Warren Buffett: Why You Should Own Stocks With Volatile Earnings

Key Concepts

• Willingness to endure fluctuating annual results: A core operational strategy of Berkshire Hathaway, accepting occasional large losses in exchange for long-term overall gains.
• Competitive advantage: The unique ability to withstand and even benefit from volatility that others avoid.
• Insurance business model: Taking on the desire of others to smooth earnings in exchange for potentially larger, lumpy earnings for Berkshire.
• Reputation as a primary asset: Prioritizing reputation over short-term financial gains, even at the risk of missing opportunities.
• Ethical conduct and intervention: A commitment to investigating and addressing unethical or illegal activities within Berkshire-owned companies.
• Talent as an inflation hedge: The idea that valuable skills and expertise are more resilient to inflation than financial assets.

Operational Strategy and Competitive Advantage

The primary differentiator of Berkshire Hathaway's operational method is its deliberate pursuit of a strategy that embraces occasional significant losses within a single year. This contrasts sharply with most other entities that strive to avoid such volatility. Berkshire's philosophy is that these large annual losses are merely "blips" in the grand scheme, and this willingness to endure fluctuating annual results provides a substantial and enduring competitive advantage. This advantage is not easily replicated, as others may understand the strategy but are either unwilling or financially unable to implement it.

This approach is particularly evident in their insurance business. Berkshire operates by accepting the desire of other parties to smooth their earnings, and in return, they anticipate receiving larger, albeit lumpier, earnings over time. Warren Buffett states, "risk we are in the business in insurance we are in the business of take taking the other guys desire to smooth their earnings and in exchange get what we think are larger lumpy earnings. uh over time." The key to this strategy's success lies in making sound decisions regarding premiums and ensuring that the company never exposes itself to a loss that could jeopardize its capital structure. This allows Berkshire to maintain a significant and widening competitive edge in this domain.

The Value of Reputation and Shareholder Trust

Charlie Munger highlights a crucial aspect of Berkshire's success: Warren Buffett's ability to maintain shareholder confidence even after a year of significant losses. Munger observes, "After a year in which Bergkshire has a big loss, he can look into his shaving mirror and say, 'Your shareholder still loves you.' Yeah. Other people are not in that position." This underscores the importance of trust and the long-term relationship Berkshire cultivates with its shareholders.

Buffett draws a parallel to Howard Robinson, a wealthy Omaha businessman from decades past who had a strong preference for owning 100% of his ventures. While Buffett doesn't share Robinson's extreme desire for complete ownership, he echoes the sentiment of wanting to be able to look in the mirror and know that "enough of my shareholders love me." This focus on shareholder sentiment is deeply intertwined with the company's commitment to its reputation.

Addressing Unethical and Illegal Activities

Berkshire Hathaway has a robust system for addressing unethical or illegal activities within its subsidiaries. Buffett confirms that the company would "jump in" to intervene. The Sarbanes-Oxley Act is acknowledged as a positive influence, particularly its provision for a hotline. Buffett receives direct letters and encourages reporting of problems. While he filters out trivial complaints, such as bad breath, any allegations of "bad behavior" are thoroughly investigated.

The company maintains an internal audit function, and issues raised through complaint lines, direct letters, or calls to the audit committee are taken seriously. Buffett emphasizes, "And every now and then there have been some important uh uh transgressions that have come to us uh via uh either letters to me or calls on the hotline or maybe letters to the audit committee, whatever. Uh we encourage that."

A key communication sent to managers roughly every two years reinforces this commitment. This letter, which Buffett considers sharing in annual reports, begins by stating that Berkshire has sufficient financial resources and while they "love making money," they "don't have a shred more reputation than we need. And we won't trade reputation for money." This message is paramount and is reinforced by the inclusion of the Solomon story in their annual presentations.

A critical addition to this message is the directive that if the sole justification for an action is that "the other guy is doing it," then that is insufficient grounds. Buffett urges managers to "Call me if anything's questionable. If you think it's close to the line, give me a call." He believes that the mere act of considering something "close to the line" often indicates it is already "over the line." The goal is to address problems promptly, as "we can cure any problem if we hear about it soon enough and take action soon enough." Allowing issues to fester or be covered up leads to more significant problems. With a workforce of 260,000, the potential for issues exists, and the priority is to hear about them quickly, ideally before they escalate to senior management.

The Culture of Fair Play and Wise Stewardship

Charlie Munger reiterates the paramount importance of reputation, stating, "we care more about that than business more." He describes the ideal at Berkshire as not merely maximizing legal profits but celebrating wealth that is "fairly won and wisely used." This ideal, when it permeates the culture of the organization, including its shareholders, is considered highly beneficial.

Inflation and the Defense of Talent

The discussion shifts to the potential impact of inflation. Buffett notes that if inflation "really gets in the saddle," it can become highly unpredictable, leading to a breakdown of faith in institutions and a cascade of negative consequences.

Munger offers a perspective on combating inflation: "The best defense, of course, is to contribute as much as you can to the civilization and expect to counter inflation's effects by your That's the safest antidote." He cautions against the notion of profiting from inflation by outsmarting others, deeming it a more dangerous approach.

The core argument is that while money can be devalued by inflation, "your talent can't be inflated away." An individual with exceptional skills, such as the "best brain surgeon in Omaha or the best painter," will always command their fair share of resources, regardless of the prevailing currency. Talent is presented as a "terrific asset to deal with any kind of a monetary situation."