During February Berkshire Hathaway released its annual report, including the eagerly awaited annual letter from Warren Buffett.
We produce an excerpt below which we believe will be of interest for our considered long-term investors:
The Power of Retained Earnings
In 1924, Edgar Lawrence Smith, an obscure economist and financial advisor, wrote Common Stocks as Long
Term Investments, a slim book that changed the investment world. Indeed, writing the book changed Smith himself,
forcing him to reassess his own investment beliefs.
Going in, he planned to argue that stocks would perform better than bonds during inflationary periods and
that bonds would deliver superior returns during deflationary times. That seemed sensible enough. But Smith was in
for a shock.
His book began, therefore, with a confession: “These studies are the record of a failure – the failure of facts
to sustain a preconceived theory.” Luckily for investors, that failure led Smith to think more deeply about how stocks should be evaluated.
For the crux of Smith’s insight, I will quote an early reviewer of his book, none other than John Maynard
Keynes: “I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point.
Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits.
In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is
an element of compound interest (Keynes’ italics) operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”
And with that sprinkling of holy water, Smith was no longer obscure.
It’s difficult to understand why retained earnings were unappreciated by investors before Smith’s book was
published. After all, it was no secret that mind-boggling wealth had earlier been amassed by such titans as Carnegie,
Rockefeller and Ford, all of whom had retained a huge portion of their business earnings to fund growth and produce ever-greater profits. Throughout America, also, there had long been small-time capitalists who became rich following the same playbook.
Nevertheless, when business ownership was sliced into small pieces – “stocks” – buyers in the pre-Smith
years usually thought of their shares as a short-term gamble on market movements. Even at their best, stocks were
considered speculations. Gentlemen preferred bonds.
Though investors were slow to wise up, the math of retaining and reinvesting earnings is now well
understood. Today, school children learn what Keynes termed “novel”: combining savings with compound interest
Reporting season commenced during the month and has generally been quite pleasing; we’ll cover this in more detail in next month’s newsletter.
We mentioned the coronavirus last month, and the market has since become more concerned due to fears of a global meltdown. The only sensible commentary we can make is to reiterate our comments from last month:
‘Whilst not making light of the human, social and environmental costs of certain issues; many of these have very little bearing on long-term investment performance…Amending an investment program based
on near-term ‘expert’ opinions on market direction is simply market timing – a strategy that has not
The reality is that nobody knows what the market is going to do and we recommend being very
cautious of anyone providing such a forecast.
Over the years we’ve counselled our astute readers to focus on the businesses they own and not focus
on the market and economic forecasts (generally negative) of the usual suspects.’