Lessons from Berkshire’s Annual Letter 2017

Chairman and CEO of Berkshire Hathaway, Warren Buffett, released his annual letter to shareholders yesterday evening. People in the investment world know that this annual letter summarises Berkshire’s financial performance for 2017 and seeks to educate investors on investing. The letter was so influential that before the advent of the Internet, professional investors owned 1 share of Berkshire just to receive a copy of the annual letter. Now, we have the benefit of reading about Buffett’s thoughts without having to own a single share. The annual letter is highly readable for amateur investors and I would strongly encourage you to take 30 mins of your time to read at least the lessons on investing portion.

The annual letter to shareholders can be found here.

Top 15 Holdings

The list excludes Berkshire’s ownership of Kraft Heinz stock.

Nothing too surprising here, this year’s list features a bunch of Banks, 2 airlines, General Motors, Coca Cola, AMEX and Apple. Conspicuous by its absence is IBM. The one interesting point here is BYD Company Ltd, which I think might be the first time a Chinese company showed up on this list (don’t quote me on this).

BYD Company is a electric vehicle manufacturer listed on the HKSE (Symbol 1211) and Shenzhen and headquartered in Shenzhen. I have known that Buffett had invested in this company for many years now, but it was never substantial enough to appear on this list. I suppose the price explosion back in September 2017 for BYD propelled it into his top 15 holdings. Having paid about HKD 8 a share about 9 years ago to the current price of HKD 73.20, that is a impressive return. One to do more work on.

Never borrow to buy stocks

Haha apparently Buffett and I were thinking about the same thing recently – Peace of Mind Matters. Part of that is to never incur debt to buy stocks. He illustrated this point through the 4 times in Berkshire’s history that its stock price collapsed by substantial amounts:

He argues that leverage unsettles you in times of severe market selloffs. In his own words:

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.

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.

Results from THAT bet

Some of you might recall that I outlined the cost of active fund management last month. In that article, I talked about how Buffett made a bet back in 2007 against Protege that a low cost S&P 500 index fund would outperform any portfolio of 5 funds. The bet expired at the end of 2017 and here are the results:

As you can see, the S&P 500 handily beat any of the funds on a final or average annual gain. Only in 1 year, 2008, where the funds outperformed the S&P 500. Looking at these figures, I can’t help but feel bad for people who invest in these funds as they experience somewhat of a lost decade while their money managers earned ridiculous sums. As Buffett says in the letter,

Performance comes, performance goes. Fees never falter.

Bet Lesson #1 – Disregard mob fears and enthusiasms and focus on a few simple fundamentals

Buffett details how in the early days of the bet, Protege and Buffett had decided to hold the bet funds in $500,000 of zero coupon US Treasury bonds. 5 years into the bet in 2012, they were faced with a valuation mismatch between bonds and equities. The Treasury bonds was yielding 0.88% if held to maturity while by holding American equities, they would have earned 2.5% from dividends with almost certain further prospects of dividend growth, share buybacks and earnings expansion.

They agreed to hold the funds in Berkshire B shares instead, resulting in the charity of Buffett’s choice, Girls Inc of Omaha, ultimately receiving $2,222,279 instead of the $1 million the bet originally started with. Seeing the fundamental mismatch in value and acting on it, yielded a much better return.

Bet lesson #2 – Risk free bonds can increase risk

Buffett describes investing as “activity in which consumption today is forgone in an attempt to allow greater consumption at a later date” and that risk is the likelihood of that not being attained.

Faced with the prospect of the Treasury bonds yielding 0.88% from holding to maturity in 2012, it was in fact riskier to hold on to the bonds as even a low inflation rate of 1% would have reduced your consumption power at the end of the bet. Evaluating risk levels based purely on bond allocation in a portfolio is a fallacy that potentially gives a warped view of investment risk.

Bet lesson #3 – Stick with big, “easy” decisions and minimise activity

The fund managers of the 5 funds undoubted would have made many asset allocation decisions over the course of the bet, while Buffett and Protege only made 1 decision – sell the Treasury bonds, buy Berkshire B – and still handily beat them at 8% while sipping margaritas on a beach somewhere. Look for good investments, stick with them and you will not regret it.

Conclusion

Buffett’s annual letter to shareholders once again delivers on educational value. After decades of writing these letters, he has developed a knack of presenting his thoughts clearly and sometimes in a “quotable quote” manner. It was also a bit uncanny how some of my recent posts echo-ed some of the lessons presented in the letter.

Much to reflect upon.

Other editions of the Annual Letter
2019 Annual Letter
2018 Annual Letter

Happy Hunting,
KK