Taking a Long Term View

Warren Buffet’s annual letter to Berkshire Hathaway shareholders should be mandatory reading for all investors.  He not only provides an economic outlook, he explains how Berkshire Hathaway makes money for its shareholders.  No other publicly traded company provides the same candor or clear explanation of its operations.  (All of the Berkshire Hathaway shareholder letters from 1977 to 2008 can be found here.)

Between 1965-2008, the book value of Berkshire Hathaway shares grew at compounded annual gain of 20.3%.  In comparison, the S&P 500 (including dividends) had a compounded annual gain of 8.9%.

Regarding the current economic environment, Warren Buffet notes:

But neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.

In good years and bad, Charlie and I simply focus on four goals:

(1) maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash;

(2) widening the “moats” around our operating businesses that give them durable competitive advantages;

(3) acquiring and developing new and varied streams of earnings;

(4) expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered Berkshire exceptional results.

An individual investor can follow Buffet’s lead by ensuring that his or her portfolio contains companies with strong balance sheets, proven management, solid earnings, strong market share, and a wide moat.  Historically, companies of this type have sold for a substantial premium (i.e., a higher P/E than their peers).  However, the market decline has reduced that premium.  This is a good time to exchange low or medium quality companies for high quality one.