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Berkshire letter: A summary and a few comments

As every year, Buffett disclosed his annual letter to shareholders. Below we summarize the main key points. Year to date Berkshire A-shares returned 2.16% vs 2.75% for the S&P 500. Over the last 12 months, it has returned 19.19% vs 16.05% for the index.

Operating performance

Berkshire’s gain in net worth during 2017 was $65.3 billion, which increased the per-share book value of both Class A and Class B stock by 23%. But only $36 billion came from Berkshire’s operations. The remaining $29 billion was due to tax changes.

Buffett reiterates the principles he follows in making acquisitions. He writes:

“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.”

However, he also questions the recent M&A activity due to poor management. He writes:

“Why the purchasing frenzy? In part, it’s because the CEO job self-selects for “can-do” types. If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.”

He discussed his acquisition of 38.6% partnership interest in Pilot Flying J. With about $20 billion in annual volume, the company is far and away the nation’s leading travel-center operator. Berkshire also made some smaller acquisitions.

Berkshire operations other than insurance delivered pre-tax income of $20 billion in 2017, an increase of $950 million over 2016. About 44% of the 2017 profit came from two subsidiaries. BNSF, the railroad business, and Berkshire Hathaway Energy (of which Berkshire owns 90.2%).

The insurance business lost $3.2 billion pre-tax from underwriting. This is due to three significant hurricanes that hit Texas, Florida and Puerto Rico.

As a general strategy going forward, Buffett wrote:

“Berkshire’s goal is to substantially increase the earnings of its non-insurance group. For that to happen, we will need to make one or more huge acquisitions. We certainly have the resources to do so. At yearend Berkshire held $116.0 billion in cash and U.S. Treasury Bills (whose average maturity was 88 days), up from $86.4 billion at yearend 2016. This extraordinary liquidity earns only a pittance and is far beyond the level Charlie and I wish Berkshire to have. Our smiles will broaden when we have redeployed Berkshire’s excess funds into more productive assets.”

Below we list Berkshire fifteen common stock investments that at yearend had the largest market value:

Berkshire received $3.7 billion worth of dividends from publicly traded companies in 2017.

Market fluctuations and leverage

Buffett warns against market fluctuations, maybe hinting at market irrationality. He shows four occasions in which Berkshire stock lost 37% or more value in a short time span. He therefore points out the risks of “using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even 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.”

The picture below (source: Advisor Perspectives) shows two worrying phenomena. First, margin lending is at the highest level in 20 years. Second, there is a strong correlation between margin lending and market performance. Meaning that market goes up when investors leverage, and investors leverage when the market goes up. This supports the saying that investors usually buy high and sell low (not a good idea).

Using a similar graph but accounting for inflation, results are even more staggering. No wonder Warren Buffett is sending a warning signal.

In fact, Buffett is excited about future crises:

“In the next 53 years our shares (and others) will experience declines resembling those in the table. No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow. When major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt. That’s the time to heed these lines from Kipling’s If:

If you can keep your head when all about you are losing theirs . . .

If you can wait and not be tired by waiting . . . If you can think – and not make thoughts your aim . . . If you can trust yourself when all men doubt you . . .

Yours is the Earth and everything that’s in it.”

He suggests a simple lesson for beating market returns:

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.” These words and behaviour contrast with Ray Dalio who recently said that investors holding cash would look foolish. Well, Buffett is holding more than 100B in cash…

Hedge funds

Buffett continues his crusade against hedge funds and active management. He writes that “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, however well-regarded and incentivized those helpers may be” and concludes this section:

“performance comes, performance goes. Fees never falter.”

Bond returns

It is well known that, in his crusade against hedge funds, Buffett had made a bet that a simple passive index fund would beat an actively managed portfolio of hedge funds. Over the last ten years, he has won this bet. The S&P 500 index fund returned 8.5% per year (125.8% in total), while the group of hedge funds returns 2.96% per year after fees

(36.3% in total).

However, he and the counterparty, Protégé, had initially purchased bonds to offer to the charity of Girls of Omaha at the end of the bet. Yet, after a few years, due to bond prices going through the roof, they shifted from bonds to Berkshire stocks. Buffett uses this story to discuss the bond market:

“After our purchase, however, some very strange things took place in the bond market. By November 2012, our bonds – now with about five years to go before they matured – were selling for 95.7% of their face value. At that price, their annual yield to maturity was less than 1%. Or, to be precise, .88%. Given that pathetic return, our bonds had become a dumb – a really dumb – investment compared to American equities. Over time, the S&P 500 – which mirrors a huge cross-section of American business, appropriately weighted by market value – has earned far more than 10% annually on shareholders’ equity (net worth) … Presented late in 2012 with the extraordinary valuation mismatch between bonds and equities, Protégé and I agreed to sell the bonds we had bought five years earlier and use the proceeds to buy 11,200 Berkshire “B” shares. The result: Girls Inc. of Omaha found itself receiving $2,222,279 last month rather than the $1 million it had originally hoped for.”

Buffett warns about the risks inherent in bonds:

By that standard, purportedly “risk-free” long-term bonds in 2012 were a far riskier investment than a long- term investment in common stocks. At that time, even a 1% annual rate of inflation between 2012 and 2017 would have decreased the purchasing-power of the government bond that Protégé and I sold.

I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates. 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.”

As of today, bonds are still returning very little. A 30-year bond in US is returning 3.15%. At these levels, after accounting for inflation, real returns might be meagre. Investors should be careful in this market environment.

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