Our equity-investing strategy remains little changed from what
it was . . . when we said in the 1977 annual report: “We select our
marketable equity securities in much the way we would evaluate a
business for acquisition in its entirety. We want the business to be
one (a) that we can understand; (b) with favorable long-term pros-
pects; (c) operated by honest and competent people; and (d) avail-
able at a very attractive price.” We have seen cause to make only
one change in this creed: Because of both market conditions and
our size, we now substitute “an attractive price” for “a very attrac-
tive price.”

But how, you will ask, does one decide what’s “attractive”? In
answering this question, most analysts feel they must choose be-
tween two approaches customarily thought to be in opposition:
“value” and “growth.” Indeed, many investment professionals see
any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed,
I myself engaged some years ago). In our opinion, the two ap-
proaches are joined at the hip: Growth is always a component in
the calculation of value, constituting a variable whose importance
can range from negligible to enormous and whose impact can be
negative as well as positive.

In addition, we think the very term “value investing” is redun-
dant. What is “investing” if it is not the act of seeking value at least
sufficient to justify the amount paid? Consciously paying more for
a stock than its calculated value—in the hope that it can soon be
sold for a still-higher price—should be labeled speculation (which
is neither illegal, immoral nor—in our view—financially fattening).

In The Theory of Investment Value, written over 50 years ago,
John Burr Williams set forth the equation for value, which we con-
dense here: The value of any stock, bond or business today is deter-
mined by the cash inflows and outflows—discounted at an
appropriate interest rate—that can be expected to occur during the
remaining life of the asset. Note that the formula is the same for
stocks as for bonds. Even so, there is an important, and difficult to
deal with, difference between the two: A bond has a coupon and
maturity date that define future cash flows; but in the case of equi-
ties, the investment analyst must himself estimate the future “cou-
pons.” Furthermore, the quality of management affects the bond
coupon only rarely—chiefly when management is so inept or dis-
honest that payment of interest is suspended. In contrast, the abil-
ity of management can dramatically affect the equity “coupons.”

The investment shown by the discounted-flows-of-cash calcu-
lation to be the cheapest is the one that the investor should
purchase—irrespective of whether the business grows or doesn’t,
displays volatility or smoothness in its earnings, or carries a high
price or low in relation to its current earnings and book value.
Moreover, though the value equation has usually shown equities to
be cheaper than bonds, that result is not inevitable: When bonds
are calculated to be the more attractive investment, they should be
bought.

Leaving the question of price aside, the best business to own is
one that over an extended period can employ large amounts of in-
cremental capital at very high rates of return. The worst business
to own is one that must, or will, do the opposite—that is, consist-
ently employ ever-greater amounts of capital at very low rates of
return. Unfortunately, the first type of business is very hard to
find: Most high-return businesses need relatively little capital.
Shareholders of such a business usually will benefit if it pays out
most of its earnings in dividends or makes significant stock
repurchases.

First, we try to stick to businesses we believe we understand.
That means they must be relatively simple and stable in character.
If a business is complex or subject to constant change, we're not
smart enough to predict future cash flows. Incidentally, that short-
coming doesn’t bother us. What counts for most people in invest-
ing is not how much they know, but rather how realistically they
define what they don’t know. An investor needs to do very few
things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety
in our purchase price. If we calculate the value of a common stock
to be only slightly higher than its price, we’re not interested in buy-
ing. We believe this margin-of-safety principle, so strongly empha-
sized by Ben Graham, to be the cornerstone of investment success.

... [A]n intelligent investor in common stocks will do better in
the secondary market than he will do buying new issues . . .. The
reason has to do with the way prices are set in each instance. The
secondary market, which is periodically ruled by mass folly, is con-
stantly setting a “clearing” price. No matter how foolish that price
may be, it’s what counts for the holder of a stock or bond who
needs or wishes to sell, of whom there are always going to be a few
at any moment. In many instances, shares worth x in business
value have sold in the market for 'ax or less.

The new-issue market, on the other hand, is ruled by control-
ling stockholders and corporations, who can usually select the tim-
ing of offerings or, if the market looks unfavorable, can avoid an
offering altogether. Understandably, these sellers are not going to
offer any bargains, either by way of a public offering or in a negoti-
ated transaction: It’s rare you'll find x for ax here. Indeed, in the
case of common-stock offerings, selling shareholders are often mo-
tivated to unload only when they feel the market is overpaying.
(These sellers, of course, would state that proposition somewhat
differently, averring instead that they simply resist selling when the
market is underpaying for their goods.)

