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In February, Buffett released his annual letter to shareholders, which is available here. I read it every year because Buffett's wisdom is a level I aspire to reach someday. Today, I want to highlight some of the comments Buffett made that spoke to me and my thoughts on them.
Ignore The Noise
"The Dow Jones Industrial Average fell below 100 on that fateful day in 1942 when I “pulled the trigger.” I was down about $5 by the time school was out. Soon, things turned around and now that index hovers around 38,000. America has been a terrific country for investors. All they have needed to do is sit quietly, listening to no one."
Warren Buffett bought into the stock market in March 1942 and has been in it ever since. He has held through some very tough times and some very large swings, but did not sell everything and try to time it. Patience is perhaps the most difficult part of investing for most.
On Stock Market Movements
After noting the "worse-than-useless" net income number required by GAAP, Buffett discussed Berkshire's preferred metric for operating earnings. He wrote:
"It is more than silly, however, to make judgments about Berkshire’s investment value based on “earnings” that incorporate the capricious day-by-day and, yes, even year-by-year movements of the stock market. As Ben Graham taught me, “In the short run the market acts as a voting machine; in the long run it becomes a weighing machine.""
Whenever you are using any number to analyze a business, it is crucial to know what that number is telling you and then identify whether or not it is relevant. In the case of Berkshire Hathaway (BRK.B), a very large amount of its GAAP "net income" is attributable to price movements in its stock portfolio. Since those are unrealized gains or losses, and gains or losses that might never be realized, it distorts the true earnings of BRK. The actual cash flow that the company is earning.
This is very important to keep in mind. For income investors like us, the priority is a metric that measures cash flow and closely represents the amount the company could pay in dividends.
We should think the same way about our portfolios. The core tenet of the Income Method is to evaluate your portfolio like a business. Focus on the "operating earnings," the cash coming into your portfolio minus expenses.
BRK's Competitive Disadvantage?
In some ways, BRK has become a victim of its own success. Buffett wrote:
"There remain only a handful of companies in this country capable of truly moving the needle at Berkshire, and they have been endlessly picked over by us and by others. Some we can value; some we can’t. And, if we can, they have to be attractively priced. Outside the U.S., there are essentially no candidates that are meaningful options for capital deployment at Berkshire. All in all, we have no possibility of eye-popping performance."
Following up with:
"With that focus, and with our present mix of businesses, Berkshire should do a bit better than the average American corporation and, more important, should also operate with materially less risk of permanent loss of capital. Anything beyond “slightly better,” though, is wishful thinking."
While "slightly better" might be modest for Buffett, it is a lesson on the tradeoffs that investors struggle with every day. If you want "eye-popping" returns, then you need to make investments that are large enough to move the needle. BRK doesn't even have that as an option anymore, as they could buy entire companies, and their position size wouldn't be large enough to move the needle.
We do have that option. We could put 20%, 40%, or 80% of our portfolio into a single pick and swing for the fences. This strategy could lead to eye-popping returns or devastatingly bad returns.
If your portfolio consists of positions that are only a few percent of your total holdings, the likelihood of material outperformance declines, along with the risk of material underperformance. In other words, the more holdings you have, the more likely it is that your performance will trend towards "average," which, with a good selection, can lead to "slightly better."
So why do we recommend holding 42+ stocks with 2-3% position sizes?
"It’s harder than you would think to predict which will be the winners and losers. And those who tell you they know the answer are usually either self-delusional or snake-oil salesmen."
We like to believe that we are not self-delusional and we certainly aren't selling snake oil. You are not going to find High Dividend Opportunities (HDO) out there promoting, "We are beating the market by 500% over the past three months! Join now so you can too!!!". While they are not saying it explicitly, they are certainly implying that you can "get rich quick."
Our goal isn't to "crush" the stock market, get massive returns flipping stocks, or "get rich quick." If that is what you are looking for, this is the wrong place, and I doubt that the right place exists.
Our goal is to build a large stream of income from a variety of sources that will provide you with the income you need to fund your retirement. Compared to the S&P 500, some years we will beat it, some years we won't. The goal is to produce the income that we need. Our promise to you is to find the best income-producing opportunities we can that you can use to build a portfolio of income-producing investments.
