The investment that changed Buffett's life forever - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

The investment that changed Buffett's life forever 

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In this issue:
» Indian boards need to be more independent
» 30% of restructured loans to turn bad
» High gas prices to impact Indian power players
» How the US Fed has distorted the market
» ...and more!

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For the true and hard core value investor, there is an annual event that he most looks forward too. And that is none other than the letter that legendary investor Warren Buffett sends to his shareholders. These annual letters are a minefield of information on value investing that more than matches any books specifically written on the subject.

And this time around too it is no different. In an excerpt from this forthcoming shareholder letter published on CNN Money, Warren Buffett shares his thoughts on investing from two real estate investments he made in the late 80s and the early 90s.

In 1986, Buffett purchased a 400 acre farm located 50 miles north of Omaha. This was at the time when the real estate bubble in the Midwest had burst and so property was available at attractive prices. Now Buffett was not an expert in the field of farming. But he opined that normalized return from the farm would be around 10%. Further, productivity would improve over time and crop prices would increase as well. Sure, there would be bad years when the crop would fail. But this would be compensated by unusually good years as well. His thinking turned out to be correct. Around 28 years later, the farm has tripled its earnings and is worth five times or more what Buffett paid.

The success of the other real estate investment is along similar lines as well. Buffett purchased a retail property next to the New York University once again after a commercial real estate bubble had popped. Again, Buffett estimated the unleveraged yield to be around 10%. The real story was that there were several vacant space to lease out. More importantly, there was a bargain lease which was due to expire in a few years and post that the overall income generated from the property was bound to jump.

What can one learn from these examples? Several things. The first is to understand one's limitations. It is not necessary for an investor to understand each and every investment out there if he wants to generate good returns. The idea is to follow a disciplined approach that is bound to work well and keep things simple. If there is an investment that is not within one's grasp, it makes sense to move on to something else. Second, it is important to be able to form a rough estimate of an asset's future earnings. If that is not possible, then once again an investor is better off leaving it. Note that trying to predict the change in the prices of an asset is tantamount to speculation, the success of which is limited. Also, it does not help paying too much heed to all the 'noise' out there in the form of TV channels, expert opinions etc. This only colours an investor's thinking process without really benefitting him.

In his letter, Mr Buffett has once again paid tribute to his mentor Benjamin Graham and his principles of investing and how the purchase of the latter's book 'the Intelligent Investor' changed his financial life. Indeed, over the course of his life, Warren Buffett has made several successful investments. So we think that it is quite apt that he should conclude his letter by stating, "Of all the investments I ever made, buying Ben's book was the best."

Have you been regularly reading Warren Buffett's annual letters to his shareholders? What are some of his investing principles that you strongly believe in? Share your experience in the Equitymaster Club. Or post your comments below.

01:26  Chart of the day
India's industrial production in the last 12 months has been erratic to say the least. While there were some months when growth was decent and fueled hopes of a recovery, these were followed by months of slump. This has been especially pronounced in recent months when industrial activity has declined on a YoY basis in the last quarter of 2013. Lack of reforms, projects getting stalled, policy paralysis of the current government has only made matters worse. The timing of an industrial activity is anybody's guess. But it does seem more and more likely that not much will happen before this year's general elections. Post that, it will be interesting to see what the new government chooses to do.

Industrial production has been erratic

Eyebrows were raised a few years back when a leading airline company appointed a leading Bollywood actor as one of its board members. When quizzed, the airline firm opined that the move was made in order to enhance brand image. In fact not just that, there were other two famous film personalities who were also on the board of the company at that time. With due respect, the expertise of these famous people lay somewhere else. Consequently, one couldn't have expected them to scrutinize whether all of the company's decisions were in the best interests of shareholders.

However, why just blame the Bollywood brigade. Indian boards have seldom been independent even after stuffing them with people with the right expertise. Instances of a corporate board asking tough questions to the senior management have been very few and far between. It is with the intention of correcting this anomaly that the new corporate governance norms have been made public by SEBI. Two key changes pertain to the limits on the tenure of independent directors on a board of a company and also the number of directorships any person can hold across firms. This step is indeed in the right direction. However, to expect it to work like a magic wand and solve all problems in a short period of time would be wrong. But there will at least be some rethink on the part of the company managements in the way they deal with their boards we reckon.

