A Look at Warren Buffett's Annual Letter
One of the highlights of a serious investor's year is the release of Warren Buffett's annual letter to the shareholders of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B). His latest letter was released at the end of February, with its usual assortment of pithy quotes and interesting insights into the market.
Listen in to this week's episode of Industry Focus: Financials to hear Gaby Lapera and John Maxfield discuss Buffett's recently released missive. Among other things, John talks about his favorite quote from the letter, and what Buffett may have been hinting at when he wrote it.
A full transcript follows the video.
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This podcast was recorded on March 6, 2017.
Gaby Lapera:Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today, on Monday, March 6, 2017. My name is Gaby Lapera, and joining me on Skype is John Maxfield, banking specialist. Hi! How are you?
John Maxfield:I'm good! How are you doing, Gaby?
Lapera:Very good! I heard it was your birthday on March 3! Happy birthday!
Maxfield:Thank you. I was telling you before the show. I'm not one of those people who thinks I'm old, because I don't. I'm 37, full disclosure. But I have found it to be true that the older you get, particularly as you approach 40, birthdays are less and less of a thing to celebrate.
Lapera:I'm also a March birthday person,my birthday is on March 17, which is St. Patrick's Day. Fun fact for a lot of people out there who don't realize this-- saints' days don't move around because they're Catholic feast days. So St. Patrick's Day is the same day every year. A lot of people think it's the third Thursday of the month or something, but no, it's March 17 every year, just like St. Valentine's Day is Feb. 14 every year. You're welcome, everyone who has ever had a question about that.
Maxfield:Mark that off on trivia next time.
Lapera:But no, I'm turning 28 in two weeks. That's two years closer to 30.
Maxfield:Oh, you're a spring chicken, Gaby. You have your whole life ahead of you.
Lapera:Oh, man. Speaking of someone who has had a very long life, Warren Buffett. Exciting news from Omaha this week. He released his long-anticipated investor letter that he does every year. That is something that's ... I don't know how to describe it. It's like the Great American novel of American investing that gets written every year. If you look back at past ones, it's just this beautiful collection of investing wisdom from one of the best investors ever.
Maxfield:If not the best.
Lapera:I know you were really excited about this, Maxfield.
Maxfield:I was.I think that's a great way that you framed it. It's not just that it's, maybe, the most valuable document that has ever been written about investing, which, I think it is, but it's a living document. He's adding to it each year. So we can not only see what he says each year, but we can see how his thought process evolved. For an individual investor, you just couldn't have a more valuable document to study than his letters.
Lapera:That's so true. For all you millennials out there, it's like Harry Potter for investing, except it doesn't end. At least I make myself laugh, and you, which is good. So one of the things that characterizes this letter is that the first page always has all the returns thatBerkshirehas had since 1965, when Buffett took over Berkshire. Do you want to expound a little bit on what's going on there?
Maxfield:Let me start out with a slightly different thing. One of the things that when the letter comes out, somebody like me reads immediately. Other people in the media industry do the same thing. What you're doing is looking for those pithy quotes, or what he has to say about stuff like the American economy or stuff like that. But I think one of the things that's really important, it's not only that investors should read his letter -- I honestly think that investors should always read his letters -- but it's also about how you read them. You don't want to just fall into that habit of going through and superficially picking out the favorite pithy quote that he had to say, or the five awesomest quotes that he had to say, or what he had to say about politics or the American economy. You really want to sit down and switch your thought process from that instinctual system one, which is how they refer to it in behavioral finance, into more of that calculated, slower thought process, where you're actually thinking and analyzing it. When you think about Warren Buffett, I think it's really important that while we can all sit around and say, "This guy is the most successful investor," I mean, as far as I know, and I've read quite a bit about investing, he's the most successful investor over such a long stretch of time of all time. But that doesn't mean that you should suspend your critical thought process even when reading Warren Buffett's letters.
Lapera:Not at all. I think one of the best things I picked up from college, and thathelped me get successfully through grad school, was marking up every single thing that I read. I know this must drive librarians crazy, and I'm so sorry about this -- I only do this to books that I actually own, but I take a pen or pencil and I mark every page. So every time that someone says something interesting or something I want to fact-check later, I circle it, I have my own little set of symbols and notations for what I think is actually going on, and at the end of each chapter, I like to give a little summary of the most important points. And at the end of the book, I go back and write down what I thought the best things were, or what were things that I disagreed with, and think on them some more.