The Wall Street Casino
"Though the stock market is massively larger than it was in our early years, today’s active participants are neither more emotionally stable nor better taught than when I was in school. For whatever reasons, 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. One fact of financial life should never be forgotten. Wall Street – to use the term in its figurative sense – would like its customers to make money, but what truly causes its denizens’ juices to flow is feverish activity. At such times, whatever foolishness can be marketed will be vigorously marketed – not by everyone but always by someone."
The Wall Street machine is filled with folks who profit from your trading. Buying or selling doesn't matter. What matters is that you buy or sell, that you turn on your TV, that you click that link, etc. The worst thing you can do in the eyes of everyone on the street – withdraw your money and spend it on yourself. Just like a casino doesn't care if you win or lose – just don't leave!
The second worst thing you can do? Hold your stocks, turn off your phone, and go fishing.
I think you should do both. What is the point of investing if you aren't going to enjoy the wealth it produces? Life is short and you've done the right thing building up a nest egg during your working years. Most likely, it wasn't easy for you. You made sacrifices that some of your peers didn't. You lived in a cheaper home, drove older cars, went out to fancy restaurants less frequently, and took less lavish vacations. You did all of this in order to save for your retirement.
It's your money, it's ok for you to enjoy it. The difficulty is in knowing how much you can spend without putting your retirement at risk. This is why the Income Method focuses on the income your portfolio is capable of producing. Set aside a reasonable amount for reinvestment (we suggest at least 25%), and treat the rest just like you treated the income you had when working.
In that spirit, we have two picks, rich in free cash flows and generous with dividends, for your consideration.
Pick #1: VZ - Yield 6.5%
Verizon Communications (VZ) is the largest U.S. telecom company by 2023 revenues and has consistently demonstrated higher profitability than its peers. VZ maintains an investment-grade A- balance sheet, with only $3.6 billion of its unsecured debt maturing this year.
VZ delivered its 17th annual dividend raise in Q3 2023, and its current $0.665/share quarterly payment calculates to a 6.5% yield. This dividend enjoys a modest 59% payout ratio, and the company’s guidance for growing FCF in FY 2024 indicates excellent prospects for another healthy raise in September.
Pick #2: EPD - Yield 7%
With 25 years of annual distribution raises,, Enterprise Products Partners (EPD) is part of the exclusive Dividend Aristocrat club. The Master Limited Partnership (MLP) operates a massive network of over 50,000 miles of pipelines in addition to several storage, handling, and processing facilities for NGL, crude oil, natural gas, petrochemicals, and refined products.
The company’s profitability is insensitive to commodity prices due to long term, fee-based take-or-pay contracts with credit-worthy customers. EPD maintains among the lowest leverage levels in the midstream industry. In this rising rate environment, EPD is a rare company to pursue debt reduction, share repurchases, distribution raises, and capital expenditures.
Your Portfolio Is Your Berkshire
"Our goal is realistic. Berkshire’s strength comes from its Niagara of diverse earnings delivered after interest costs, taxes and substantial charges for depreciation and amortization (“EBITDA” is a banned measurement at Berkshire). We also operate with minimal requirements for cash, even if the country encounters a prolonged period of global economic weakness, fear and near-paralysis."
What is BRK? Originally, it was a textile company, but after Buffett acquired 100% ownership, the textile business was abandoned, and Buffett used it as a vehicle to invest. It was Buffett's private fund, which would IPO in 1980, raising capital and allowing Buffett to become a much wealthier man owning a smaller piece of a much larger pie. BRK continues to contain the vast majority of Buffett's net worth. It is, for all practical purposes, his investment portfolio.
Your portfolio is probably a smidge smaller by only about 1 inch and a comma or two. Yet the principles are the same. Be prepared for the worst and keep your finances very conservative. Don't carry debt, keep your essential expenses at a level that is easily achieved by your income, and keep a reasonable amount of cash on hand for an emergency.
With the Income Method, our goal is for your portfolio to have a Niagara of interest and dividends flowing into it from diverse sources. That's so even when things go poorly for a section of the economy or for picks that end poorly, you can still have significant cash flow. Your bills are still easily paid, and you don't have to stress about whether or not you have enough to get through retirement.
There is simply no replacement for knowing that you have an income that can comfortably support your chosen lifestyle.
Are you ready to become an income investor?
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