More wise words from Warren Buffett

Once a year, Warren Buffett writes an eagerly anticipated letter to the shareholders of Berkshire Hathaway, the investment holding company he founded 45 years ago and which has made his reputation as the world's most successful investor.

The letter is a good read and well worth a look at www.berkshirehathaway.com/letters/letters.html

Berkshire Hathaway had a bad year by its high standards last year. Although the book value of its assets rose by 19.8% in 2009, that compared with a 26.5% gain for the S&P 500 Index. The 6.7% underperformance of the benchmark was only the 7th time out of 45 that Buffett has failed to beat the index (and one of those was by less than half a percentage point!)

The consistency of Berkshire Hathaway's performance is underscored by the fact that there has not been a single 5 year period in the company's 45-year existence when the book value gain did not exceed that of the S&P's. Also, in every one of the 11 years in which the S&P went backwards, Buffett beat the benchmark. A great defensive record.

Pearls of wisdom

The purpose of the letter is to bring investors up to speed with Berkshire's many subsidiaries and investments but there is always another side benefit, a glimpse into the common-sense but laser-sharp mind of the world's best investor. It is a powerful antidote to the tricky gloss of many annual reports.

Here is a sample of the nuggets from this year's letter:

"Charlie (Munger, Buffett's business partner) and I avoid businesses whose futures we can't evaluate." This might sound like so much motherhood and apple pie but there's real wisdom here. As Buffett points out, some of the most attractive business stories over the years have turned out to be the worst investments because the industries (think airlines, cars, TVs) ended up being so competitive that "even the survivors tended to come away bleeding". Just because a business is growing fast, it is not a given that its profit margins and returns on capital employed, the lifeblood of any investment, will be worth pursuing.

"We will never become dependent on the kindness of strangers." Again, this is easily said, but Berkshire Hathaway has always been extremely conservatively run even when, as now, it earns a pittance on the $20 billion of spare cash it keeps as insurance against the kind of rainy day that washed away so many other apparently blue-chip businesses during the financial crisis. As Buffett says, it's a high price to pay, but "we sleep well". The same might be said not just of other companies but of whole economies too. It is no coincidence that the most attractive growth prospects are to be found in the emerging world where public and private debts are low and savings rates high. The developed world has to a large extent enjoyed tomorrow's growth today and we could pay the price for years to come.

"Last year your chairman closed the book on a very expensive business fiasco entirely of his own making." This is vintage Buffett, humble and honest. It shows that even the best mind in the business can get it wrong. Against the advice of the managers in GEICO, one of Berkshire's insurance businesses, Buffett thought it would be a good idea to launch a credit card to GEICO customers. He was right that there would be demand for the card, but wrong to assume that GEICO customers would be good credit risks. "We got business all right - but of the wrong type.....I subtly indicated that I was older and wiser. I was just older."

"When it's raining gold, reach for a bucket not a thimble." Buffett is referring here to the fantastic opportunity that existed a year or so ago to buy attractively priced corporate and municipal bonds, which traded at historically high yields compared with those on US Treasury bonds. He saw the opportunity (and indeed told Berkshire investors in last year's letter) but he failed to back his judgement to the extent he should have. "Big opportunities come infrequently," he concluded.

"Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance." The time to invest is not when all around are talking about investment opportunities but when none are. At the top of the market, everyone believes investing is a good idea but because they do so prices are high and valuations excessive. "In the end, what counts in investing is what you pay for a business ... and what the business earns in the succeeding decade or two."

The final pearl of wisdom in this year's letter is about the dangers of buying other companies with shares rather than cash. "If we wouldn't dream of selling Berkshire in its entirety at the current market price, why in the world should we ‘sell' a significant part of the company at that same inadequate price by issuing our stock in a merger?"

He illustrates this neatly with the case of the sale of a small bank to a larger one (in which Berkshire was a shareholder) at a price that made a great deal more sense to the seller than the purchaser. The owner of the small bank made one final demand towards the end of the negotiation: "I'm going to be a large shareholder of your bank, and it will represent a huge portion of my net worth. You have to promise me, therefore, that you'll never again do a deal this dumb."

Wise words indeed and compulsory reading every year for all investors. 

The above article has been sourced from FIL Investment Management (Australia) Limited. 

Important Information

The above information provides an overview or summary only and it shouldn’t be considered a comprehensive statement on any matter or relied upon as such. The above information doesn’t take into account your personal objectives, financial situation or needs. It’s important for you to consider these matters before making any financial decision and I recommend you seek help from a financial adviser.