In this column I would like to highlight a number of items from Warren Buffett’s annual letter to Berkshire Hathaway shareholders. I hope that this kind of analysis becomes a regular feature of Credere Argentum and I plan on covering each of the letters beginning with the most recent and heading back to the very first letter published in 1977. Although there are many Buffett fanboys around the internet and probably just about every amateur investor thinks of themselves as a potential investor of Buffett’s class in a way similar to the average golfer dreaming of playing on the PGA Tour, this will be an attempt to understand and analyze Buffett, not merely worship him as an oracle. I hope you enjoy the journey with me.
This year’s letter has a few important insights which I have included below in no particular order:
1. “When the partnership I ran took control of Berkshire in 1965, I could never have dreamed that a year in which we had a gain of $24.1 billion would be subpar, in terms of the comparison we present on the facing page. But subpar it was.”
Buffett is remarkably fair and modest, to the point of being negative, in how he values his own expertise and success. Most companies trade at a multiplier to their book value per share (the value of all of their assets divided by the number of shares outstanding) and this makes sense because their earning potential may continue to rise over time and therefore their assets can be expected to rise over time as well. He compares the growth in book value of Berkshire to the growth of the S&P 500 which is trading at multipliers of the book value of its representative companies. Berkshire’s book value also includes a negative “hit” for taxes, which the S&P 500 does not take in its growth. In short, it’s not really a fair comparison, but nonetheless Berkshire has consistently outperformed the broader market index.
The lesson here for the average person, I think, is to value yourself in a similar fashion and build in a pessimistic form of valuation. This can apply to just about every error of personal finance, be fair but be fair in the “worst way” possible. This way you bake in value and give yourself a margin of safety.
2. ”American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don’t forget that shareholders received substantial dividends throughout the century as well.)
Since the basic game is so favorable, Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.
My own history provides a dramatic example: I made my first stock purchase in the spring of 1942 when the U.S. was suffering major losses throughout the Pacific war zone. Each day’s headlines told of more setbacks. Even so, there was no talk about uncertainty; every American I knew believed we would prevail.
The country’s success since that perilous time boggles the mind: On an inflation-adjusted basis, GDP per capita more than quadrupled between 1941 and 2012. Throughout that period, every tomorrow has been uncertain. America’s destiny, however, has always been clear: ever-increasing abundance.
If you are a CEO who has some large, profitable project you are shelving because of short-term worries, call Berkshire. Let us unburden you.”
A long quote to be sure and I know doing so breaks some cardinal rules of blogging. Nonetheless I think the message here explains itself. Prudent investing is the least risky of all activities and errors of omission are more dangerous than errors of commission. In short, the greatest risk you can take is not investing. You are kneecapping yourself and your heirs. Similarly, if you run a business, don’t pass up profitable opportunities due to vague fears about the future of the broader economy.
3. Buffet breaks down all of the vast assets that Berkshire owns into several distinct businesses.
This might be a good lesson for the average investor as well. Pick a few broad business categories that you think will continue to grow in value over time and are good, healthy businesses. Then, try and pick the very best companies from these broader domains. A simple, but perhaps very effective way of investing. Then, as time goes on, you can adjust and expand as you see changes occur. Buffet writes, “because we operate in so many areas of the economy, we enjoy a range of choices far wider than that open to most corporations. In deciding what to do, we can water the flowers and skip over the weeds.”
4. ”Above all, dividend policy should always be clear, consistent and rational.”
Buffett goes on an extended explanation of the rationale for Berkshire not paying a consistent dividend. It is worth reading and he clearly explains how each investor is better off selling their own small slices of the company at their own discretion, in effect making their own dividend. This can be a method you might apply in your investing as well.
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