Almost no one reads the annual reports published by most publicly traded companies. Even professional investors tend to ignore them because they are rarely the most efficient or timely way to gain information about an investment. What’s worse, most of these reports are seemingly written not so much to convey information as they are to state facts as drily as possible and avoid legal liability. However, for Buffett’s regular writings on Berkshire Hathaway, that’s just not the case. They’re impressively well-written and entertaining, which is important. But what I really like about them is that they offer a return to my roots and an opportunity to reflect on my own growth as an investor.
When I started studying investing, Buffett’s letters were among the first things I read. My early takeaways were good: “stocks represent ownership in real businesses” and “valuation matters, don’t overpay.” But in my hands, these were merely platitudes, I didn’t particularly understand how to apply either of these insights in a way that would actually make money. I’ve grown since then, and so has my appreciation of his letters. Each year, I notice a few new things, or think about old lessons with a little greater depth. In this way, his letters are less like a corporate statement, and more like a piece of classic literature whose message transcends time.
This year, I took down some reflections, not notes exactly, but kind of a stream of thoughts that occurred to me as I read his letter. I hope you’ll find them useful, or at least enjoyable.
- Berkshire’s portfolio has a number of companies with large market share of a fragmented industry (Clayton and Homeservices are what prompted this thought). What got my attention was that this is typically a sign of strength in a business, according to this interview between Pat Dorsey and Patrick O’Shaughnessy: http://investorfieldguide.com/dorsey2/. Companies in this position typically have some advantage that got them there, and once there, can usually command greater profit margins through greater scale and efficiency, as well as pricing power. This is probably an attribute to look for in future investments. It doesn’t have to be a big share. 4% market share in an industry where the next closest competitor has less than 1% is huge.
- A lot of textbook finance talks about optimal leverage for a company. Certainly, part of what has made Berkshire successful in the past has been it’s access to safe, cheap leverage. I think though, that the mathematical economic advantage to leverage is less significant than any formula might imply. The opportunity cost of having dry powder in good times might be comparable to the opportunity cost of not having dry powder in bad times. The world is unpredictable in it’s presentation of opportunities, after all. Plus, and this isn’t so much about investing as it is about survival, having a healthy balance sheet does wonders for avoiding catastrophe.
- If you’re running your own, small business, do you optimize for pure growth or for the long term expected value of a business. If optimizing for growth, you get, well, growth. But you do so by incurring a few risks and challenges. You might be so busy hiring, scaling, and fundraising (which has its own tradeoffs) that your relationship with your customers deteriorates. Maybe your next product doesn’t quite hit the mark, maybe quality suffers, maybe you lose touch in your marketing… Rapid growth increases the risk of failure in some situations. So, even though the value of the company if you succeed is higher, you have to reduce that projected value by the likelihood of implosion. The slow and steady approach, which admittedly not all businesses can afford to do, can be pretty attractive by comparison. You’re less likely to collapse, you can avoid frenzied decisions based on what competitors are doing, and you can plan a little better for the long term. So high growth is sexy, but not always. If I were to build a business that had to last a hundred years, I’d probably favor a business model and industry that would be right at home at Berkshire Hathaway.
- Personal note: what information do I need to be tracking and assimilating for my podcasting experience to translate into skill as an investor (Angel or otherwise)?
- Traits of a great investment vary from industry to industry. Insurance companies rarely have structural advantages and are subject to commodity-level margins. On the other hand, insurance businesses have a few great traits (access to float, predictability of profits and payouts) that make it a worthy part of Berkshire’s portfolio. You don’t need every advantage, just a few that matter for your situation.
- Berkshire’s “ownership” of companies often means less than 100% control. Usually, it looks a lot like a partnership where existing owners (especially of family-founded businesses) get to keep a 10% stake, as well as total autonomy in running the business. This is valuable for founders, and can help make the decision to sell a lot easier. Buffett did a great job setting up these “win-win” deals and his reputation for them. The sellers and buyers want different things, and this complementarity has led to some great partnerships. Berkshire offers capital, security, freedom from as well as freedom to…. Operators provide excellence and superior long term results that couldn’t be had if Buffett demanded total control.
- Muzzling your ego leads to some pretty great results.
- Buffett is at a point with his cash pile where he has to accept lower returns on investments if he wants to put that money to work. Charlie Munger has said their business model is to borrow at 3% and lend at 13%, which sounds about right. Right now though, he’d be hard-pressed to find deals offering 13% returns over the long term.
- There are a lot of ways to get to that 13% figure. None of which require insane risk taking on any one investment. Buffett seems to prefer slow, predictable earnings growth, and a good cash flow yield. I’m guessing like, 3-5% growth and 8-10% cash flow yield on cash invested. The mix might vary depending on the operating leverage of a company. But evidently you really can get quite rich with these slow, boring investments if you do them right. Assessing the rigor of that predictability is hard though.
- I wonder if Buffett was sweating at all when making his purchase of BNSF, his biggest deal at the time. Did he consider things like the future economic strength of China v Latin America v Africa? Did he evaluate the trend towards digitization as a risk to material-reliant railroads? Was he concerned it might underperform? Does Buffett worry about his investments underperforming? Does he worry much at all?
- Berkshire apparently has roughly $20 B more in cash today than it did a year ago. That’s some serious cash flow.
- Berkshire is worth $500B today. Probably, it will reach $1T someday, owning an ever-increasing percent of the US economy/market. Would Buffett buy Berkshire if he were in my shoes? What would he buy? (I did some crude math to show that it’s probably a little bit of a stretch to say it’s quite as high of a future return as non-US stocks might offer).