Maxfield:Yeah. It's funny, when you were explaining that, there are a lot of people who talk about the process of reading, and a lot of really good readers apply a very similar process to that. So, now, let me answer your first question, Gaby. On the very first page of Warren Buffett's letter, it compares the performance of Berkshire Hathaway since 1965, which is the year that he actually took over the company, until today, and it looks at the performance of Berkshire Hathaway, both the growth and book value per share, the growth in its market value of its actual shares on the exchanges, and it compares that to the S&P 500. And what I love about this first page is, the law of compounding returns, one of those things that is so difficult to get your brain around, because it's just a difficult thing to define. Albert Einstein, who I think we can all agree was a pretty smart guy -- right, Gaby? Do you agree that Albert Einstein is smart?
Lapera:Sure, he's OK.
Maxfield:Yeah. He calls that the Eighth Wonder of the World. So Albert Einstein says this is a difficult concept to understand. But the first page on Warren Buffett's letter really drives home, even if you can't understand it, how incredibly powerful compound returns are. Let meput this into perspective. Over that 52-year stretch, Buffett hasaveraged a 20.8% annualized gainon Berkshire Hathaway stock. Now that's anannualized gain. Over that entire period, he's earned nearly a 2 millionpercentage return on his investors money. What that translates into is, a $10,000investment in Berkshire Hathawayin 1965 -- which,if you factor inflationinto the equation,that's basically enough to buy a BMW 5 Series,a nice car but nothing ridiculously fancy -- thattransformed that amount of money into $88 million, i.e., generational wealth for most families.
Lapera: That's crazy.
Maxfield:Isn't it? It's justsuch a good example. And the other thing that really drives this point home about thepower of compounding returns --to put that in perspective, whileBuffett has returned to 2 million percentover that time period,the S&P 500 has returned 12,700%.
Lapera: That'salso very impressive.
Maxfield:It is, but it's like a rounding errorwhen you look at it compared to Warren Buffett's returns. So that second point is,even small differences in percentages over an extended stretch of time, when those returns compound, canresult in a huge difference. Let me give you an example from that first page. The per-share change in Berkshire'sbook value per share is anannualized gain of 19%. But the same, like I was saying, themarket value of its actual shares is20.8%. So a1.8% difference. Over that stretch of time period, that transforms that 2 million percentreturn all the way down to 884,000% return. So just, on a yearly basis,even though it's less than a 2% difference,over the stretch of that 52-year time period,you're looking at a 1.1 millionpercentage difference. The point is, compounding returns issomething that you want to grasp onto as an investor andtake advantage of to the greatest extent that you can.
Lapera: Yeahdefinitely.Let's talk a little bit more about the returns. One of the things you can see is that there'ssomething going on with Berkshire'sreturns. They're going down over time. It looks like it's tracking the S&P 500. And Buffettexplains why in the shareholder letter.
Maxfield:Right. That19% annualized return on their book value,what's interesting is, that's over that entire 52-year stretch. Butif you actually break it down and chart outBerkshire'sreturns on an annualized basis,what you see is that you startsuper-duper high in the 1970s, wayover the S&P 500, like 20% over the S&P 500, but then theycome down gradually. So if you look at a five-year average differencebetween the S&P 500 and Berkshire's premium returns, it'sactually dipped into negative territory threeout of the last five years. So the question is, what's going on here? Has Buffett lost his sense of touch? The answer is no, that's not what it has to do. The answer is thatBerkshire has become,because of Warren Buffett's success, becauseof his prudent capital allocation, hasbecome such an enormous companythat in order for him to continuegenerating those ridiculous returns that he did 40 years ago,he has to earn $60 billion. Let me give you the exact math. Hehas to earn $54 billion each year atBerkshire Hathaway in order to maintain that 19% annualized growth rate. So the returns are going down dramatically,but it's not because Buffett doesn't know what he's doing anymoreby any stretch of the imagination. It's just because Berkshire has gotten to be so enormous.
Lapera:Yeah,think about it this way. Think about when you arefirst learning how to do a sport. Say it issoccer, which I don't really know that much about. Justminimal increases in your knowledge make you a much better player. Onceyou become the best player in the world, ittakes a lot more knowledge toincrease your performance as a player. It's the same thing with the company,except with returns. If you're a really small company, minoracquisitions or purchases or decisions can have a hugeimpact on how much return you get. The bigger you get,the bigger the changes you have to make to increase your performance. It'sthe same thing,which is something that I think a lot of people don't realize. They'relike, "You'rebigger, so you should be able to make more money," butit actually makes it harder to outperform what you did in the past. Sure,you are making more money as a whole, but as a percentage,it's not as much.
