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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Alright, Shani, we're going to talk about Warren Buffett today.

Jayamanne: The last time we did a podcast on Warren Buffett, we released it at 6 pm on a Saturday night because as long-time listeners know, we encourage you to play the Warren Buffett drinking game.

LaMonica: Which is very complicated. Every time we say Warren Buffett, you have a drink.

Jayamanne: Exactly. And the last episode was about Berkshire Hathaway and you would have been on the floor within the first five minutes. We thought a Saturday release would be much more appropriate than a 6 am on Sunday.

LaMonica: I mean, do you not think that most people have better things to do at 6 pm on a Saturday night, Shani?

Jayamanne: I thought so, but some of you don't, because 496 of you listened to our podcast on the Saturday night.

LaMonica: So you went back and checked.

Jayamanne: I did.

LaMonica: Because 496 seems like a very exact number.

Jayamanne: Yes.

LaMonica: Alright, well, we will dedicate this podcast to those 496 people. And today we're going to talk about Buffett's 2023 Annual Report that was recently published.

Jayamanne: And there's a lot to unpack in there. So we'll go through some of the key takeaways that have been put together by Morningstar's Susan Dziubinski. But Buffett also called out three stocks that he says Berkshire will hold indefinitely. We're going to go through these stocks and what Morningstar equity analysts think of them.

LaMonica: And one thing that we should call out is it's sad, but this is the first shareholder letter that he released since his partner Charlie Munger died, which happened in November of 2023.

Jayamanne: Investment partner.

LaMonica: Yes, sorry, investment partner. We did go through, I think in that last episode, or some episode, his very complicated marital situation, but probably once is enough, right, Shani?

Jayamanne: Yeah, I think you're right. But back to the letter. He added a letter to the beginning of 2023's edition to acknowledge Munger's contribution to Berkshire. He has often been credited for changing Buffett's perspective of investing and shifting his and then Berkshire towards quality companies. Buffett calls Munger the architect of present Berkshire, whereas Buffett was a general contractor that carried out the vision.

LaMonica: Wow, that's quite an analogy there.

Jayamanne: Romantic.

LaMonica: Yes. All right. Well, aside from that special note, Buffett's letters always follow a certain theme. It's not focusing on the hot stocks that investors should invest in that year. It's focusing on reminders for investors on how to invest successfully.

Jayamanne: He notes in this letter, and this is a quote, though the stock market is massively larger than it was in our early days, today's active participants are neither more emotionally stable nor better taught than when I was in school. For whatever reason, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants.

LaMonica: Well, there we go. And I know that I'm a lot less emotionally stable than I was when I first started investing. So similar, I'm like the Warren Buffett of this podcast, basically because I'm the old white guy, right?

Jayamanne: No comment.

LaMonica: Okay, there we go. Earlier, Shani was ranting once again about the theft of national treasures in Sri Lanka and the fact that they're in the British Museum. So just a little caveat here to her present attitude. But let's go back to speculation and investors. So really what Buffett's talking about is the increase in speculation, which we've talked about a lot on this podcast, especially newer entrants to the market since COVID.

Jayamanne: And he goes on to say that investors should focus on fundamental principles. The first is clarity of purpose when investing. We advocate for that through having structure and a plan, starting with an investment policy statement and going through the portfolio construction process. We talk about this all the time, so we won't need to spend time on the steps here, but you're able to find articles and podcast episodes that go through this process on

LaMonica: And the second is focusing on quality investments or in Buffett's words, wonderful businesses. This is about seeing yourself as a business owner. We invest in companies for their future earnings. Think about whether businesses are profitable over the long term, understand whether they have sustainable competitive advantages or moats that will protect them from competitors and stop them from eroding their earnings.

Jayamanne: Then it is favoring companies run by good managers. Capital allocation decisions will ultimately determine the level of success of the company. It is good managers that will know where best to distribute profit, whether that'd be investing in growth, distributing dividends, or share buybacks.

LaMonica: And then one big tenant, obviously, of Buffett's is hold for the long term, and this one is pretty self-explanatory. I recently spoke about how I don't plan to sell my long-term holdings, and this is coupled with other factors mentioned by Buffett, quality investments with good managers. Why would you sell a quality asset run by good managers?

