4 Gold Nuggets from Warren Buffett’s Annual Letter

For investors, very few names provoke such admiration and reverence as Warren Buffett — the Oracle of Omaha.

As a self-made investor, Buffett has become the paradigm of financial success…and is perhaps followed by more disciples than any other investor in history.

He’s chiselled out a unique approach to evaluating and purchasing stock — called ‘value investing’ — and it’s made him a pretty penny along the way.

On 12 February 2019, Buffett’s personal net worth was calculated to be a hair shy of US$85 billion (NZ$123 billion). He is the third-richest human being alive.

While he makes money on his own, most of Buffett’s profitable activities happen through his mega-conglomerate, Berkshire Hathaway. It’s a massive collection of businesses and investments that give Buffett and his right-hand man Charlie Munger room to play and capitalise on the market.

Together, Buffett and Munger make strategic decisions in buying ownership stakes in various companies that they see as undervalued. They summarise their goal this way:

To buy ably-managed businesses, in whole or part, that possess favorable and durable economic characteristics. We also need to make these purchases at sensible prices.

This approach has built Berkshire Hathaway into the third-largest public company according to Forbes’ Global 2000 formula.

And if you want to buy a share in this publicly-traded company, you’ll need at least US$300,000 to get your foot in the door. That’s right: one share of Berkshire Hathaway’s stock [NYSE:BRK-A] costs over a quarter of a million dollars US. It’s the most expensive share in the world.

If anything, the remarkable price is a testament to the value that Buffett has created…and continues to create.

In fact, since 1964, the per-share book value has increased over a million percent, and the market-value has surged nearly 2.5 million percent.

If you compare that to the S&P 500 with dividends included, you’d only have made 15,000% in the same time period.

The numbers don’t lie.

In layman’s terms, this man — Warren Buffett — is an investor with a gift. He understands business and finance more than just about any other person alive. He uses his talent by buying companies/stock where he sees long-term potential…and opportunities to purchase ownership at a good price.

Over the past five decades, he’s bought and sold businesses with tremendous success through the company, Berkshire Hathaway. And the stock for Berkshire Hathaway has reflected that consistent good-fortune through about a 20% increase in value every single year for 50 years.

So you can see why investors listen closely when he speaks…because he knows what he’s talking about.

That brings us to Buffett’s annual letter to the shareholders of Berkshire Hathaway.

Like Moses descending Mt Sinai with the Ten Commandments, investors eagerly await Buffett’s annual commentary on what worked last year and what his plans are for the next. It’s a window into his unique mind…and often shapes how investors approach the markets.

Technically, he’s simply addressing Berkshire shareholders as the chairman like other chairmen would do with their businesses. However, his insight and hard-hitting quips can be inspirational.

If you’d like to read it for yourself (which I’d recommend any investor do), you can do so here.

Let’s dive into this year’s letter…and dig up some golden nuggets…

Focus on operating earnings, paying little attention to gains or losses of any variety.’

This comment comes off the back of a new accounting principle that Buffett doesn’t much like. Basically, the new rule requires companies like Berkshire Hathaway report how their stock positions have performed each quarter.

The problem for Buffett is that his whole methodology revolves around picking long-term profitable businesses with strong leadership. To him, evaluating Berkshire Hathaway based on short-term swings in the stock prices of his various holdings is ridiculous.

For example, in Q1 2018, they reported a loss of $1.1 billion based on this new rule. The next quarter, a $12 billion profit. The next, an $18.5 billion profit. Followed by a $25.4 billion loss. ‘Wild and capricious swings,’ Buffett calls it.

In a general sense, he’s echoing the idea that smart investors should pick stocks based on strong fundamentals…and watch them succeed over the long-term. Don’t mind the short-term ups and downs. If you’ve correctly identified a wise investment, it should pan out profitably over time.

When we say “earned,” moreover, we are describing what remains after all income taxes, interest payments, managerial compensation (whether cash or stock-based), restructuring expenses, depreciation, amortization and home-office overhead. That brand of earnings is a far cry from that frequently touted by Wall Street bankers and corporate CEOs. Too often, their presentations feature “adjusted EBITDA,” a measure that redefines “earnings” to exclude a variety of all-too-real costs.

Here’s a simple yet unpopular piece of advice — don’t base your decisions on EBITDA. If you’re not familiar, EBITDA is a number that companies like to show off to describe their earnings for a certain period.

‘Look how much money we’re making!’

But the problem is that EBITDA doesn’t include lots of real-life costs that businesses face.