Maxfield:Yeah. And you know, whenyou see that chart, and I wrote an article about this, where you see the linecomparing Berkshire's returns to the S&P 500, when you see that it's come down, it's now basicallya little bit above the S&P 500 on a five-yearaverage basis, a little bit below that or right around it, you know what this has led me to believe? Berkshire, at some point, it'sgoing to get so big that it's just not going to be able to find enough places to invest its capital. Andone of the things that Berkshire has always done, because Buffett is such a goodcapital allocator,is that it has retained all of its earnings. His thought process is, "If we retain our earnings,I'm going to make more on that money for our shareholders than ifI returned it and they invested it elsewhere." Butthe situation this is putting Berkshire in is that may not be the case anymore,because it's gotten so bigand it basically mimics the S&P 500 now. TheS&P 500, in many cases,may even be better. I think there's anargument there. What that would lead one to believe is that there could be a point here whereBerkshire pays a dividend, wherethat is the rational thing, and Buffett can't get around the fact that he'snot going to be able to beat the S&P 500the same that he hasin the past.
Lapera: Yeah.I know he had something to say about buybacks,and I know that's where a lot of people's minds go towhen they think about extra capitalfor companies. What did he have to say about buybacks?
Maxfield:Right. That'sactually a great tie-in. There'stwo ways to return money. You can return it in dividends or you can return it in buybacks, by buying back stocks. And Buffetthas been pretty tough on buybacks in the past. Let me givea little bit more context on this buyback conversation. Because of business confidenceand consumer confidence and the slow-growtheconomy that we're stuck in,what a lot of businesses have been doing is,they've been taking all their earnings and, asopposed to reinvesting lot of those into business investments,because they don't see the return on thoseand they don't want to raise their dividend a whole bunch because then they're stuck at that rate forever more,they've been using buybacks as apressure-release valve. The problem with that is,as you know, we're in the midst,maybe at the end, we're somewhere in this huge bullmarket where stocks have gone way up, so these companies are spending all this money on buybacks and buying back their shares at these really high values. Theproblem with doing that is,if you buy back at too high of a value,the company is actually destroying value. They'redestroying value on a per-share basis. Just like if you as an individual investor paid too much for a stock. So Buffett has come out in the past and said, "Berkshire isn't going to do that. Berkshire would only buy back it stockif it trades for below 120% above its book value." Butin his most recent letter, he has a reallyaggressive conversation about the fact that a lot of companies, while buybacks aren'tnecessarily good or bad as a general rule,a lot of companies in their application of the buybacks arewasting a lot of their shareholders' money.
Lapera: Yeah. It'sdefinitely a really interesting conversation, andsomething that people should look at withother companies when they're thinking about buying. Is management responsible with buybacks? Becausethere is a point where Buffett will buy back shares of Berkshire Hathaway, but that's when he thinks Berkshire is beingcompletely undervalued by the market,and not just because we have all this extra money and we don't knowwhat to do with it.I want you to do one thing for me beforewe get on to the next Buffett thing, which is,pick out a quote that really stood out to you in this letter, and tell me about it.
Maxfield:Ohmy God, I'm so glad you asked me that. We didn't prep for this ahead of time,but I have one for you, Gaby! It'syour lucky day, it's your birthday a week and a half early!
Lapera:Thank you; this is what I've always wanted!
Maxfield:So in the conversation of the letter,in the very beginning of it,the first two paragraphs of Buffett'sconversation -- and when you're a guy like Buffett, he is so smart, he knows how to order his letters. So there is significance to where in the lettercertain things fall. And the closer to the beginning, they'reprobably pretty important. So he spends the first two paragraphs talking about this fact that,because they're getting so big, theirreturns aren't going to blow out of the market every year like they used to. Butthen, in the third paragraph, after teeing that up, he talks about the fact that, what you're going to see withBerkshire is that our returns are going to be lumpy. There aregoing to be some years where we have huge returns. It's in this context that he says this quote. "Every decade or so,dark clouds will fill the economic skies,and they will briefly rain gold. Whendownpours of that sort occur, it'simperative that we rush outdoorscarrying wash tubs, not teaspoons. And that we will do." So,what he's basically saying is that, "Look, we haveaccumulated an enormousamount of cash," andI don't have it off the top of my head, but,tens of billions of dollars' worth of cash that they're waiting to pool in on investments. And basically,what he's saying is,at this point, now, they're just waiting for that opportunity.