Jayamanne: The last fundamental principle of success is practicing fiscal conservatism, and this is a promise that he makes to shareholders of Berkshire. He holds a sizable amount of cash and he treats this as an insurance policy on Berkshire, which he calls a fortress-like building thought to be fireproof. Buffett plans to safeguard the savings, so shareholders are not exposed to permanent loss of capital. Cash naturally plays an important role in that strategy. In a personal investment strategy, this is your emergency fund.

LaMonica: One other point to note about cash is the role that Berkshire played in the financial crisis in 2008. The U.S. economy was imploding, and of course Buffett had a sizable cash balance that could be deployed, and it was deployed. A couple of examples of this is the investment in Goldman Sachs, and then a few years later in Bank of America.

Jayamanne: And this isn't just charity or a parachute to save the U.S. economy out of the goodness of Berkshire's heart. It is the ability to purchase distressed assets at extremely attractive prices. This is another lesson for investors. Investors should be wary of holding cash in case of a downturn. This is very much tactical allocation and timing the market.

LaMonica: However, purchasing quality assets that are undervalued is the key to successful long-term investing. Investors can take advantage of undervalued opportunities in the right circumstances. They have liquidity, they are not deviating too far from their strategic asset allocation, and they have the time horizon required for the investments that they're investing in.

Jayamanne: Okay.So those are the principles that form the basis of Buffett's investment philosophy. There was a much more interesting part of the letter that ties in with the quality companies as long-term holdings.

LaMonica: And there's no longer holding period than forever, which sounds like a diamond commercial, right?

Jayamanne: Yes,for De Beers. Buffett called out three stocks that Berkshire would hold indefinitely due to the strength and prospects of businesses. All of these stocks are listed in the U.S.

LaMonica: And it is worth noting that all three of these stocks aren't undervalued. And many quality businesses rarely fall into the undervalued territory, and if they do, it's not by much.

Jayamanne: Mark recently spoke about purchasing a stock on his watch list. It wasn't undervalued, but it met all of his investment objectives and was at a price he considered reasonable for a stock that he was going to hold indefinitely. And this stock was on his watch list for a little while. It was American Tower. And we've done an episode on American Tower and why Mark wants to buy it. It's called Making a List and Checking it Twice.

LaMonica: That's very festive. So we made that. We recorded that podcast, I think a year before I actually purchased the share.

Jayamanne: Well, there you go. And now you've got it.

LaMonica: Yes. And now look at my life. It is complete. All right. So another thing, of course, that you can do is make sure you have a defined investment strategy and then see if stocks fit with your investment policy statement and whether or not it's worth putting them on your watch list.

Jayamanne: So let's start with the first stock. It is Coca-Cola and Mark is a huge fan of Coke.

LaMonica: Thank you for that. Berkshire owns about 90% of Coke's outstanding shares. And it's a pretty classic case of the type of business that Buffett likes to own.

Jayamanne: The world's best known beverage company has built a wide economic moat around its businesses with its storied brands, a loyal following and a significant cost advantage. A wide economic moat indicates that our analysts believe the company can maintain a sustainable competitive advantage for at least the next 20 years.

LaMonica: And the company dominates the carbonated soft drink market. And as a result, generates predictable cash flows. And Coke's management team has done an exceptional job of maintaining a healthy balance sheet that can withstand economic uncertainties and making astute investments to benefit top line growth.

Jayamanne: The company has also consistently returned cash to shareholders via share repurchases and dividends. We think Coke stock is worth $60. And right now it's trading at a range that we consider fairly valued because it's around $60 as of 11th of March. The next stock is American Express, another business that Mark uses.

LaMonica: These are a lot of personal details about my life. If you consider my soft drink of choice and the credit card that I carry personal details. But anyway, something about me. Berkshire actually owns more than 20% of AmEx. And if I own more than 20% of AmEx, I wouldn't need a credit card, right? The company has a wide economic moat, according to your analysts, because it's a closed loop network. And Shani loves these terms, walled garden and closed loop network. But what closed loop network means is that it issues credit cards, it operates the payment network, and it maintains a direct relationship with the merchant.

Jayamanne: And what this allows is a full economic profit to be captured from a single credit card payment. A result of this is that it gives an edge above its competitors because it is less reliant on net interest income than its competitors.

LaMonica: And because of that wide moat, again, we believe that AmEx will be able to maintain its sustainable competitive advantages and protect and grow earnings for at least the next 20 years. Company has an enviable position with small and mid-sized businesses in America, which is its biggest market.

