Warren Buffett: How To Understand Annual Reports

Summary

In this engaging discussion, Steve Davis and Charlie Munger share their insights on understanding annual reports and investment strategies. They emphasize the importance of transparent management communication, noting that candid discussions about both successes and challenges foster investor confidence. The conversation highlights Coca-Cola's long-term growth potential compared to Pepsi and the value of stock buybacks as a strategic tool for strong companies. They also advocate for independent investor analysis over broker recommendations, showcasing a preference for individual shareholders who align with the company’s values. Overall, the dialogue offers valuable perspectives for investors seeking to navigate the complexities of financial reporting.

Takeaways

• 😀 Understanding annual reports starts with focusing on companies that investors can comprehend.
• 📊 Candid management communication about both successes and challenges is crucial for building trust with investors.
• 📈 High-quality annual reports can provide insights equivalent to conversations with top management, enhancing investment confidence.
• 🔍 Avoiding jargon and using straightforward language in reports can positively influence investor interest.
• 🍹 Long-term growth predictions favor Coca-Cola over Pepsi, indicating confidence in Coca-Cola's market strategies.
• 📚 Recommended readings, such as 'Guns, Germs, and Steel' by Jared Diamond, can offer valuable perspectives on business and decision-making.
• 💰 Share repurchase strategies, even at high price-to-earnings ratios, are viewed as beneficial for long-term shareholder value.
• 🤔 Investors are encouraged to make independent decisions rather than relying solely on broker recommendations.
• 🔔 Management should prioritize transparency by discussing challenges promptly and avoid only presenting positive news.
• 📝 A well-informed investor is more likely to engage with a company and remain committed over the long term.

Q & A

What is the primary focus when evaluating annual reports according to the speakers?

The primary focus is on finding companies whose reports are understandable and provide candid information about their management and business operations.

How do the speakers feel about the use of jargon in annual reports?

The speakers believe that the use of standardized jargon can be a turn-off and prefer straightforward, coherent language that communicates the business's true state.

What example do the speakers give of a company with an informative annual report?

They highlight Coca-Cola's annual report as being particularly informative, stating that it provides insights comparable to a personal conversation with management.

What is the recommended approach for managers regarding bad news?

Managers are encouraged to communicate bad news immediately and openly, as this fosters trust and understanding with shareholders.

What long-term growth prediction do the speakers make regarding Coca-Cola and Pepsi?

The speakers predict that Coca-Cola will continue to gain market share compared to Pepsi in the long term.

What book does Charlie Munger recommend, and why?

Charlie Munger recommends 'Guns, Germs, and Steel' by Jared Diamond for its analytical approach and the way it encourages readers to ask insightful questions.

What do the speakers think about share repurchases by strong companies like Coca-Cola?

They view share repurchases as a wise use of capital, especially for strong companies, as it can lead to increased ownership and value over time.

What caution do the speakers express regarding stock repurchase programs?

They caution that not all stock repurchases are well-reasoned and can lead to poor management decisions if done excessively or for the wrong reasons.

How do the speakers perceive individual investors compared to institutional investors?

They prefer individual investors, believing they are more engaged and understand the impact of investments on their lives better than institutional investors.

What key factor do the speakers believe enhances their investment decisions?

They believe that having a deep understanding of a company's business operations and being informed by transparent annual reports enhances their investment decisions.

Outlines

00:00

📊 Understanding Annual Reports

In this part, Steve Davis shares insights on how to effectively read and understand annual reports. He emphasizes the importance of selecting companies whose reports are comprehensible and well-communicated. Davis highlights that the quality of management's transparency in reporting critical business aspects directly impacts investment decisions. He mentions the Coca-Cola annual report as a prime example of informative documentation, asserting that they made their investment decision based solely on it. Both Davis and Charlie Munger express their disdain for jargon-heavy reports and advocate for candid communication, urging managers to convey bad news promptly to maintain investor trust.

05:05

🥤 Long-Term Growth: Coca-Cola vs. Pepsi

In this segment, the discussion shifts to the long-term growth prospects of Coca-Cola compared to Pepsi. Davis expresses confidence that Coca-Cola will continue to outperform Pepsi, illustrating his point with insights from Munger. The importance of maintaining competitive advantages and the effectiveness of management strategies are highlighted as key factors in this prediction. The conversation underscores the value of experience in assessing company prospects and reinforces the rationale behind their investment choices.

10:06

💸 Capital Deployment and Stock Buybacks

This part revolves around the strategic considerations of companies like Coca-Cola when buying back their shares. Davis argues that repurchasing shares is often a wise decision for strong companies, citing Coca-Cola's consistent history of share repurchases as a positive practice. He discusses how repurchases have enabled Berkshire Hathaway to increase its stake in Coca-Cola without additional capital outlay. Munger adds that while there can be instances where share buybacks are inappropriate, great companies can successfully buy back stock even at high prices. The discussion also critiques the trend of companies repurchasing shares for the wrong reasons, urging a more judicious approach to capital deployment.