Lapera: Yeah. Which willmaybe give them a little spike above theS&P 500.
Maxfield:That'sexactly right. But it also speaks to where Buffett's brain is at,in terms of what he's thinking about the market. We know that the market has correctionsregularly. Warren Buffett is basically saying, "I'mwaiting for a very large correction." So you can work backwards from that.
Lapera: Yeah,which will be really interesting. Maybesome of these gains that we've seen, the "Trump bump" as some people are calling it, might be washed away. Butthat's also just the nature of the market. Onelast thing I wanted to touch on with Buffettbefore we move on to our next topic is,I don't know if you remember this, but back in 2008,Warren Buffett made this betwith some hedge fund managers, saying that he bet them theS&P 500 wouldoutperform the hedge funds over a 10-year period. And whoever won, so, whoever'smoneymaking device went up in agreater percentage over the course of the 10 years, would pay $1 million to a charity of their choice. And we are nearing the end of that. There'sonly one year left in that competition.
Maxfield:Yeah,we have one year. To recap, Buffett has basically said, "Nineyears ago, I bet a hedge fund manager that aselection of hedge funds that they choosecan't beat the S&P 500." So now,fast-forward to today,one hedge fund manager took him up on that offer, selected five hedge-fund funds of funds, that's a hedge fund that invests in other hedge funds, so that gives youeven greater diversity,which would presumably give you a better chance to beat theS&P 500. The best of the five funds thatthis manager selected is up 62.8% since the bet was made. TheS&P 500 is up by 85.4%. Andthat was the best group,by far. The other ones are like 2.9%,7.5%, 8.7%, and 28.3%.
Lapera: That's so rough.
Maxfield:Yeah. Andit just goes to show, andhe talked extensively about this in the letter, maybe these investors -- the rate structure for hedge funds, they pay a ton of money for these things --maybe there isn't as much value there as people think.
Lapera: Yeah,and this is a big thingthat Warren Buffett is about, and The Motley Fool,to some extent, too. Ifyou don't have time to closely monitor your investments,consider investing in the S&P 500. It will probably get you abetter rate of return over time formuch cheaper than a hedge fund, without thepotential pitfalls of owning individual stocks. But yeah, I bet those hedge fundmanagers are kept up at night by this bet.
Maxfield:Yeah, butyou know what I love about this? Buffett isbasically telling people, "Look,complicated investing isn't necessarily the best investing."The Motley Fool, we're a company that speaks to individual investors that don't haveall the money and sophistication to pour into developing models anddoing all of these things. And what this shows is,you don't need that to compete in the markets in acompetitive way. It's just a reassuring thing for investors,and it's something that I think investors should really listen to, and take that advice.
Lapera: Yeah.So on the back half of our show,I don't know if you remember doing this,I don't know if our listeners remember this,we had a stock face-off series of showsa couple weeks ago, where Industry Focus hosts and analyststalked about some stocks that they liked, andI agreed that at the end of it that I would buy stocks if I liked them, andif they had done a good job selling me on it and I did agood job convincing myself that I actually wanted to buy them. So I wanted to talk a little bit about which stocksI actually ended up buying. I will say that before I decided to buy,I looked at all the fundamentals,and all of them looked very good on every company, whichyou might expect, because Industry Focus hosts and analysts were thepeople who had picked the companies. So I'm going to talk to you aboutsome of the qualitative things that helped memake my choice. As you remember,Maxfield, you and Jordan Wathen,you actually pitchedJPMorgan Chase(NYSE: JPM), and Wathen pitchedMoody's(NYSE: MCO).I ended up picking JPMorgan Chase, and the reasonbasically comes down to the weight that both of these companies behavedduring the financial crisis and the period leading up to the financial crisis.JPMorgan Chase did a great job ofmanaging its risk, and Moody's wasone of the reasons that the financial crisis happened,one could say, and that has made menot trust them very much in the long term. And I'm not really sure that they have fixed the problems that caused them to mislabel certain securities. So, JPMorgan Chase was my winner there. AndI felt like, as the Financials host,I have to own at least one bank.I felt like I was cheating listeners by not owning at least one bank.