Jayamanne: You would hope so for a company named American Express.

LaMonica: Yeah, I mean, exactly. So we think, our analysts think, that AmEx has a fair value of $190 and it's currently trading for around $220. So that's about a 17% premium. All right, we're going to turn to the last company, Occidental Petroleum with the ticker symbol OXY.

Jayamanne: I'm unsure if Mark is a frequent customer of OXY. We've lost a streak of just look at products that Mark uses and buy them. But Berkshire owns more than 28% of the company. OXY is one of the largest independent oil and gas producers in the world.

LaMonica: And the company has taken on, because you're probably sitting there thinking, oh no, it's an oil company. But the company has taken the lead on carbon capture initiatives. And Buffett thinks that this is promising. Our analysts think that OXY doesn't have an economic moat. And this is mainly due to an expensive acquisition that they made in 2019 that put a dent in the company's profitability.

Jayamanne: But on a positive note, management has been de-leveraging the company's balance sheets since the purchase and the books look better than they have for a while. It's our expectation that the company's financial health will continue to improve.

LaMonica: So we have a fair value of $56 on OXY right now. It's currently trading at around $61 on the 11th of March. And that's within a range that we would consider fairly valued.

Jayamanne: So these are the stocks at Buffett and Berkshire, imagine that they will hold forever. In June of 2020, the average holding period of a share on the New York Stock Exchange was 5.5 months. And this wasn't always the case. In the 1950s, the average holding period was 8.8 years. As investors, our behavior has collectively changed to hold assets for a shorter period of time.

LaMonica: And there's a cost to this. We constantly reference the Mind the Gap study, which estimates the cost at 1.7% a year. Ultimately, investing is a trade-off between risk and reward. When we're speaking about it in reference to investments, we often speak about volatility, or how much an asset bounces around in the short term. In riskier assets like shares, we exchange that short-term volatility for higher expected returns over the long term. And the key to this is the long term. If you want to consistently achieve high returns from shares, you need to hold them for long periods of time so that the short-term drops in price can be counteracted. If your holding period is forever, you'll never have to realize a capital gain or loss, and that volatility from share prices starts to not matter.

Jayamanne: There are other benefits as well to indefinite holding periods. You will avoid capital gains tax. You will also pay less in transaction costs, both brokerage and buy-sell spread. Longer holding periods afford you the opportunity to reinvest dividends, and that has a compounding effect on not just the number of shares you hold, but also the income generated from your holding if you were to turn off dividend reinvestment in the future. Far outweighing these other benefits is a likelihood that longer holding periods result in less mistakes.

LaMonica: If you're holding an investment that continues to conform to your investment thesis, as well as your investment policy statement, it starts to become harder to justify selling. An important part of this is ensuring that you purchase quality businesses, and you can't deny that businesses like Coke, AmEx and OXY are perfect examples of this.

Jayamanne: And as investors, think about your own portfolio in the same way. Many investors that we hear from have core holdings that make up a good percentage of their portfolios. These might be companies that have been owned for years. Over that time, it can be obvious that the philosophy of the company closely aligns to your own philosophy as an investor. It can be a conservative approach to capital allocation decisions, keeping some dry powder to strike when opportunities arise, or simply a focus on returning cash to shareholders through dividend and buybacks.

LaMonica: That's right, Shani. I know that's something that I do with my own portfolio. There are many ways to be a successful investor, and there are many different approaches that are ingrained within a company through their culture. Getting that alignment is really important, allows us to sleep at night as investors, and allows us to maintain confidence in holding when markets get choppy. Creating that symbiotic relationship can remove a lot of the behavioral risk from investing. The investment world is quick to jump on anything Buffett does. I'm not announcing Buffett's death, just to be clear.

Jayamanne: That would be crazy.

LaMonica: That would be crazy. Anything Buffett does. The investment world is quick to jump on anything Buffett does. Each share he buys or each share he sells. But the real lesson is his temperament and patience. It is easy to dismiss Buffett by talking about how much money he has and his recent returns. But a wise investor focuses on how he built that fortune in the first place.

All right. Thank you for listening to our Buffett episode. For those that are still coherent at the end of this, maybe people pause and start this up again after a couple of hours. We appreciate it. If you have any ideas for future shows or any suggestions, you can send me an email. It is in the show notes. Of course, we love ratings in your podcast app. Any comments you want to leave? Thank you.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)