📉 Recommendations and Individual Investors

In this final part, the conversation touches on stock recommendations and the nature of Berkshire Hathaway's shareholder base. Davis explains their preference for individual investors over institutional ones, emphasizing that individuals tend to have a longer-term perspective. He reflects on how little Berkshire Hathaway is recommended in the institutional market due to perceptions of its difficulty in large-scale investments. The discussion emphasizes the emotional and practical impacts of successful investing on individuals' lives, contrasting it with the often short-sighted strategies employed by institutional investors.

Keywords

💡Annual Reports

Annual reports are comprehensive documents produced by companies to summarize their financial performance and activities over the past year. These reports are crucial for investors as they provide insights into a company's health and management's effectiveness. The speakers emphasize that a well-structured annual report should communicate essential information transparently, allowing investors to gauge whether they would want to own the company entirely.

💡Transparency

Transparency refers to the openness and clarity with which a company communicates its operations and financial status. In the video, it is highlighted as a key factor for attracting investors, as it builds trust when management candidly discusses both successes and challenges. The speakers express a preference for companies that are straightforward in their reports, contrasting this with those that use vague jargon that obscures the truth.

💡Investment Strategy

An investment strategy is a plan designed to guide an investor's decisions on how to allocate resources in various assets or businesses. The conversation reflects a long-term perspective on investments, where the speakers rely heavily on detailed analyses of annual reports rather than fleeting conversations with management. They believe that a solid strategy includes understanding the fundamentals of a business before making investment decisions.

💡Coca-Cola

Coca-Cola serves as a case study in the dialogue for a successful business model and investment. The speakers express confidence in Coca-Cola's long-term growth prospects compared to competitors like Pepsi. They note that their investment in Coca-Cola was based primarily on the insights gained from its annual reports, showcasing how comprehensive documentation can influence investment decisions.

💡Candid Communication

Candid communication involves straightforward and honest discussions about a company's performance and challenges. The speakers advocate for this approach, suggesting that managers should not shy away from discussing bad news. They argue that this kind of honesty is essential for fostering a trustworthy relationship between management and investors, contributing to better long-term partnerships.

💡Stock Buybacks

Stock buybacks occur when a company repurchases its own shares from the marketplace, often seen as a way to return value to shareholders. In the transcript, the speakers discuss the merits of Coca-Cola's share repurchase strategy, asserting that it can be beneficial even at high price-to-earnings ratios. They illustrate this by noting that their ownership percentage in Coca-Cola increased due to these repurchases, reinforcing the idea that smart buyback strategies can positively impact long-term shareholder value.

💡Jargon

Jargon refers to specialized language or terminology that may be difficult for outsiders to understand. The speakers criticize the use of industry-specific jargon in annual reports, which can obscure the company's true performance. They argue that clear and simple language is more effective in communicating essential information, making it easier for investors to make informed decisions.

💡Long-Term Growth

Long-term growth refers to the sustained increase in a company's value and market share over an extended period. The speakers express confidence in Coca-Cola's ability to maintain this growth trajectory compared to its rivals. They suggest that understanding a company's fundamentals and potential for long-term success is crucial for investors looking to make informed decisions.

💡Reading Recommendations

Reading recommendations involve suggestions for books or literature that can enhance one's understanding of a subject. In the video, the speakers provide suggestions like 'Guns, Germs, and Steel' by Jared Diamond, which encourages critical thinking and a deeper understanding of complex concepts. This reflects their belief in continuous learning as vital for effective investing and management.

💡Individual Investors

Individual investors are private persons who invest their personal funds in various assets, as opposed to institutional investors, who manage pooled funds from many individuals. The speakers express a preference for having individual shareholders in Berkshire Hathaway, as they believe these investors are more likely to have a long-term perspective. They argue that individual investors are generally more engaged and invested in the outcomes of their decisions compared to institutional holders.

Highlights

Steve Davis seeks advice on understanding annual reports and what to focus on.

The importance of transparency and candid communication from management is emphasized.

Investors should seek reports that help them understand the business as if they own it entirely.

Coca-Cola's annual report is cited as an exemplary model of effective communication.

The speakers purchased Coca-Cola stock based on insights from the annual report, not management conversations.

The rejection of standardized jargon in annual reports is highlighted as a negative aspect.

A call for management to share bad news immediately for better investor understanding.

The speakers assume every business has problems that should be transparently communicated.

Munger mentions the importance of reading insightful books beyond standard investment literature.

Charlie Munger recommends 'Guns, Germs, and Steel' for its analytical perspective.

Munger mentions a book on Einstein's commentary as a valuable read for its insights.

The speakers discuss share repurchases and their implications for long-term shareholders.

