The annual letter from Warren Buffett to Berkshire Hathaway’s shareholders is a cultural touchstone. In the 2015 letter released Saturday, Buffett and his longtime partner, Charlie Munger, review not just the 2014 financials of the Berkshire “conglomerate,” but look back over the last 50 years. In his avuncular style, Buffett provides plenty of advice for professional investors and “the little guy” along the way.
In the letter, Munger also addresses “the elephant in the room”: how Berkshire will proceed after Buffett departs.
While reading the entire 42-page letter is well worth it, especially for Berkshire (BRK.A) shareholders, whose annual meeting is scheduled for the weekend of May 1-3 in Omaha, Nebraska — including the annual Newspaper Toss competition — we’ve pulled out some of the gems in the form of eight warnings to advisors and investors.
Warning 1: Don’t be too concentrated (or too bloated)
Berkshire owns a number of businesses outright and has partnerships and partial ownership of many more. However, the company also “passively” owns stakes in a number of companies. For example, in its listing of its top 15 common-stock holdings as measured by market value, there are six financial services companies: Goldman Sachs; US Bancorp; Moody’s; American Express, Munich Re and Wells Fargo. The fifteen biggest stakes have a total current market value of $117 billion (while Berkshire owns “only” 9.4 percent of Wells Fargo, that stake is worth $26 billion.) Why this approach? Buffett explains:
Our flexibility in capital allocation — our willingness to invest large sums passively in non-controlled businesses — gives us a significant advantage over companies that limit themselves to acquisitions they can operate. Our appetite for either operating businesses or passive investments doubles our chances of finding sensible uses for Berkshire’s endless gusher of cash.
And in a different place in the letter, Buffett allows himself a little gloating over a lack of bloating:
Berkshire’s year-end employees … totaled a record 340,499, up 9,754 from last year. The increase, I am proud to say, included no gain at headquarters (where 25 people work). No sense going crazy.
Munger considers in the conclusion of his letter “whether Berkshire’s great results over the last 50 years have implications that may prove useful elsewhere.” Munger writes:
The answer is plainly yes. In its early Buffett years, Berkshire had a big task ahead: turning a tiny stash into a large and useful company. And it solved that problem by avoiding bureaucracy and relying much on one thoughtful leader for a long, long time as he kept improving and brought in more people like himself.
Compare this to a typical big-corporation system with much bureaucracy at headquarters and a long succession of CEOs who come in at about age 59, pause little thereafter for quiet thought, and are soon forced out by a fixed retirement age.
I believe that versions of the Berkshire system should be tried more often elsewhere and that the worst attributes of bureaucracy should much more often be treated like the cancers they so much resemble.
Warning 2: Don’t neglect the next generation of leadership
Warren Buffett is 84 years old, and Vice Chairman Charlie Munger — to whom he gives plenty of credit for Berkshire’s success — is 91. Buffett recently gave an interview in Fortune magazine where he revealed his “secret” to staying young: “If I eat 2,700 calories a day, a quarter of that is Coca-Cola. I drink at least five 12-ounce servings. I do it every day.”
Why? Fortune Senior Editor Patricia Sellers quotes Buffett as saying, “I checked the actuarial tables, and the lowest death rate is among six-year-olds. So I decided to eat like a six-year-old.”
However, Buffett is well aware of the importance of grooming successors at Berkshire, as he writes in the letter:
I’ve mentioned in the past that my experience in business helps me as an investor and that my investment experience has made me a better businessman. Each pursuit teaches lessons that are applicable to the other. And some truths can only be fully learned through experience. (In Fred Schwed’s wonderful book, Where Are the Customers’ Yachts?, a Peter Arno cartoon depicts a puzzled Adam looking at an eager Eve, while a caption says, “There are certain things that cannot be adequately explained to a virgin either by words or pictures.”)
Among Arno’s “certain things,” I would include two separate skills, the evaluation of investments and the management of businesses. I therefore think it’s worthwhile for Todd Combs and Ted Weschler, our two investment managers, to each have oversight of at least one of our businesses. A sensible opportunity for them to do so opened up a few months ago when we agreed to purchase two companies that, though smaller than we would normally acquire, have excellent economic characteristics. Combined, the two earn $100 million annually on about $125 million of net tangible assets.
I’ve asked Todd and Ted to each take on one as Chairman, in which role they will function in the very limited way that I do with our larger subsidiaries. This arrangement will save me a minor amount of work and, more important, make the two of them even better investors than they already are (which is to say among the best).
Warning 3: Watch out for thumb-sucking …
While touring the stellar performance of Berkshire’s investments — “It was a good year for Berkshire on all major fronts, except one” — Buffett acknowledged a misstep as well on that exception, one for which he takes full blame.
Attentive readers will notice that Tesco, which last year appeared in the list of our largest common stock investments, is now absent. An attentive investor, I’m embarrassed to report, would have sold Tesco shares earlier. I made a big mistake with this investment by dawdling.
