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February 27, 2014 at 09:32 AM
What is of true value in investing, and what is a distraction or worse, are key themes in Warren Buffett’s widely anticipated annual shareholder letter, set for release over the weekend.
The Berkshire Hathaway CEO draws lessons applicable to stock investors, including nonprofessional investors (hint: a Vanguard index fund may be just the thing) from two tracts of real estate the Oracle of Omaha purchased decades ago.
In a lengthy excerpt of the annual letter, published exclusively by Fortune, Buffett recalls the thinking behind his purchase of a 400-acre farm 50 miles north of Omaha for $280,000 in 1986.
Farm prices had exploded in the previous decade but the farmland bubble burst in the 1980s, with prices retreating 50% or more. In that context, Buffett, whose son had a love of farming, acquired the property for less than the bank had lent against it. But he did so after making two key estimates: how many bushels of corn and soybeans the farm would produce and what its operating expenses would be.
Because he also expected productivity gains and higher crop prices, Buffett could see no downside and potentially great upside to such a purchase. That farm is today worth at least five times its purchase price.
Similarly, in 1989, Buffett and two partners bought a large retail property adjacent to New York University after the bursting of a bubble in commercial real estate so significant that the Resolution Trust Corp. was established to sell off failed banks’ real estate assets.
Here, too, Buffett describes the analysis as “simple.” He looked at the unleveraged current yield (like the farm purchase, it was 10%). That indicated little downside, but he saw enormous potential upside if the property was leveraged, by filling the property’s many vacancies and replacing tenants paying submarket rates when their leases expired.
Earnings tripled with the new leases, annual distributions today represent a whopping 35% of the buyers’ initial investment, and special distributions upon refinancing the property already totaled more than 150% of the investment. The Nebraska-based investor has never viewed the property in his quarter century of ownership, but had confidence NYU would continue to draw students and keep the area vibrant.
From these two “small investments,” the billionaire investor draws multiple lessons about investing fundamentals. To summarize:
- “You don’t need to be an expert in order to achieve satisfactory returns.”
- “Focus on the future productivity of the asset you are considering.”
- “If you instead focus on the prospective price change of a contemplated purchase, you are speculating.”
- “I thought only of what the properties would produce and cared not at all about their daily valuations.”
- “Forming macro opinions or listening to the marcro or market predictions of others is a waste of time.”
Buffett elaborates on all the above-quoted points, but of most relevance for securities investors is his discussion of the one major difference between real estate and stock investments: “Stocks provide you minute-to-minute valuations for your holdings, whereas I have yet to see a quotation for either my farm or the New York real estate,” he writes.
While stock investors would thereby appear to enjoy a relative advantage, it often does not work out that way.
Buffet says that some investors, himself included, would benefit from this added information.
“If a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his — and those prices varied widely over short periods of time depending on his mental state — how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming,” Buffett writes.