The issue of bad loans in Indian banking is getting dire by the day. As per Firstbiz, as of December 2013, the CDR cell had restructured loans of around Rs 2.9 trillion. Of this nearly 10% of the loans have turned into bad loans with promoters not paying up. Not surprisingly, the top PSU banks including State Bank of India (SBI), which have been the worst hit, have reported gross NPAs in excess of 5%. The Chairman of the CDR cell expects this number to go up to 15%. More worryingly, the RBI estimates that nearly 25-30% of the restructured loans may ultimately turn bad. The central bank clearly blames the bad credit appraisal system in PSU banks for the state of asset quality. In fact it has pointed out that infrastructure, steel, textile, aviation and mining contribute about 51% of the total stressed assets. It does not take long for one to realize that corruption and crony capitalism have been rampant in these sectors. And that the managements of the PSU banks have been facilitators! It remains to be seen if the RBI can even bring the guilty to book.

Let's consider a hypothetical scenario. Say tomorrow the Reserve Bank of India Governor Raghuram Rajan makes an announcement to cut policy rates by 775 basis points. This means the repo rate would come down from 8% to 0.25%. Banks will follow up will similar cuts in lending rates. Just imagine how the economy would do if interest rates were as low as 0.25%? It would give an unprecedented boost to consumption, investment and corporate earnings. This, in turn, would send the stock markets skyrocketing to new all-time highs. But there would be huge side effects. Bringing down interest rates so low would have a devastating effect on savers and inflation would soar to never-before seen levels. Before you start taking this too seriously, let us tell you that this is never going to happen in India, at least in the foreseeable future.

But what if we tell you that this has happened somewhere else in the world and still continues to happen? Well, the country we are referring to is none other than the United States of America. In its response to the credit crisis, the US Fed lowered interest rates to near-zero levels and pumped in unprecedented amounts of liquidity into the system. Such extreme measures may have created a temporary sense of recovery. Stock markets have been rising. But we believe that a recovery based on such artificial measures is a fake recovery.

Sooner or later when interest rates rise, corporate earnings would take a big hit. The stock market would crash. And the whole economy will go in utter disarray. So effectively, the US Fed has only distorted the market by suppressing interest rates. By doing so, it may have delayed the crisis, but next crisis would be much bigger and even more devastating.

There has been a lot of controversy surrounding gas price hikes in recent times. On one side, the Oil Ministry is of the view that higher gas prices are required to help make exploration and production activity more viable; thereby leading to higher production in the future. At the same time, higher gas prices will impact the related businesses that have already set up capacities; with power sector being one such case. With nearly a tenth of India's power capacity running on gas, higher prices will increase the costs of producing power. Given the sensitivity to tariff hikes, the chances of passing on prices in the short term seem unlikely. There are also questions over the demand of such power produced as costs of power generated using other fuels/ sources are much lower. While there have been discussions of the government agreeing to make good for power supplied above a particular price, more clarity is required on this. But this would not be a long tern viable solution as it is another case of eventually passing on the burden to the taxpayer.

We believe these developments are only adding to the woes of the sector, one which is already reeling under a handful of controversies and pressures. With capacity utilisation of gas-fired power plants being way below the desired levels and additional pressure of price hikes in gas prices, one cannot rule out the possibility of shutting down of such gas based power plants as well. A quick and definite solution needs to be found.

China's iron and steel industry is looking down the abyss. Plagued by over-capacity and high competition, profits have plunged. And this situation is not likely to change anytime soon. Steel companies in China enjoy huge subsidies from local governments, whose main focus is to meet job and growth targets. Encouraged by easy financing and cheap energy supplies, the country has steadily built more steel mills than needed. Currently, the world's second-largest economy has about 300 m metric tons of excess steel capacity, equivalent to nearly twice the steel output of the whole European Union last year. According to China Iron & Steel Association (CISA), overcapacity in the sector is unlikely to reduce anytime soon and that the sector was facing an extremely complicated situation as a result of slowing growth, structural adjustments in the economy and policies to close old capacity.

The Indian equity markets pared early gains and have slipped in the red. At the time of writing, the benchmark BSE-Sensex was marginally down by 6 points. Metal, power and oil and gas are the biggest losers. Barring Japan, majority of the Asian indices are trading in the red with the Chinese and Indonesian markets being the biggest losers.

04:50  Today's investing mantra
"Investment is most intelligent when it is most business like."- Benjamin Graham
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