Warren Buffett's
Shareholder Letter: 5 Lessons for All Investors (from Motley Fool)
By John
Maxfield)
Feb 25, 2017
There are few
things more valuable for serious investors to read each year than Warren
Buffett's annual letter to the shareholders of Berkshire Hathaway (NYSE:BRK-A)(NYSE:BRK-B).
His letter for 2016, released early Saturday
morning (2/25/2017), is no exception. In it, Buffett covers his usual range of subjects,
from the performance of Berkshire Hathaway and its operating units, to the
future prospects of the United States, to advice for corporate executives and individual
investors.
The whole letter
is worth reading -- it is, after all, less than 30 pages long. But for those of
you who want to view the highlight reel, here are my five favorite takeaways
from Buffett's latest shareholder letter.
WARREN BUFFETT, THE CHAIRMAN AND CEO OF BERKSHIRE HATHAWAY.
IMAGE
SOURCE: THE MOTLEY FOOL.
1. On market panics
A growing number
of high-profile investors and institutions have begun to issue warning signs that
stocks are approaching unsustainable levels, following the market's surge in
the wake of the presidential election.
Prominent hedge
fund managers such as Ray Dalio and Seth Klarman have both touched on this in
the past month, and the chief U.S. equity strategist at Goldman Sachs,
David Kostin, wrote in a recent report that "financial market
reconciliation lies ahead."
Buffett both buys
this line of thinking and doesn't. While the market is certain to experience
major declines, it's impossible to predict when they'll occur, he notes in this
year's letter. At the same time, Buffett urges investors to look at these as
opportunities to -- as he's said in the past -- be fearful when others are
greedy:
"The years ahead
will occasionally deliver major market declines -- even panics -- that will
affect virtually all stocks. No one can tell you when these traumas will occur
-- not me, not Charlie [Munger], not economists, not the media. Meg McConnell
of the New York Fed aptly described the reality of panics: "We spend a lot
of time looking for systemic risk; in truth, however, it tends to find
us."
During such scary periods, you
should never forget two things: First, widespread fear is your friend as an
investor, because it serves up bargain purchases. Second, personal fear is your
enemy. It will also be unwarranted. Investors who avoid high and unnecessary
costs and simply sit for an extended period with a collection of large,
conservatively financed American businesses will almost certainly do well.
2. On share buybacks
One of the
hottest topics in the corporate world over the past few years concerns share buybacks. Tepid
economic growth and lagging confidence have led companies to allocate excess
earnings not into business investments, but rather into share repurchases.
In theory,
there's nothing wrong with this, as stock buybacks are just another avenue for
companies to return capital to shareholders. Done at the right price, moreover,
they add value to existing shareholders' stakes. But in practice, as Buffett
notes in this year's letter, companies tend to ignore this nuance, preferring
instead to repurchase stock irrespective of price:
Assessing the
desirability of repurchases isn't that complicated.
For continuing
shareholders ... repurchases only make sense if the shares are bought at a
price below intrinsic value. When that rule is followed, the remaining shares
experience an immediate gain in intrinsic value. ... Ergo, the question of whether
a repurchase action is value-enhancing or value-destroying for continuing
shareholders is entirely purchase-price dependent.
It is puzzling,
therefore, that corporate repurchase announcements almost never refer to a
price above which repurchases will be eschewed. That certainly wouldn't be the
case if a management was buying an outside business. There, price would always
factor into a buy-or-pass decision.
When CEOs or
boards are buying a small part of their own company, though, they all too often
seem oblivious to price. Would they behave similarly if they were managing a
private company with just a few owners and were evaluating the wisdom of buying
out one of them? Of course not.
My suggestion: Before even
discussing repurchases, a CEO and his or her board should stand, join hands,
and in unison declare, "What is smart at one price is stupid at
another."
3. On competitive advantage
If there's one
thing I've learned from reading Buffett's letters, it's about the critical importance of competitive
advantage. A company with a competitive advantage over others in its
industry can continuously grow its market share while simultaneously earning
superior returns.
And no
competitive advantage is stronger than efficiency. A company that operates at a
lower cost base than its competitors has the world at its fingertips, so to
speak. It can underprice other companies in its industry, capturing many of
their customers, and still generate wider margins and thus higher
profitability.
