Berkshire Hathaway’s latest chairman letter was released late Saturday night. The annual letter by Warren Buffett has been a great source of wisdom for aspiring investors globally. While this letter was one of his shorter ones in recent times, it still is a very worthwhile read for investors.

2017 was a light year of acquisitions

“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. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.”

Warren observed a couple of reasons for this environment, including overoptimistic projections by CEOs and “availability of extraordinarily cheap debt.”

With relatively low levels of acquisitions conducted by Berkshire, their holdings of U.S Treasury Bills have ballooned to USD 116 billion (up from USD 86.4 billion at the end of 2016). Warren is not pleased by this amount: “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.”

Conservative use of debt to ensure long-term success

Berkshire is now a mammoth corporation- but it was not always that way. Warren Buffett gained control of it when it was a shrinking textile manufacturing company in 1962. Throughout the next half of the century, he built it through a series of savvy acquisitions away from the textile business. In his own words “the company has built value by reinvesting its earnings and letting compound interest work its magic.”

Nevertheless, the Berkshire journey was not linear and experienced “four truly major dips” that ranged from 37% to 59% decline in price. Warren highlighted this as a way to remind investors of the importance of being conservative in the use of debt. “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 decision.”

“The bet” and its investment lessons

In 2007, Warren Buffett made a bet with Protégé Partners that an S&P500 index fund will beat a selection of hedge funds in a 10 year period. Warren Buffett won that bet by a wide margin and talked about it in length in the 2016 letter. The lessons that came out of it was:

  • Layers of high fees in money management puts investors at an unnecessary disadvantage to passive investors. Warren did acknowledge that there will be “skilled individuals who are highly likely to out-perform” passive investors over time- he should know, he is one himself! Charlie Munger, Berkshire’s Vice Chairman added his thoughts on this in a recent Daily Journal General Meeting. He believes there are 5 qualities that he believed are highly important when choosing an active investment manager: “total integrity”; “actual deep, deep fluency in whatever it is you’re going to do on behalf of the client”; “a fee structure that is actually fair in both directions”; “an uncrowded investment space”; “a long runway, meaning that the manager is reasonably young in age”.
  • 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.”
  • “…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.”
  • “A final lesson from our bet: Stick with big, “easy” decisions and eschew activity.”

Some other quotes

“Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase. Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size. Investment bankers, smelling huge fees, will be applauding as well. (Don’t ask the barber whether you need a haircut.) If the historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint.”

“…it is insane to risk what you have and need in order to obtain what you don’t need”

“The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.”

“Betting on people can sometimes be more certain than betting on physical assets.”

“Charlie and I view the marketable common stocks that Berkshire owns 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. 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.”

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