Tuesday, October 22, 2013

Building the Next Berkshire Hathaway

Frequent readers of this blog well know that one of my favorite "books" is in fact the collected annual shareholder letters of Berkshire Hathaway run by investing legend Warren Buffet. For $20 you can pick up your very own copy here. This should be standard reading for high school students, college students, and anyone else interested in creating a proverbial wealth machine.

Invest Like A Farmer's goal is to help identify macro economic trends that can be implemented by the average investor to potentially garner exponential returns. Mr. Buffet has essentially laid out the entire blueprint in an orderly, step-by-step process. There are, however, several caveats that the average investor should be well aware of; mainly the starting block in this investing marathon is slightly to significantly skewed in favor of those who have either tremendous political or economic advantages. These two factors help push them along the time (x-axis) discussed in yesterday's post anywhere from a decade or more. They have the ability to fabricate time on a scale the average person does not. Those are just the facts, nonetheless is quite possible for an ordinary person with interest in investing, a hunger for education, and a decent salary to build his or her very own wealth machine. This is how Mr. Buffet did it, and I think any reasonable financial farmer can also create a sizable wealth machine over time too.

One of the key tenants in creating a wealth machine is how it is structured. Mr. Buffet ran in all respects a successful precursor to today's hedge fund; it was an investment partnership that netted the manager a hefty personal return. This investment partnership then purchased a publicly traded company that became the investment vehicle which purchased many, many other assets over the ensuing years. The average investor does not and probably will not run a hedge fund, and that's just fine.  The lesson to learn from this initial "start-up" scenario is that rather than draw personal taxable income, the investor runs a company that becomes a wealth machine. That's the first step, buy or create an entity that will house your potential compounding wealth. The genius in this is the compounding effects generated by "saving" unrealized gains that compound themselves. Let me repeat that because it is vital; the genius is not taking passive, unrealized gains. The business or businesses themselves are bought or started for a reasonable price; they hopefully increase in value (passive gain) and increase earnings (taxable income) to the owner(s) over time. 

After creating the correct "housing" structure for the wealth machine, the next step is either creating, buying, or otherwise acquiring additional business(es) that generate significant cash flow, and ideally profits. The insurance business was Mr. Buffet's big coup; it allowed him to control large swaths of capital, termed "float," which in turn let him invest in multiple other assets. Essentially the company became an asset grabbing machine that acquired and successfully integrated winning businesses, product lines, and additional market share in the respective existing businesses.

The effectiveness of this business model cannot be overstated; proper execution, however, is vital. It requires excellent management and diligence, but creating the next Berkshire Hathaway is completely possible, even for an average investor. I encourage readers of this blog to pick up a copy of the annual shareholder letters and read through them. What you will see unfolding is probably one of the greatest wealth creation systems ever successfully executed. What's really cool about this process is that it is repeatable. For $20 you get the proverbial receipt for success, and that's tough to beat!