How can I learn more from arguably the best investor in the world? Read what he has to say about his own company and investments. I’ve never read Berkshire Hathaway’s Annual Letters to its Shareholders.
I simply thought why not read the letter and see what I may gain from it, in the grand scheme of things.
The full 15-page letter, discussing Berkshire’s 2017 operations can be found here.
From reading the letter and making little notes, there are a few takeaways I’d like to share with you.
1. Honesty and Transparency
Page 3 of the letter states that “a new accounting rule will severely distort Berkshire’s net income figures and very often mislead commentators and investors.”
I like how this was disclosed at the beginning of the letter. It refers to reporting net changes in unrealized investment gains and losses in net income. Buffett states that changes in securities unsold can go up and down by $10 billion or more and Berkshire’s bottom-line will be “useless”.
I can apply this theory to the investment making decisions by not allowing my heart of feelings to come in the way of investment decisions. For example, if I like a certain product or service, this doesn’t mean the organization providing it is in a position to succeed for years to come. Instead, an honest and transparent view must be taken to make an informed investment decision.
Additionally, when we have unrealized gains and losses, we may let emotions take over and force us to sell a position. I know I’ve done this in the past only to find out the investment later experienced much more in gains.
2. Investing Fundamentals Reiterated
Page 4 of the letter describes key qualities Berkshire seeks for acquisitions as having a “durable competitive advantage, high-grade management, good returns, opportunities for internal growth and a sensible purchase price.”
I can apply this when making my own investment decisions, sell ones perhaps. I’m more focused on index-funds and ETFs for future acquisitions. But I can look at some of my single stock holdings to see if the criteria mentioned above hold true. If not, selling may be a serious consideration.
3. Debt Avoidance
Page 4 of the letter states “[a]t Berkshire, we evaluate acquisitions on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual business would generally be fallacious.”
From this statement, my belief in avoiding margin accounts for trading is solidified. I’d rather save for a period of time and then deploy capital. In that time, I can continue research on fine-tuning my investment plan to make sure it’s meeting my objectives. Also by not having enough capital, you are motivated to work harder (e.g., other income streams) to gain the capital needed.
Another section of the letter, p. 10, discusses debt avoidance too. It states that “[e]ven 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.”
I’d like to add a few more words to this topic just because I like what was said and how it was said. At the bottom of the same page, Buffett continued by saying “[o]ur aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need.”
4. What’s Important to Berkshire – Float
Float is a term used frequently in the insurance industry. It’s the premiums paid by a customer to the insurer which are held before losses are paid out. The insurer will typically invest the float funds. I learned a bit more from Investopedia.
On page 6 the letter states “float has been or great importance to Berkshire … and all dividends and gains from the deployment of the funds belong to Berkshire, as well as losses.”
Berkshire is the industry’s leader in float. At the end of 2017, it reported $114 billion in float. By having such a large sum of float, Berkshire has the ability to generate enormous investment income. Check out how float has continued to increase for decades at Berkshire:
Page 6 of the letter also states that “Berkshire has been a leader in long-tail business for many years.” Long-tail means that an organization is holding float for a longer period of time.
On page 7 the letter mentions the conservative and careful behavior of Berkshire’s underwriters and “that disciplined behavior has produced underwriting profits in most years, therefore cthe ost of float was less than zero.” Cost of float is an underwriting loss where the insurer has to pay more in claims than it collects in premiums.
It’s clear that this strategy has allowed Berkshire to succeed for many years and resulted in massive wealth for Buffett.
How can I apply it? I’m not sure yet. All the money I have to invest belongs to me. And I don’t have to make payouts to anyone.
The ability to obtain and keep float for such long periods of time is attributed to the conservative nature of the underwriters as the letter notes.
I believe this can be applied in the later investment stage when I will, hopefully, be in the capital conservation stage. Presently, my primary goal is capital appreciation.
As previously mentioned, Berkshire has a system to evaluate and make acquisitions. It would like to make large acquisitions to increase earnings in the non-insurance group. Page 9 of the letter states “[a]t yearend, Berkshire held $116.0 billion in cash and U.S. Treasury Bills and … smiles will broaden once these funds are redeployed into more productive assets.”
For individual investors, the Price to Earnings ratio is one good indicator of stock selection. The S&P 500’s P/E ratio is hovering around 25 for August 2018. Some may argue it’s a bit high.
Many exchange-traded funds including low-fee options from Vanguard are trading at higher prices. Therefore, it’s the ability to recognize if an investment is fairly priced. If not, it’s the patience to forgo it and wait for a favorable opportunity to present itself.
BONUS: Lower Fees Shall Prevail
From many articles read and ones written, I’ve come to understand that index funds in general perform better than managed mutual funds. When it comes to Buffett’s personal life, he’s said that after he passes away, he wants the money for his wife to be invested into a Vanguard index fund.
On page 11 of the letter, there is mention of a ten-year bet placed in December 2007 placed between Berkshire and Protégé Partners, the counterparty where “a virtually cost-free investment in an unmanaged S&P 500 index fund-would, over time, deliver better results than those achieved by most investment professionals.”
It goes on to mention fees, the counterparty used for the bet, and ofcourse the results of the bet; see for yourself:
As you can see, the S&P averaged to 8.5% over the 10-year period and not a single fund of funds came close – C was closest with a difference of 2%. The letter went on to mention that the managers made money (through fees), “however, many of their investors experienced a lost decade.”
Proceeds from the bet of over $2 million were distributed to Girls Inc. of Omaha, a non-profit organization that provides education, counseling, meals, transportation and other services.
Reading the Berkshire Hathaway Annual Letter was an educational and fun exercise. It provides underlying hints and tips for your everyday DIY investors like me. This may be something to add to my regular reading list for future years.
Join The Discussion:
- Do you read Berkshire Hathaway’s Annual Letter to Shareholders?
- Are annual letter and reports helpful for passive investors?
- Has Berkshire Hathaway’s Annual Letter or Report helped/changed your investment strategy?
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