berkshire invested $232 million in a relatively small and unknown Chinese electric-vehicle company called BYD (HKD: 1211). That was a couple of years before Tesla (NASD:TSLA) became famous for its all-electric line-up. After 13 years, this bet reaped a 33x-gain for Berkshire. Sometimes, you have to search for new companies/sectors that are promising.

Source: Fortune (2009)

In the next decade, many new promising tech, energy, and others companies will emerge, including:

• Alternative energies – New electric-vehicle companies, new hydrogen companies, new battery manufacturers
• Innovative tech and manufacturing companies
• New health companies, including pharmaceuticals,
• Disruptive financial companies, etc

Of course, the array of new industries is mind-boggling. How do we go about investing in these sectors? You can look at exchange-traded funds that invest in a large number of innovative stocks, such as Scottish Mortgage (LSE:SMT) or Ark Fund (NASD:ARKK). These funds will provide some sort of diversification for investors.

Look at what they are buying. Research associated opportunities in the same sectors.

Allocate a percentage of your portfolio to some of these innovative sectors may aid to improve returns over time. Of course, not every blue-sky bet will pay off.

Lesson 6: Look at unfashionable sectors

Warren Buffett does not like chasing stocks in a ‘hot’ area. Instead, he prefers to buy when the market is depressed or jittery because competition is lower. He can buy in at scale at favourable prices.

Here is an example. In 2020, Berkshire invested $6 billion in five Japanese trading houses (Itochu Corp, Marubeni Corp, Mitsubishi Corp, Mitsui & Company and Sumitomo Corp). Remember at that time, tech-related stocks were all the rage. Shares of Zoom, Peloton, and crypto-related stocks soared. Who would invest in ‘boring’ trading companies and, of all places, in Japan?

Well, these boring stocks have yielded significant profits this year. Look at Marubeni’s (8002 JP) chart. Its share prices climbed to new all-time highs last week despite the ongoing geopolitical tensions.

You can start the search process by asking: Where is the most depressed sector now? Are there opportunities to buy? Once you have a list of possibilities, watch them actively. Sometimes, a high-volume rebound could signal the end of the downtrend.

Lesson 7: Avoid big mistakes

Investment is about making capital gains over the years. The process is partly psychological, numerical, and statistical. In a sentence: Your gains have to be bigger than your losses.

Warren Buffett, admittedly, made many mistakes over the years, including buying Dexter Shoes and textiles factories. But his investment gains far outstripped his losses. Throw compounding into the process, he turned Berkshire into an $800 billion juggernaut.

How to avoid big mistakes? According to Warren Buffett, there are three general principles:

• Margin of safety – You buy a business at decent prices rather than ‘cheery’ prices. To understand what the margin of safety is, you need to know what the business is worth (roughly).
• Avoid sunset industries – Stick to predictable franchise and/or businesses that have near monopolistic pricing power
• Use bear markets to your advantage – Buffett loves buying in a downturn because prices are far cheaper. You should do so too.

For example, after a multi-year hiatus, Berkshire Hathaway splashed out $11.6b to buy Alleghany (Y) last week, on top of a $8-billion buying spree in Occidental Petroleum (OXY). These purchases marked a change from Buffett’s lethargic acquisition trail, which he lamented in his latest shareholder letter (2022) ‘…there was little action…in 2021‘. Clearly, the recent market volatility has opened up opportunities for some bargain hunting.

Conclusion

The market is a complicated and noisy place. To profit from it, you have to have a rough plan and some rules to abide by. Warren Buffett, through Berkshire’s portfolio, has shown us how he structured his investments over the years. I have distilled them into seven instructive lessons and hopefully, you can reap the rewards from investing just like Buffett.