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Each year, Warren Buffett writes a letter to the shareholders of Berkshire Hathaway. The letters are not only a record of the progress of the company, but his words become popular quotes for investors and writers for decades after they are written.
This year’s letter, released 24th February, is shorter than usual, and Buffett does not write much about his views on the market, beyond share prices being expensive and the US still being the best place to invest.
But his statements about bonds being riskier than shares for the long-term investor will become the most enduring observation from this year. He says (page 13):
“I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.”
Prior to its release, the market was focussed on four main expectations for the letter, but none of these rated much of a mention:
1. Succession planning, as Buffett is now 87-years-old.
2. How Berkshire plans to spend its US$110 billion cash pile, which even Buffett says is much too high but he can’t find suitable, large investments.
3. Portfolio changes.
4. Health care, on the back of the recently-announced tie up with Amazon and JP Morgan to lower health care costs for employees.
Here are 10 highlights, with the usual gems thrown in:
1. Buffett says nearly all deals examined in 2017 were ruled out due to prices hitting all-time highs. He riles against CEO ‘can-do’ types who drive acquisitions without considering value. Executive compensation grows with corporate size, and subordinates and investment bankers cheer the CEOs from the sidelines. Spreadsheets never disappoint, although expected synergies are never found. “Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase.”
2. Buffett estimates the three hurricanes of 2017 in Texas, Florida and Puerto Rico might cost the insurance industry US$100 billion, of which Berkshire Hathaway’s share may be US$3 billion. He says that if a ‘mega-cat’ (massive catastrophe) of say US$400 billion hit the industry, most of the other property/casualty insurers would be wiped out.
3. Buffett and Charlie Munger consider minority holdings of shares as interests in businesses, not stock to be bought and sold based on target prices. “In America, equity investors have the wind at their back.”
4. Stockmarkets do a poor job of detecting growth in value of the short term, with prices rising and falling untethered to the build-up of value. He says Berkshire Hathaway has moved forward year by year and yet its share price has suffered four major dips, two of which were 1973 to 1975 when it fell from US$93 to US$38 (59%) and 2008 to 2009, when it fell from US$147,000 to US$74,200 (51%). He says this is a massive reason not to borrow to buy stocks:
“Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”
He says in the next 53 years (ie the time period he has been managing this company), the same level of declines will happen again, and “The light can at any time go from green to red without pausing at yellow.”
5. He reflects on his winning ten-year bet made in December 2007 where his counterparty selected five ‘fund-of-funds’ that it expected to outperform the S&P500 index. These funds owned interests in over 200 hedge funds with fixed fees averaging a “staggering” 2.5% per annum. “Performance comes, performance goes. Fees never falter.” The index rose 8.5% per annum on average, while annual returns on the five funds were 2.0%, 3.6%, 6.5%, 0.3% and 2.4%. Buffett easily won the bet, and the single purchase of an index beat the thousands of trades made by the hedge funds.
“What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.”
6. Buffett gives his own definition of risk, which is too often defined by others with volatility of prices. He says:
“Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. ‘Risk’ is the possibility that this objective won’t be attained.”
He says that on this measure, long bonds paying less than 1% in 2012 were a far riskier investment than a long-term investment in common stocks.
“It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.”
7. Berkshire Hathaway appointed Ajit Jain and Greg Abel as directors recently, allowing them to run the businesses and Munger and Buffett to focus on investments and capital allocation. There was no further mention of the expected succession plan in the letter, but remember those names, because one of them will probably become Chairman one day.
8. The Trump tax cuts were a huge win for the company, and over 2017, the per share book value of the stock rose by 23% with nearly half (US$29 billion) coming from changes in the US tax code. Since Buffett and Munger took over 53 years ago, per share book value has increased 19.1% compounded annually, from US$19 to an unbelievable US$211,750.
9. Buffett does not meet large institutional shareholders one-on-one. The most important shareholder is one of limited means who trusts him with a substantial share of their savings. He announced that the Annual Meeting of Berkshire Hathaway will be held on 5 May 2018, with Yahoo! webcasting the event from 8.45am (US Central Daylight Time) to about 3.30pm. Buffett and Munger are likely to field over 60 questions. Mark the diary.
10. Finally, he reassured investors that when major declines occur, they offer great buying opportunities to those not carrying too much debt. He quotes from Kipling’s If:
“If you can keep your head when all about you are losing theirs …
If you can wait and not be tired by waiting …
If you can think – and not make thoughts your aim …
If you can trust yourself when all men doubt you …
Yours is the Earth and everything that’s in it.”
Content first published in the financial newsletter cuffelinks.com.au on 27 February 2018.