At the end of 2012 we owned 415 million shares of Tesco, then and now the leading food retailer in the U.K. and an important grocer in other countries as well. Our cost for this investment was $2.3 billion, and the market value was a similar amount.
In 2013, I soured somewhat on the company’s then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior “thumb-sucking.” (Considering what my delay cost us, he is being kind.)
During 2014, Tesco’s problems worsened by the month. The company’s market share fell, its margins contracted and accounting problems surfaced. In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.
We sold Tesco shares throughout the year and are now out of the position … Our after-tax loss from this investment was $444 million, about 1/5 of 1 percent of Berkshire’s net worth.
Warning 4: … But don’t be afraid to be patient
Buffett can be patient when it comes to cashing in on a good investment. For example, in a footnote to a list of his common-stock holdings, he writes of an investment in another financial services company:
Berkshire has one major equity position that is not included in the table: We can buy 700 million shares of Bank of America at any time prior to September 2021 for $5 billion. At year-end these shares were worth $12.5 billion. We are likely to purchase the shares just before expiration of our option. In the meantime, it is important for you to realize that Bank of America is, in effect, our fourth-largest equity investment — and one we value highly.
Warning 5: Don’t take credit for what you didn’t create
With phrases like “gusher of cash” (see Warning 1 above), Buffett isn’t averse from blowing Berkshire’s own horn, but he also gives credit where credit is due — even when it’s not of his doing:
Our investment results have been helped by a terrific tailwind. During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196 percent.
Warning 6: Beware the difference between stocks and dollars
Right after acknowledging those market tailwinds above, Buffett voices his strong feelings not just on currency investing but on what constitutes volatility and risk, with a nod toward behavioral finance that large and “little guy” investors alike should take to heart. While the S&P 500 has been heading to the stratosphere, he writes:
Concurrently, the purchasing power of the dollar declined a staggering 87 percent. That decrease means that it now takes $1 to buy what could be bought for 13 cents in 1965 (as measured by the Consumer Price Index).
There is an important message for investors in that disparate performance between stocks and dollars…
The unconventional, but inescapable, conclusion to be drawn from the past 50 years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities — Treasuries, for example — whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.
It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors — say, investment banks — whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.
Warning 7: Don’t be distracted by the shiny objects of quotational declines
Buffett famously considers Berkshire to be operating for the long run, and he cites a very large reinsurance policy written in 2014 as proof of that long-term focus:
Last year, our premier position in reinsurance was reaffirmed by our writing a policy carrying a $3 billion single premium. I believe that the policy’s size has only been exceeded by our 2007 transaction with Lloyd’s, in which the premium was $7.1 billion.
In fact, I know of only eight P/C policies in history that had a single premium exceeding $1 billion. And, yes, all eight were written by Berkshire. Certain of these contracts will require us to make substantial payments 50 years or more from now.
When major insurers have needed an unquestionable promise that payments of this type will be made, Berkshire has been the party – the only party – to call.
Beyond insurance policies, however, Buffett also writes about the importance of the long-term in investing:
For the great majority of investors, however, who can — and should — invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.
If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).
Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a lifelong owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist or TV commentator — and definitely not Charlie nor I — can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
The commission of the investment sins listed above is not limited to “the little guy.” Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.
There are a few investment managers, of course, who are very good – though in the short run, it’s difficult to determine whether a great record is due to luck or talent. Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship. Rather than listen to their siren songs, investors — large and small — should instead read Jack Bogle’s The Little Book of Common Sense Investing.
Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.”
Warning 8: Don’t forget America
Buffett has been consistently bullish on the United States. In the letter he writes:
Our subsidiaries spent a record $15 billion on plant and equipment during 2014, well over twice their depreciation charges. About 90 percent of that money was spent in the United States. Though we will always invest abroad as well, the mother lode of opportunities runs through America. The treasures that have been uncovered up to now are dwarfed by those still untapped. Through dumb luck, Charlie and I were born in the United States, and we are forever grateful for the staggering advantages this accident of birth has given us.
Buffett provides a specific example to make his point:
Late in 2009, amidst the gloom of the Great Recession, we agreed to buy BNSF, the largest purchase in Berkshire’s history. At the time, I called the transaction an “all-in wager on the economic future of the United States.”
That kind of commitment was nothing new for us. We’ve been making similar wagers ever since Buffett Partnership Ltd. acquired control of Berkshire in 1965. For good reason, too: Charlie and I have always considered a “bet” on ever-rising U.S. prosperity to be very close to a sure thing.
Indeed, who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita U.S. output has sextupled. My parents could not have dreamed in 1930 of the world their son would see. Though the preachers of pessimism prattle endlessly about America’s problems, I’ve never seen one who wishes to emigrate (though I can think of a few for whom I would happily buy a one-way ticket).
The dynamism embedded in our market economy will continue to work its magic. Gains won’t come in a smooth or uninterrupted manner; they never have. And we will regularly grumble about our government. But, most assuredly, America’s best days lie ahead.