Maxfield: Let me saysomething really interesting that I learned the other dayabout the rating agencies. Earlier in the week,I was on the phone with a CEO ofone of our really large banks. And he told me that the ratingsagencies are his single most important constituents. Aboveshareholders, above the board of directors,above regulators, above customers,above analysts. And I thought, "Wow,that's such an interesting point." Sorry,that's just a random thing, but I thought you would find it interesting.
Lapera: Yeah,that's definitely very interesting. And who knows,maybe my opinion about Moody's will change eventually, when I have more money to invest. Butfor now, I could only pick one, and JPMorgan Chasewas my choice.
Then, in theAmerican Outdoor Brands(NASDAQ: AOBC)-versus- [Anheuser Busch InBev](NYSE: BUD) faceoff,I ended up going with American Outdoor Brands,mostly because I thought their umbrella business model was really interesting, the fact that they were getting into more technical things that they could do, they were buying these companies that had a lot of niche expertise, and they have a lot more room to grow versus the AB InBev of beer, which is basically agiant monolith of beer.
For healthcare, threwa little bit of a curveball, I ended up buying both [Gilead Sciences](NASDAQ: GILD) andIllumina(NASDAQ: ILMN), becauseI think both of them have a lot of potential. Illumina,I really wish I had one of their machines whenI was doing my master's work,I could have done so many very interesting things. But, alas,I was a lowly gradstudent without access to one in a lab. And Gilead,I think, has a lot of room to grow, and it's a little undervalued at this point.
[8point3 Energy Partners](NASDAQ: CAFD)versus [General Electric](NYSE: GE), I went with GE because the energy space, frankly, scares me, and I understand what GE does. I'm still not 100% sure what 8point3 does. ForShopify(NYSE: SHOP) versusFacebook(NASDAQ: FB),unfortunately I couldn't buy either of them. Remember, if you will, that I mentioned that The Motley Fool has a great number oftrading restrictions. We have trading restrictions on both Shopify and Facebookbecause we are using them for some unknown internal purpose, at least to me. Butfor the record, I would have bought Shopify,because I think their story was the more compelling of the two, even if theirfundamentals work, perhaps, not as compelling. But yeah, that'swhat I ended up picking. If you guys have any questions about why, go ahead and ask me. Idon't know that I'll be able to answer them satisfactorily to you.I hope you guys enjoyed that week,I got a lot of feedback saying that you did, andmaybe we'll be able to do something like that again in the future.Maxfield, thank you very much forjoining us, and happy birthday again.
Maxfield: Thank youvery much,always a pleasure, and happy birthday in advance for you.
Lapera: Oh,thank you very much. As usual, people on the program may have interests in the stocks they talk about, andThe Motley Fool may have formal recommendations for or against,so don't buy or sell stocks based solely on what you hear. Obviously,I have a great deal of interest in the stocks that I just mentioned. Definitely don't buy those based solely on what you've heard from me. That wouldmake me feel very bad,especially because I checked my portfolio this morningand it was a lot of red, and that's a very sinking feeling that has not yet risen from my gut. Also,I have this book in the studio that I'veactually been using it to silencethe clink of my cup as I put it down on the table; it is Buffett: The Making of an American Capitalist, byRoger Lowenstein. Since we talked about Warren Buffett today,this is a great book. You should go ahead and buy it and not just use it to stop your mug from making noise when you set it down on the table. Contact us at firstname.lastname@example.org, or by tweeting us @MFIndustryFocus. If you want to talk to us,I would love to hear you talk. Thank you very much to Austin Morgan.I missed you last week, Austin.
Austin Morgan: I was having fun, not here. I was hanging out in Nashville, and it was awesome.
Lapera:Well,in that case, I don't feel bad for you at all,and I don't miss you anymore. But thanks for being today's producer. Andthank you to you all for joining us. Everyone, have a great week!
Gaby Lapera owns shares of American Outdoor Brands, General Electric, Gilead Sciences, Illumina, and JPMorgan Chase. John Maxfield owns shares of Facebook. The Motley Fool owns shares of and recommends Anheuser-Busch InBev NV, Berkshire Hathaway (B shares), Facebook, Gilead Sciences, Illumina, Moody's, and Shopify. The Motley Fool owns shares of General Electric. The Motley Fool has a disclosure policy.