Coca-Cola's stock repurchase strategy is seen as beneficial, even at high price-to-earnings ratios.

The potential for companies to abuse share repurchase strategies is acknowledged.

The importance of individual investors making informed decisions rather than relying on broker recommendations.

A preference for a committed individual shareholder base over institutional investors is expressed.

Transcripts

okay zone

two hello I'm Steve Davis from San

Francisco I'd like your advice on how to

understand annual reports what you look

for what's important what's not

important and what you've learned over

the years from Reading thousands of

reports thank you well we've read a lot

of reports I will tell you that

and we uh well we start by looking at

the reports of companies that we think

we can understand so we hope to find we

hope to be reading reports and I and I

do read hundreds of them every year we

hope to be reading reports of businesses

that are understandable to us and then

we

see from that report whether the

management is telling us about the

things that we would want to know about

if we owned 100% of the company and when

we find a management that does tell us

about those things and that is candid in

the same way that a manager of a

subsidiary would be candid with us and

talks in life anguage that we can

understand it it definitely improves our

feeling about about investing in such a

business and and the it it definitely

improves our feeling about about

investing in such a business and and the

reverse uh turns us off to some extent

so if we read a bunch of public

relations gobble

leuk it has some effect toward a

business we want to understand the

business better when we get through with

the annual report than when we picked it

up and that is not difficult for a manag

to do if they want to do it if they

don't want to do it you know we we think

that is a

factor uh and whether we want to be

their Partners over a 10 10 year period

or so but we've learned a lot from

annual reports for example I would say

that uh the cocacola annual report over

the last good many years been an

enormously informative document I mean I

can't I I can't think of any way if I

had had a conversation with Roberto

voicea or now Doug ivester and they were

telling me about the business they would

not be telling me more than than than

than I get from reading that annual

report we bought that stock based on on

an annual report we did not B buy it

based on any conversation of any kind

with the top management of Coca-Cola

before we bought our interest we simply

bought it on based on reading the annual

report plus our knowledge of how the

business worked

Charlie yeah I do think the if you've

got a standardized bunch of popular

jargon that looks like it came out of

the same consult for him I I do think

it's a big turn

off that's not to say that some of the

Consulting mantras aren't right but

uh I think there's a lot that for sort

of candid simple coherent

Pros a lot to be said for

it almost every business has problems

and we just assume the manager would

tell us about them uh we would we would

like that in the businesses we run in

fact one of the things we we give very

little advice to our managers but one

thing we always do say is to tell us the

bad news immediately and and I don't see

why that isn't a good advice for the the

manager of a public company uh uh over

time you know I'm I'm positive it's the

best you know I'm I'm positive it's the

best policy but but uh a lot of compan

they they're dying just to pump out what

they think is good news all the time and

they they have this attitude that you

know that you've got to buy buch of

animals out there to be fed and that

they're going to feed them what they

want to eat all the time and over time

the animals learn uh so it's we we try

to stay away from businesses like that

what you seldom see in an annual report

is a sentence like this this is a very

serious problem and we haven't quite

figured out yet how to how to handle

it but believe me that is an accurate

statement much of the time

all right zone

three I'm L dks and I live I'm L dks I

live in the area and I would like to

know what your prediction is for

Coca-Cola's longterm growth versus Pepsi

cola's recent efforts to increase the

competitiveness with Coke

yeah

uh long term I would expect Coke to

continue to gain versus

[Laughter]