Inactivity strikes us as intelligent behavior. Neither we nor
most business managers would dream of feverishly trading highly-
profitable subsidiaries because a small move in the Federal Re-
serve’s discount rate was predicted or because some Wall Street
pundit had reversed his views on the market. Why, then, should
we behave differently with our minority positions in wonderful
businesses? The art of investing in public companies successfully is
little different from the art of successfully acquiring subsidiaries. In
each case you simply want to acquire, at a sensible price, a business
with excellent economics and able, honest management. Thereaf-
ter, you need only monitor whether these qualities are being
preserved.

When carried out capably, an investment strategy of that type
will often result in its practitioner owning a few securities that will
come to represent a very large portion of his portfolio. This inves-
tor would get a similar result if he followed a policy of purchasing
an interest in, say, 20% of the future earnings of a number of out-
standing college basketball stars. A handful of these would go on
to achieve NBA stardom, and the investor’s take from them would
soon dominate his royalty stream. To suggest that this investor
should sell off portions of his most successful investments simply
because they have come to dominate his portfolio is akin to sug-
gesting that the Bulls trade Michael Jordan because he has become
so important to the team.

In studying the investments we have made in both subsidiary
companies and common stocks, you will see that we favor busi-
nesses and industries unlikely to experience major change.

The reason for that is simple: Making either type of purchase, we are
searching for operations that we believe are virtually certain to
possess enormous competitive strength ten or twenty years from
now. A fast-changing industry environment may offer the chance
for huge wins, but it precludes the certainty we seek.

I should emphasize that, as citizens, Charlie and I welcome
change: Fresh ideas, new products, innovative processes and the
like cause our country’s standard of living to rise, and that’s clearly
good. As investors, however, our reaction to a fermenting industry
is much like our attitude toward space exploration: We applaud the
endeavor but prefer to skip the ride.

Obviously all businesses change to some extent. Today, See’s
is different in many ways from what it was in 1972 when we bought
it: It offers a different assortment of candy, employs different ma-
chinery and sells through different distribution channels. But the
reasons why people today buy boxed chocolates, and why they buy
them from us rather than from someone else, are virtually un-
changed from what they were in the 1920’s when the See family
was building the business. Moreover, these motivations are not
likely to change over the next 20 years, or even 50.

We look for similar predictability in marketable securities.
Take Coca-Cola: The zeal and imagination with which Coke prod-
ucts are sold has burgeoned under Roberto Goizueta, who has
done an absolutely incredible job in creating value for his share-
holders. Aided by Don Keough and Doug Ivester, Roberto has
rethought and improved every aspect of the company. But the fun-
damentals of the business—the qualities that underlie Coke’s com-
petitive dominance and stunning economics—have remained
constant through the years.

A far more serious problem occurs when the management of a
great company gets sidetracked and neglects its wonderful base
business while purchasing other businesses that are so-so or worse.
When that happens, the suffering of investors is often prolonged.
Unfortunately, that is precisely what transpired years ago at both
Coke and Gillette. (Would you believe that a few decades back
they were growing shrimp at Coke and exploring for oil at Gil-
lette?) Loss of focus is what most worries Charlie and me when we
contemplate investing in businesses that in general look outstand-
ing. All too often, we’ve seen value stagnate in the presence of
hubris or of boredom that caused the attention of managers to
wander. That’s not going to happen again at Coke and Gillette,
however—not given their current and prospective managements.

Let me add a few thoughts about your own investments. Most
investors, both institutional and individual, will find that the best
way to own common stocks is through an index fund that charges
minimal fees. Those following this path are sure to beat the net
results (after fees and expenses) delivered by the great majority of
investment professionals.

Should you choose, however, to construct your own portfolio,
there are a few thoughts worth remembering. Intelligent investing
is not complex, though that is far from saying that it is easy. What
an investor needs is the ability to correctly evaluate selected busi-
nesses. Note that word “selected”: You don’t have to be an expert
on every company, or even many. You only have to be able to
evaluate companies within your circle of competence. The size of
that circle is not very important; knowing its boundaries, however,
is vital.

To invest successfully, you need not understand beta, efficient
markets, modern portfolio theory, option pricing, or emerging mar-
kets. You may, in fact, be better off knowing nothing of these.
That, of course, is not the prevailing view at most business schools,
whose finance curriculum tends to be dominated by such subjects.
In our view, though, investment students need only two well-taught
courses—How to Value a Business, and How to Think About
Market Prices.

Your goal as an investor should simply be to purchase, at a
rational price, a part interest in an easily-understandable business
whose earnings are virtually certain to be materially higher five,
ten and twenty years from now. Over time, you will find only a few
companies that meet these standards—so when you see one that
qualifies, you should buy a meaningful amount of stock. You must
also resist the temptation to stray from your guidelines: If you
aren’t willing to own a stock for ten years, don’t even think about
owning it for ten minutes. Put together a portfolio of companies
whose aggregate earnings march upward over the years, and so
also will the portfolio’s market value.