Friday, December 31, 2010

Thinking about the long-term and as part-owners the Warren Buffett way

I remember reading in The Essays of Warren Buffett about how investors can really benefit by building portfolios based on the idea of accumulating stocks that they believe will result in their portfolios generating the best possible long-term look-through earnings.  Buffett says this will force investors to think about the long-term business prospects of the companies behind the stocks in their portfolios and not the short-term prospects of the stock market.

Look-through earnings reflect in the operating income of a company both its share of the earnings paid out as dividends and its share of the operating earnings retained by the companies it has a below 20% stake in. GAAP or generally accepted accounting principles only let a company take into account the dividends it receives from the companies it owns less than 20% of, but not its share of the earnings retained by those companies, which is being reinvested for its economic benefit. You can read more about look-through earnings in this article I wrote here

Here's the formula for calculating look-through earnings: the company's operating profit + the company’s share of the operating earnings retained by the companies it has a below 20% stake in – the extra taxes it would have to pay if those retained earnings were all paid out as dividends. To calculate the look-through earnings of your investment portfolio, simply total the look-through earnings belonging to each of your holdings.

After all, the best way to invest is to buy small pieces of great companies and hold on to those shares for the long-term. And if we don’t have this mentality of making long-term commitments to businesses, but think of investing in stocks as simply buying pieces of paper that we hope to sell to someone else for a higher price because of reasons not related to the underlying businesses, then we’re gambling, and gamblers never win in the long-term.

If you don’t focus on the long-term and on becoming a part owner in your investing approach, then it becomes very unlikely that you will ever find stocks that will  make you incredibly wealthy, stocks like the modern day versions of young Berkshire Hathaway and McDonald’s that can multiply your investments in them by many, many times.  

Thank you for reading, and may you always sustain good returns on your portfolio. Take care and have a very happy new year!