Pepsi what has he been doing while I was

gone what' you say

Charlie I knew I I knew I was taking a

what was a question I said that long

term I expected Coke to continue to gain

versus Pepsi oh well it's those kind of

insights is why we why we keep him on

the job year after

year Zone

one I'm Ben null and I'm from

Minneapolis and uh first I just wanted

to thank you for providing your uh past

annual letters to the shareholders and

Mr Munger for providing your speech to

The Graduate students at uh the USC a

couple years ago um drawn a lot of

insights from that not only in investing

but also in my uh day job as a as a

business manager and I'm wondering if

you can help me with my summer reading

list and uh provide some additional

suggestions for reading in the fields of

investing and management other than the

standards of Graham Fisher so

forth Charlie

yeah I have uh recently read a new book

twice which I very seldom do and that

book is Guns Germs and Steel by Jared

diamond and uh it's a marvelous book and

the the way the guy's mind works would

be useful in business he's got a mind

that is always asking why why why why

and he's very good at coming up with

answers I would say it's the best work

of its kind I have ever

read I read a little easier book

uh recently I I I'm not even sure of the

title I I don't pay much attention to

titles when I get into the books but it

it's something to the effect of the

quotable Einstein I mean it's it's it's

all it's a lot of his commentary over

the years and it's great

reading the firm OD theum was with the

book but that isn't the exact title

either it it's the story of the of the

uh discovery of the answer on that that

that's a very interesting book one of

our shareholders from Sweden gave me a

copy of that when I was in New York and

I've enjoyed it Zone

7 yes um Bill Amman from New York uh

there is there a price at which it's

inappropriate for a company use its

capital buyb its

stock give me that again example

Coca-Cola at 40p is that a smart place

for Coke to deploy Capital well it it

sounds like a very high price when you

name it in terms of a PE to buy back the

uh stock at at uh uh that sort of number

but I would say

this uh Coca-Cola's been

around what 12 years now and uh

uh there are very few times in that 112

years if any when it would have not have

been smart for Coca-Cola to be

repurchasing its shares Coca-Cola is

probably in my

view among businesses that I can

understand it's the best large business

in the world I mean it it is a fantastic

business and uh we love it when coch

repurchases shares and our interest goes

up we owned 6.3% % of Coca-Cola in 1988

when we bought in we

actually increased that a little bit a

few years later but if they had not

repurchased shares we probably would own

about 6.7% or 6.8% of coke now as it is

we own a little over

8% uh through

repurchases uh there are going to be

about a billion 8 ounce servings of coke

sold around the world or Coca-Cola

products sold around the world

today uh 8% of that is 80 million and

6.8% is 68 million so they're 12 million

extra servings for the account of

birkshire Hathaway being sold around the

world and they're making a little over a

penny of serving so you know that that

gets me kind of

excited

and I I I think it all I can tell you is

I approve of of coke repurchasing shares

I'd lot rather have them repurchasing

shares at at at 15 times earnings but

but uh when I look at other ways to use

capital I still think it's a very it's a

very good use of capital and maybe the

day will come when they can buy it at 20

times earnings and if they can I hope

they go out and borrow a lot of money to

buy a ton of it at those prices and uh I

think we will be better off 20 years

from now if cop follows a consistent

repurchase uh approach I do not think

that is true for many companies I mean I

think that repurchases have become in

Vogue and done for a lot of silly

reasons and uh so I I I I don't think

everybody's repurchase of shares uh is

well reasoned at

all uh you know we see

companies that issue options by the ton

and then they repurchase shares much

higher you

know I started reading about Investments

when I was six and I think the first

thing that I read was you know Buy Low

sell high but these companies through

their options you know they they sell

low and then they buy high and they

they've got a different formula than I

was taught uh so there a number that we

don't approve of it when when we had

when we own stock in a wonderful

business uh we we we we like the idea of

repurchases even at prices that uh that

may give you nose bleeds uh it it

generally turns out to be a pretty good

policy Charlie well I think the answer

is that in any company the stock could

get to a price so high it would be

folish for the corporation to repurchase

its shares sure

and you can even get into gross abuse uh

before the crash the insole utilities

were madly buying their own shares as a

way of promoting the stock higher it was

like a giant Ponzi scheme at the end uh

so there's all kinds of excess that's

possible but the really great companies

that buy a high price earnings rate

that's that can be wise

our interest in Geico went from 33% to

50% without us laying out a dime because

Geico was repurchasing it shares and uh

uh we benefited substantially but we

benefited a lot more obviously when

prices were were lower I mean we would

we would our interest in the Washington

Post company's gone from nine and a

fraction percent to 17 and a fraction

percent over the years without us buying

a single share um but the post or Coke

or any number number of companies don't

get the bargain in repurchasing now that

that they used to uh we still think it's

probably the best best use of money in

many cases the question about

recommending the stock we we've very

seldom had stock recommendations over

the years as I think back to 1965 I I uh

I can't think of a lot of brokerage

reports that have recommended burer that

I I I'm not looking for any you know

reports at all we we are not to have

Berkshire sell at the highest possible

price and we're not looking for to try

and attract people to birkshire who are

buying stocks because somebody else

recommends them to them we we we prefer

people who who figure out for themselves

why they want they themselves want to

buy burshire because they're much more

likely to stick around if they enter the

restaurant because they decide it's the

restaurant they want to eat at than if

somebody has touted them on it and

that's that's our approach so we uh we

do nothing to encourage but I think even

if we did we probably wouldn't generate

a lot of recommendations it's it's not a

great stock to get rich on if you're a

broker yeah I think the

[Applause]

reason I think the one of the main

reasons why it's so little recommended

in the institutional Market is that it's

perceived as hard to buy in

quantity wait we prefer we we've got

some good institutions as holders one

that's run by a very good friend of ours

but frankly it's more fun for us to have

a bunch of individual shareholders I

mean you see it it translates if there's

money made it translates into changes in

people's lives and not some change in

somebody's performance figure for one

quarter and we think that individuals

are much more likely to join us with the

idea of staying with us uh for as long

as we stay around and and you know

that's the way we look at the business

very few institutions look at

Investments that way and and frankly we

think they're often less rational

holders than we get with individuals