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Buffett’s Annual Letter – Some Key Takeaways

Summary:
Well, it’s that time of year – the annual Buffett letter is out. Love him or hate him, these letters are always must reads as they’re filled with awkward sex jokes and investment knowledge that you can pass on to your kids. The investment knowledge, that is, not the sex jokes. Here are some key takeaways from this year’s letter: Stocks are really expensive. 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. That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but

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Well, it’s that time of year – the annual Buffett letter is out. Love him or hate him, these letters are always must reads as they’re filled with awkward sex jokes and investment knowledge that you can pass on to your kids. The investment knowledge, that is, not the sex jokes. Here are some key takeaways from this year’s letter:

Stocks are really expensive. 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.

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.

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.”

It took him two pages before he made an awkward sex joke. He’s getting impatient in his old age. But one thing he’s definitely patient about is buying stocks at a reasonable price. He apparently doesn’t love the market at these valuations….

Don’t use leverage to buy stocks. Here’s a timely comment on using leverage given the recent fiascos with leveraged ETFs and volatility ETFs:

“This table (referencing four 35%+ declines in Berkshire stock) offers the strongest argument I can muster against ever 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.”

Low fees + discipline = investing success. There’s a long section on his index fund bet with hedge funds over the last 10 years. I’ve talked about this bet a bit because the most interesting point to me is that Buffett’s own company lost the bet to the S&P 500. The greatest stockpicker of our era should have taken his own advice and invested in an index fund!  But Buffett really needles the high fee aspect of this bet:

“Performance comes, performance goes. Fees never falter.

************

The bet illuminated another important investment lesson: 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.”

This really can’t be emphasized enough. Fees are performance killers. But low fees combined with the ability to be disciplined will be the key to investment success.

Stocks vs Bonds. There was a lot of talk about stocks and bonds in the letter. Some of it conflicting from my reading. Buffett seems to think stocks and bonds are both expensive, but he likes stocks “for the long run” more:

“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.”

I think he’s right about this in some sense. Remember, Buffett has a perpetual time horizon. His favorite holding period is “forever”. Pension funds and endowments are similar. They should be thought of as perpetual entities. So they have the luxury of waiting very long periods to ride out potential stock market turbulence. After all, the stock market is essentially a perpetual instrument so if you can wait forever then you don’t have an asset and liability mismatch. But this is not true for most “savers”. Most savers have some sum of savings that they can and will need in the short-term. They do not have have the luxury of being an entity with a perpetual time horizon or a billionaire with more money than he knows what to do with. So most of us have to better balance how to allocate that savings because it is imprudent to just pile it all into stocks and hope that we don’t have to ride out a 10 or 20 year bear market at some point.

This was the only section of the letter I didn’t really like. He preaches a “stocks for the long-run” mentality which is right in theory and wrong in reality. Stocks definitely get less risky if you can hold them for super long periods of time. But they can also be very risky for long periods of time. So I don’t know how he balances the view that stocks are expensive (and probably riskier than they are on average) with the view that most savers should pile into stocks for the long-run. Something doesn’t add up there. I suspect that all these years being a billionaire have left him a little bit out of touch with how most people actually live their financial lives.

That’s all from me. Go have a read if the Berkshire site site isn’t bogged down. If it is you can find the letter here since I am pretty sure the Buffett website is running on some sort of early stage internet protocol from the 80s.

Cullen Roche
Former mail delivery boy turned multi-asset investment manager, author, Ironman & chicken farmer. Probably should have stayed with mail delivery....

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