Lessons from Warren Buffett’s annual letter to investors

Article #528 by Edward Rizzo - Published Weekly

The Chairman and CEO of Berkshire Hathaway, Warren Buffett, published his annual letter to shareholders on Saturday 24 February. The letter by the 87 year-old billionaire is widely followed by the international financial media and by many investors around the world due to his remarkable track record over more than five decades and also since it is considered as one of the best reviews on the US stockmarket and the wider economy.

Having read the 16-page letter and various media articles that analysed the more important revelations in the letter, a number of important lessons emerged which I thought of sharing in my article this week since they can be a good guide for many Maltese investors.

The world’s most successful value investor acknowledged that Berkshire Hathaway currently has USD116 billion in idle liquidity earmarked for one or more large acquisitions. However, Mr Buffett and his partner Charlie Munger were unable to find suitable opportunities to invest this sizeable sum since share prices were considered too high in 2017. Warren Buffett again explained his rationale for making acquisitions and stated that:

“In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price. That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high.”

This is a very important point since Mr Buffett is highlighting the significance of purchasing a company or a shareholding at a sensible earnings multiple and to not get carried away in times of investor euphoria.

Investors must however not interpret this statement that no purchases were conducted by Berkshire Hathaway last year. Mr Buffett referred to ‘stand-alone businesses’ implying the complete acquisition of certain companies. The last takeover that was conducted by Berkshire Hathaway was Precision Castparts in 2015.

The media widely follows the quarterly reports published by Berkshire Hathaway to understand the changes made to the overall investment portfolio. In fact, what was evident in recent months was that Warren Buffett bought sizeable amounts of Apple shares during the course of last year and Apple now ranks as the second largest holding within the portfolio with a value of USD28 billion. Berkshire Hathaway currently holds 3.3% of the total issued share capital of Apple Inc.

In my view, the most important lesson from this year’s annual letter was the statement which again highlights Mr Buffett’s philiosophy as a value investor. Warren Buffett explained that he views the investments in those shares that are listed on a stock exchange (the various other businesses owned by Berkshire Hathaway in their entirety are not tradeable on a stock exchange) as “interests in businesses, not as ticker symbols to be bought or sold based on their ‘chart’ patterns, the ‘target’ prices of analysts or the opinions of media pundits.” He added that “instead, we simply believe that if the businesses of the investees are successful (as we believe most will be), our investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results. In America, equity investors have the wind at their back.”

This is also a very important point for investors to understand. Very often I receive several calls questioning the reason behind the decline in the share price of a particular company from one day to the next. It is difficult to explain the rationale for short-term price movements. Moreover, I often aired my views that equity investors should take a long-term view and disregard short-term price movements. As Warren Buffett explained in great detail in various publications in the past, investors should monitor the financial performance, the business pipeline and the financial strategy of a company rather than short-term movements in a share price which are often unrelated to the progress achieved by a company.

Warren Buffett also warned against the practice of borrowing money to invest and he stated that “our aversion to leverage has dampended our returns over time. 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”.

The renowed value investor also made reference to the bond market and to avoid the assumption that bonds are less risky than shares. He explained that “investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date”. Moreover he stated that “risk is the possibility that this objective won’t be attained”. Warren Buffett added that "it is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment 'risk' by their portfolio's ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk."

This is another stark reminder of how several high-profile investors are viewing the current cycle of the bond market as yields had dropped to historically low levels in recent years and bond prices are now expected to decline as various central banks move towards a normalization of monetary policy. The US Federeal Reserve and the Bank of England have already started to raise interest rates while the European Central Bank is widely expected to stop its quantitative easing programme in September. I mentioned this topic at length in various articles in recent months and Maltese investors who continue to hold large positions in long-term Malta Government Stocks should question the rationale for maintaining these securities given that prices are still well-above par value implying a very low yield to maturity.  Although MGS prices have declined from their record levels in October and November 2016, they ought to decline further in the future, as yields continue to move higher.

Through his publications over the years Warren Buffett taught many investors that succeeding in the stock market requires the discipline to act sensibly. In fact, he stated that “the less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own”. Moreover, in this year’s letter he also hinted at the current stock market behavior and the importance to have the available liquidity to take opportunities that can be presented if share prices decline rapidly. He stated that “though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential."

Maltese investors would do well to follow such legendary investors since there are some important lessons which can also be useful even for those individuals solely exposed to the Maltese capital market.

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