- Buffett owns 35.8% of his company. Bezos owns 20% of his and is richer. Both own far more than most founders.
- With international investments, should I buy market-cap weighted funds? EM, FM? Aggregate? Different countries? Equal weight? Are there specific companies that benefit most from the trends I foresee in the emerging market economies? TCEHY? MELI? ABT?
- Excited to have monthly investment plan putting money to work and leaving it depending on what is cheap at any moment (provided it meets minimal durability standards that would let me hold it forever).
- I love buying cheap stuff, I hate holding it. It’s bad for me and I know it. And yet….
- I want a portfolio that gives me early retirement money and flexibility throughout life. With some eye to keeping taxes small (but clearly not minimal). Probably some level where it’ll grow into enough by retirement age, then put the rest towards enjoying life.
- Buffett’s portfolio: 3-baggers and 4-baggers are much harder to get than people realize, especially when they don’t reflect dividend payments. And they feel great (I’m told). Broad market doesn’t do that easily. Going off of the Dow, a 3-bagger in an index fund could take 9 years (at an exceptionally good time to purchase), 10 years, 15 years, or 20 years (at a bad time to purchase). Depends if you bought in 2009, 2008, 2003, 2002, or 1998 (I’m going off of a google chart for the dow, so forgive my imprecision if any of these are wrong). Berkshire has been sitting on AXP forever (a 13 bagger). And there are a few others in the stocks portfolio, but not really that many. Probably, though, Buffett’s style isn’t to buy “multi-baggers.” It’s to buy cash flows (dividends, preferred stock, etc), and that’s really the lens through which he shines.
- Some of Berkshire’s best IRR deals have had the smallest dollar impact. That’s an annoying obstacle. But Buffett has a few advantages at Berkshire that most would kill for.
- Berkshire has had 4 massive declines in value in 50 years. That strikes me as pretty infrequent.
- My favorite part of the letter was when he was discussing the investment of the collateral for his bet with Protege Partners. They started out with a 10-year, zero coupon Treasury bond. But it rose to full value prematurely due to the decline in interest rates. Rather than leave the money to sit and earn next to nothing, they used it to buy Berkshire stock. But that’s not the interesting part. What’s interesting to me is the reasoning behind it, and the notion that great investments are usually more a matter of common sense than of brilliant insight. Rather than restate what has already been written, here’s Buffett’s explanation, which is my favorite part of the whole letter:
“In November 2012, as we were considering all this, the cash return from dividends on the S&P 500 was 21⁄2% annually, about triple the yield on our U.S. Treasury bond. These dividend payments were almost certain to grow. Beyond that, huge sums were being retained by the companies comprising the 500. These businesses would use their retained earnings to expand their operations and, frequently, to repurchase their shares as well. Either course would, over time, substantially increase earnings-per-share. And – as has been the case since 1776 – whatever its problems of the minute, the American economy was going to move forward. Presented late in 2012 with the extraordinary valuation mismatch between bonds and equities, Protégé and I agreed to sell the bonds we had bought five years earlier and use the proceeds to buy 11,200 Berkshire “B” shares. The result: Girls Inc. of Omaha found itself receiving $2,222,279 last month rather than the $1 million it had originally hoped for. Berkshire, it should be emphasized, has not performed brilliantly since the 2012 substitution. But brilliance wasn’t needed: After all, Berkshire’s gain only had to beat that annual .88% bond bogey – hardly a Herculean achievement. The only risk in the bonds-to-Berkshire switch was that yearend 2017 would coincide with an exceptionally weak stock market. Protégé and I felt this possibility (which always exists) was very low. Two factors dictated this conclusion: The reasonable price of Berkshire in late 2012, and the large asset build-up that was almost certain to occur at Berkshire during the five years that remained before the bet would be settled. Even so, to eliminate all risk to the charities from the switch, I agreed to make up any shortfall if sales of the 11,200 Berkshire shares at yearend 2017 didn’t produce at least $1 million.
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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. By that standard, purportedly “risk-free” long-term bonds in 2012 were a far riskier investment than a longterm investment in common stocks. At that time, even a 1% annual rate of inflation between 2012 and 2017 would have decreased the purchasing-power of the government bond that Protégé and I sold. 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. 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.
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A final lesson from our bet: Stick with big, “easy” decisions and eschew activity. During the ten-year bet, the 200-plus hedge-fund managers that were involved almost certainly made tens of thousands of buy and sell decisions. Most of those managers undoubtedly thought hard about their decisions, each of which they believed would prove advantageous. In the process of investing, they studied 10-Ks, interviewed managements, read trade journals and conferred with Wall Street analysts. 13 Protégé and I, meanwhile, leaning neither on research, insights nor brilliance, made only one investment decision during the ten years. We simply decided to sell our bond investment at a price of more than 100 times earnings (95.7 sale price/.88 yield), those being “earnings” that could not increase during the ensuing five years. We made the sale in order to move our money into a single security – Berkshire – that, in turn, owned a diversified group of solid businesses. Fueled by retained earnings, Berkshire’s growth in value was unlikely to be less than 8% annually, even if we were to experience a so-so economy. After that kindergarten-like analysis, Protégé and I made the switch and relaxed, confident that, over time, 8% was certain to beat .88%. By a lot.”
So that’s what I strive to do, and what you should consider as well: “Stick with big, “easy” decisions and eschew activity.” Life is just better that way.