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Abu Dhabi, UAETuesday 18 September 2018

What Warren Buffett is really telling investors in his latest letter

The world's greatest investor has released his latest annual shareholder memo 

Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc., speaks at the Goldman Sachs 10,000 Small Businesses Summit in Washington, D.C., U.S., on Tuesday, Feb. 13, 2018. Goldman's 10,000 Small Businesses is an investment that brings economic opportunity and assists entrepreneurs to create jobs by providing better access to education, capital and business support services. Photographer: Andrew Harrer/Bloomberg
Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc., speaks at the Goldman Sachs 10,000 Small Businesses Summit in Washington, D.C., U.S., on Tuesday, Feb. 13, 2018. Goldman's 10,000 Small Businesses is an investment that brings economic opportunity and assists entrepreneurs to create jobs by providing better access to education, capital and business support services. Photographer: Andrew Harrer/Bloomberg

Annual shareholder letters are usually intended to pump the stock of the company concerned. But in the case of Berkshire Hathaway they are also an occasion for its chairman and the world’s most successful investor, Warren Buffett, to provide a few useful lessons in how to do it like he does.

Of course the not always so subtle subtext is that you ought to invest in his own ‘B’ shares to profit from his skill. That said the pearls of wisdom he drops along the way are well worth picking up. His 2017 letter was published on Saturday.

Firstly, he bought hardly anything in terms of serious acquisitions last year and now has a record cash pile of $116 billion handy, just in case markets have a hiccup and he can buy on the cheap.

Not that Berkshire Hathaway would escape such a storm itself. Mr Buffett reports that the four major downturns in his 53 years running the company all saw his shares fall between 37.1 to 59.1 per cent.

He says nobody can predict these bad years and that it’s a fool’s errand to try to time markets. And yet his $116bn in the bank does suggest he is currently trying to do just that, or at least be very patient in anticipation of a major slump in stock prices.

His letter spends sometime explaining how his famous 10-year bet against hedge fund managers, that ended last year, panned out.

Basically in 2007 he bet $1 million that an S&P 500 tracker fund - with no active management from him or anybody else - would outperform a collection of the brightest hedge fund managers chosen by Wall Street experts.

The five ‘funds and funds’ each made a decade-long gain of 2.8 to 87.7 per cent by comparison to the S&P Index fund performance of 125.8 per cent.

Mr Buffett blames the 2.5 per cent average annual fees paid for the underperformance, and not the basic investment competence of the managers. It was an uphill struggle for them from day one to pay themselves and the investors.

Mr Buffett even managed to more than double the value of the $1m stake, that has now gone to a charity, by switching it from zero coupon bonds to Berkshire ‘B’ shares halfway through the bet.

However, for those who have not yet fully appreciated what the so-called Oracle of Omaha was trying to prove by this exercise, the lessons for investors are pretty simple.

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OK, in 2008 "the roof fell in" writes Mr Buffett with a huge stock market crash. But "in every one of the nine years that followed, the fund-of-funds trailed the index fund".

In short, the impact of fees on long-term performance was a far more important factor than the genius of the fund managers or a stock market crash. As Mr Buffett says: "Wall Street prospered … many investors experienced a lost decade."

Another lesson to be learnt here is that holding bonds is not nearly as ‘risk free’ as it appears.

"It is a terrible mistake for investors with long-term horizons - among them pension funds, college endowments and savings-minded individuals - to measure ‘risk’ in their portfolio’s ratio of bonds to stocks," Mr Buffett warns. "Often, high-grade bonds in an investment portfolio increase its risk."

But where does all this wisdom leave the average Gulf-based investor today?

Over the years of reading the Berkshire annual shareholder letter I’ve become reasonably adept at reading between the lines for hidden messages, and this year’s 17-pager contained several in my humble opinion.

First there is a clear warning about an impending stock market disaster: Mr Buffett has not been buying stocks. Why not if he thinks they are always a great investment and you should not try to time markets?

Why keep all that cash? $116bn is not small change even for one of the world’s richest men and is much more than he is worth personally.

Secondly, note that in the bad times Berkshire has also taken a big hit, as it did most recently in 2008. But its stock price came back with a vengeance afterwards.

Reading the rest of the annual letter goes a long way to explain why. It is an extraordinarily solid and robustly constructed company with little debt and a lot of cash and a considerable capacity to grow its earnings over time.

Thirdly, Wall Street investment managers really are not the best people to manage your money over the longer term. That said, at 87 Warren Buffett is not getting any younger and his 94-year-old business partner, Charlie Munger, is even older.

Was it not the great economist John Maynard Keynes who once reminded us that "in the long run we are all dead"?

Still you could have used that argument to bet against Mr Buffett and have gone for hedge funds in 2007 and yet even then he would have won posthumously, as presumably he intended.

Is it the case that in Berkshire, the world’s greatest investor has created a machine that can perform extraordinarily well even after his own demise? Will it carry on beating the market as he has so spectacularly in the past 53 years?

Fourthly, Mr Buffett reminds investors not to used borrowed money to buy shares, mainly because this will leave them with an ‘unsettled mind’ in a crash that will prevent them from picking up bargains.

Here the final lesson from this maestro: Stick with big, "easy" decisions and eschew activity.

"During our 10-year bet, the 200-plus hedge fund managers that were involved certainly made tens of thousands of buy and sell decisions. Most undoubtedly thought hard about them …

"We made only one investment decision in 10 years (selling a bond investment and buying Berkshire stock that owned a diversified group of solid businesses ) … Fuelled by retained earnings, Berkshire’s growth in value was unlikely to be less than 8 per cent annually, even if we were to experience a so-so economy."

If I am reading this letter correctly, a Gulf investor should be raising cash ready to invest in great companies (perhaps like Berkshire) when their share prices are temporarily cheap in a crash, avoid the high fees of professional investment managers like the plague, and keep it all as simple as possible. That’s all very sound advice.

Peter Cooper has been writing about finance in the Gulf for more than 20 years

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