Each year, after Warren Buffett took office in Berkshire, he will write a letter to shareholder together with annual report. In this letter, Warren not only summarize the performance of Berkshire in the past year, but also brief his investment philosophy. It’s a holy bible to every value investor.
In Feb 26, 2017, Warren Buffett released latest letter to the world as usual. Numerous of critics or news have reported and analyzed for the letter, so I don’t want to detail his every word. Nevertheless, I am more interested to spend some time to talk about some investment wisdoms I am interested in from it.
1. Invest in a business which can increase intrinsic value always.
Every year, warren Buffet list Berkshire performance vs the S&P 500 in the first page. This year, the comparison from 1965 since Buffett took over management till 2016 was listed, as showing in the following figure.
Buffett said during the first half of those years, Berkshire’s net worth was roughly equal to the number that really counts: the intrinsic value of the business. The similarity of the two figures existed then because most of our resources were deployed in marketable securities that were regularly revalued to their quoted price. However, since the early 1990s, his focus was changing to the outright ownership of businesses, a shift that materially diminished the relevance of balance sheet figures. That disconnect occurred because the accounting rules (commonly referred to as “GAAP”).
He believes that the intrinsic value of Berkshire Hathaway far exceeds book value today, and gives a detail explanation. Interestingly, he thinks it’s very difficult to calculate the accurate intrinsic value number, so book value can still be used as a good proxy.
So in the above tabulate data, we can see the comparison between the book value and market value of Berkshire. As illustrated in the data, during last 52 years from 1965 to 2016, the compound annual gains of book value of Berkshire is 19%, and the CAGR of market value is 20.8%. In contrast, the compound annual gains of the S&P 500 is only 9.7%. Buffet said, overtime, stock prices gravitate toward intrinsic value. That’s what has happened at Berkshire, a fact explaining why the company’s 52 year market price gain shown on the facing page materially exceeds its book value gain.
The most intriguing fact in the data is the overall gain during the last 52 years, showing the amazing compound strength. The overall gain of book value of market is 884,391%, the market value gain is 1,972,595%, in contrast, the S&P gain is 12,717%. That means assuming you invested 1$ in Berkshire in 1964, the net value grows to 8,843$ in 2016, the market value grows to 19,725$ in 2016, however, if you invest 1$ in the S&P 500 index funds in 1964, you can merely get 127$ in 2016.
The difference between compound annual gain of book value and the S&P 500 is around 10%, but the overall gain after long time will be so huge. That’s the real power of the compound, and time is always friend of good business.
2. Invest in business that can deliver huge growing earning every year.
The net earning is the foundation for increasing book value. The compound annual gain of book value of Berkshire during past 52 years is around 19%, that means the net earning divided book value should keep 19% in average for the past 52 years and the net earning should keep at a pace of 19% growing every year in average for the past 52 years.
This is coincidence with my “20/20” theory. Try to find a business has already proved that the average ratio of net earning / Equity >20% and the net earning growth rate >20% in the past, and will have a large chance in the long future. One thing should be note that the earning is easily manipulated in the accounting rules, the cash flow is the key indicator to identify if the earning power is real or not.
Finding the great business is not so hard, it requires you have a basic accounting skills to read financial report to know the past history, and a solid business knowledge to judge the business grow potential in the future. That’s the circle of competence that Warren Buffet called. However, If you are in the stock market, there is one more thing that one should master: emotion control. I will discuss this one later.
Great businesses are hard to be born if there is full of wars,corruption, and irresponsible government. So in the shareholder letter, Buffet said he feels very lucky to be born in US, this is a wonderland that provide a market system and abundance soil to generate numerous great business in the past, and will deliver increasing wealth to our progeny far into the future, even there will be some bumps and panic sometimes. That’s the same reason that I feel lucky to be born in China as well.
3. Greedy when others fear, fear when others greedy.
Due to focusing on acquiring whole business now, Buffet didn’t talk about so much on stock investment. However, he said he consider buying shares of stock in the same principle as purchasing whole business.
There are two points Buffet mentioned in the letter regarding to stock buying.
On the one side, Buffet said, Charlie and I have no magic plan to add earnings except to dream big and to be prepared mentally and financially to act fast when opportunities present themselves. Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When down pours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.
This is about emotion control. Normally, the business performance can not be changed overnight, however, the frenetic stock market provides frequent opportunities to make big money. When the market is in panic, that’s the best way to make money, just like Buffet said “dark clouds will fill the economic skies, and they will briefly rain gold.” In reality, most people behave in opposite, they flock away when market crush; they are fearless throwing money into market when market heating up.
Actually, when everyone makes huge money and believes that they are brilliant, there is high risk; when everyone says why the market is so lousy and don’t want to see the market, that means the market is in bottom and have a high potential. And the great business can be bought at a high discount price and make the wise men rich. Just as Buffet said “When down pours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do in future.”
One the other hand, one need to reserve certain amount of cash to prepare for the dark clouds time. Buffet love insurance industry especially, that’s because that insurance business generate huge float which can be used for investment.And he views the insurance business as the engine propel Berksheire high grow. Just like what he mentioned in the letter, one reason we were attracted to the P/C business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums–money we call “float”–that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit.
Buffet allocated these float to invest in stock market and prosper businesses at discounted price when the market is in panics. In the mean time, the owned businesses generated many sources of cash flow for Berkshire every year. When you read the annual report, you will find Buffet always keep buying high earning capability companies and stocks in long term, such as BNSF, Berkshire Hathaway Energy, Coca Cola, etc.
As normal people, we can not behave like Buffet, since he has a giant business corps working for him day and night. We need to find at least a high paying job first to provide cash flow to prepare for a dark clouds time.
One more thing worth noted is that Buffet emphasized on the share repurchase. He said : I am authorized to buy large amounts of Berkshire shares at 120% or less of book value because our Board has concluded that purchases at that level clearly bring an instant and material benefit to continuing shareholders. By our estimate, a 120%-of-book price is a significant discount to Berkshire’s intrinsic value, a spread that is appropriate because calculations of intrinsic value can’t be precise.
Although this is an internal policy for share repurchase, we still can see the basic idea how Warren Buffet buy stocks. That is buying huge amount of stock shares when the price is at or below 120% of book value. Actually, this share repurchase policy comes from the Margin of Safety, which Buffet learned from his mentor Graham and views as the number one investment principle. Nevertheless, in reality,we should treat different industries for different analysis based on our insights.
4. “The bet” with Wall Street.
Buffet long times sniffed about the active investment funds, and the investment managers are fees oriented instead of value creation for their customers. So he made a bet publicly in 2005 annual report that no investment pro could select a set of at least five hedge funds–wildly popular and high fee investing vehicles–that would over 10 years match the performance of an unmanaged S&P-500 index fund charging only token fees. Finally, an asset manager who invested in many hedge funds stepped up to this challenge.
Here is the record of the past 9 years data history from this letter.
As we can see from this table, that all the 5 hedge funds have a dismal return comparing with S&P index funds, three of which gains less than 10% after 9 years.
Buffet concluded the reason behind is that no active investment manager can beat the average market for a long term and huge fees incurred for investors. You can find the detail analysis in this letter, it’s very worthy to read.
In this letter, Buffet also warned Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something “extra” in investment advice. Those advisors who cleverly play to this expectation will get very rich. This year the magic potion maybe hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage: “When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”
Finally, the bottom line suggestion from Warren Buffet is that when trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low cost index funds.
There are hopes and risks existing in this world, however, be vigilant with the guys boasting the hopes for high return business, that will only give themselves real hopes and drag you into high risks.
The night is dark and full of terrors!