As Buffett
explains in this year's letter, Berkshire Hathaway's auto-insurance unit,
Geico, offers a real-life demonstration of these forces in action:
Auto insurance
is a major expenditure for most families. Savings matter to them -- and only a
low-cost operation can deliver those. ...
Geico's low
costs create a moat -- an enduring one -- that competitors are unable to cross.
As a result, the company gobbles up market share year after year, ending 2016
with about 12% of industry volume. That's up from 2.5% in 1995, the year
Berkshire acquired control of Geico. Employment, meanwhile, grew from 8,575 to
36,085.
Geico's growth accelerated
dramatically during the second half of 2016. Loss costs throughout the
auto-insurance industry had been increasing at an unexpected pace and some
competitors lost their enthusiasm for taking on new customers. Geico's reaction
to the profit squeeze, however, was to accelerate its new-business efforts. We
like to make hay while the sun sets, knowing that it will surely rise again.
4. On accounting red flags
Buffett prides
himself on being a straight shooter. He calls things how he sees them and
doesn't try to inflate the performance of Berkshire Hathaway through accounting
adjustments that exclude temporary, but nevertheless real, costs, as so many
companies do nowadays when reporting "adjusted earnings."
The 86-year-old
billionaire has taken issue with this practice in the past, and he does so
again in this year's letter:
Too many
managements -- and the number seems to grow every year – are looking for any
means to report, and indeed feature, "adjusted earnings" that are
higher than their company's GAAP earnings. There are many ways for
practitioners to perform this legerdemain. Two of their favorites are the
omission of "restructuring costs" and "stock-based
compensation" as expenses.
Charlie and I
want managements, in their commentary, to describe unusual items -- good or bad
-- that affect the GAAP numbers. After all, the reason we look at these numbers
of the past is to make estimates of the future. But a management that regularly
attempts to wave away very real costs by highlighting "adjusted per-share
earnings" makes us nervous. That's because bad behavior is contagious:
CEOs who overtly look for ways to report high numbers tend to foster a culture
in which subordinates strive to be "helpful" as well. Goals like that
can lead, for example, to insurers underestimating their loss reserves, a
practice that has destroyed many industry participants.
Charlie and I cringe when we hear
analysts talk admiringly about managements who always "make the
numbers." In truth, business is too unpredictable for the numbers always
to be met. Inevitably, surprises occur. When they do, a CEO whose focus is
centered on Wall Street will be tempted to make up the numbers.
5. On holding periods
If you scan the
list of Berkshire Hathaway's major stock holdings on Page 19 of Buffett's
latest letter, there's a glaring absence: Wal-Mart (NYSE:WMT).
At Berkshire's
2003 annual meeting, Buffett was asked what his biggest mistake was in recent
years. His response: "Wal-Mart." As he went on to note: "I set
out to buy 100 million shares of Wal-Mart at a [pre-split price of] $23. We
bought a little and it moved up a little, and I thought maybe it will come back
a bit. That thumb-sucking has cost us in the current area of $10 billion."
Two years later,
in 2005, Buffett tried to remedy this matter by establishing a major position
in the discount retailer. By 2016, Berkshire's stake in Wal-Mart was worth
nearly $6 billion.
But that stake is
no more, causing some investors to question Buffett's sincerity when he said in
the past that he and Munger's favorite holding period is "forever."
But as Buffett clarified in this year's letter, this rule applies to the whole
companies that Berkshire owns, not its stakes in marketable securities:
Sometimes the
comments of shareholders or media imply that we will own certain stocks
"forever." It is true that we own some stocks that I have no
intention of selling for as far as the eye can see (and we're talking 20/20
vision). But we have made no commitment that Berkshire will hold any of its
marketable securities forever.
Confusion about this point may
have resulted from a too-casual reading of Economic Principle 11 on pages
110-111, which has been included in our annual reports since 1983. That
principle covers controlled businesses, not marketable securities. This year
I've added a final sentence to No. 11 to ensure that our owners understand that
we regard any marketable security as available for sale, however unlikely such
a sale now seems.
That rounds out
my five favorite lessons from Buffett's 2016 shareholder letter. But let me
repeat: If you're a serious investor who's intent on getting better at the
craft, there are few better ways to do so than digging into the Oracle of
Omaha's letters yourself.