Companies have to pay interest on their debt. They pay tax. They buy capital. Their old assets depreciate. These expenses are all-too-real to omit from your investor pamphlet, yet you’ll still hear EBITDAs thrown around like they’re useful for your decision-making as an investor.

Buffett’s advice to us is to ignore that claptrap and look at the cold, hard facts…because if you don’t, you’re only hurting yourself.

In managing, I will make expensive mistakes of commission and will also miss many opportunities, some of which should have been obvious to me. At times, our stock will tumble as investors flee from equities. But I will never risk getting caught short of cash.’

When’s the last time someone recommended that you hold cash reserves? In today’s optimistic world, you’re much more likely to hear that you should spend every last cent you’ve got…or borrow if you can…to buy your ticket on this gravy train. That, by holding back cash, you’re missing out on profitable investments.

But here’s the thing: cash is paramount to a successful financial future. On one hand, it’s there for emergencies. Something unexpected come up and you need some cash quick? Surgery…bail bond…car repair…ransom…etc. Nothing beats the liquidity of cash.

On the other hand, it gives you room to take advantage of opportunities if they arise. Buffett, for example, is looking to make a large purchase in 2019…so he’s holding on to cash for just the right moment. Maybe, for you, it could mean a good deal on a car, or a cheap stock opportunity.

On the third and final hand, cash is a hedge against market downturns. It’s a safeguard and cushion in case things go awry. In 2008 for example, folks were losing 10%, 25%, 50% or more on their portfolios. Cash only loses the rate of inflation…so about 1% to 2% each year. 1% loss versus 50%. It simply makes sense.

All of our major holdings enjoy excellent economics, and most use a portion of their retained earnings to repurchase their shares. We very much like that: If Charlie and I think an investee’s stock is underpriced, we rejoice when management employs some of its earnings to increase Berkshire’s ownership percentage.

Lastly, I wanted to quickly mention Buffett’s thoughts on share repurchasing…because it was the one thing he said that surprised me.

Share repurchasing is when companies buy some of their stocks back. You may know it as ‘stock buybacks’. Let’s say Company ABC has 20,000 shares out in the stock market. They could use a little of their cash to buy back 5,000 shares, so the total available becomes 15,000.

This does a few things. For one, it consolidates ownership of the company into fewer slices…which can be helpful if the company’s leadership wants to take the company a different direction than shareholders.

It also reduces the cost of capital. It can ‘re-balance’ the financial statements. Earnings per share (EPS), for example, is one key number that investors like to look at. By repurchasing shares, EPS goes up and makes the stock more attractive.

But the big thing that stock buybacks cause is an increase in stock price. Less supply and equal demand means higher prices. That rewards all the shareholders who don’t sell because their stock price goes up, up, up.

That’s why I don’t think I’m a fan of share buybacks.

It’s literally using company funds to increase the stock price…which does little to help the business grow in the future. If the company put that money into new capital, it could result in real business growth, higher profits, and greater earnings for shareholders over time.

For Buffett, his strategy is a bit different from your average individual investor. He’s pouring millions and billions into these companies, often so he can buy a significant ownership stake.

When a company buys its shares back, it means that holders like Buffett get a greater slice of the pie.

Remember our example with Company ABC? Well, let’s say Buffett owned 5,000 of the shares. When they bought back some of the shares and took the total volume from 20,000 to 15,000, then Buffett’s ownership percentage goes from 25% to 33%.

That’s a win in his books because he can exercise that ownership to influence the long-term trajectory of that business towards greater profitability.

For many of us, we don’t necessarily care for the ownership percentage part of investing. We just want a good return on our investment. So stock buybacks may help that cause in the short-term, but actually hurt us over time.

It’s a contentious issue…and I’m not fully decided on where I stand. If you’ve got an opinion and would like to help us connect the dots with share buybacks, then let me know at letters@moneymorning.co.nz

Until then, happy investing.

Best,

Taylor Kee
Editor, Money Morning New Zealand


Taylor Kee is the lead Editor at Money Morning NZ. With a background in the financial publishing industry, Taylor knows how simple, yet difficult investing can be. He has worked with a range of assets classes, and with some of the world’s most thought-provoking financial writers, including Bill Bonner, Dan Denning, Doug Casey, and more. But he’s found his niche in macroeconomics and the excitement of technology investments. And Taylor is looking forward to the opportunity to share his thoughts on where New Zealand’s economy is going next and the opportunities it presents. Taylor shares these ideas with Money Morning NZ readers each day.


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