11 Take-Aways from Buffett's Annual Letter

I took some time on Sunday afternoon to read Warren Buffett's annual letter. I don't make it an annual practice to read the Berkshire Hathaway (BRK. A) letter as many do (nor have I ever been to the shareholders' meeting which Buffett calls "Woodstock for Capitalists"). But given that 2008 was a year unlike any that I have ever witnessed, it seemed like the thing to do on a cold and snowy afternoon.

Buffett and his partner Charlie Munger are the most successful stock market investors of the 20th century and they have consistently outperformed the public markets as shown by this table (click to enlarge) of annualized returns that I put together with data from the first page of Berkshire's annual report (I love that Buffett starts with the numbers):

It is very interesting to me that the past five decades have seen the S&P significantly outperform the long term average for equities of around 7% per annum. Even with the miserable performance of the public markets this decade, we'd have to be flat for another decade at least for the markets to average 7% per annum from 1965 on.

But Buffett and Munger's performance is something else entirely. While it is correlated to the market for sure, it has been so consistently superior for so long that it is clear that they are doing something right (and better).

So with that in mind, here are my take aways from reading Warren's letter.

1) The economy - It's really bad. Warren says the "freefall in business activity" is "accelerating at a pace that I have never witnessed before."

2) TARP and related efforts to stablize the financial system - The Fed "stepped in to avoid a financial chain reaction of unpredictable magnitude. In my opinion, the Fed was right to do so." But it will "bring on unwelcome aftereffects." One likely consequence is "an onslaught of inflation." And "major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won't leave willingly." That last line is classic and true and Obama's greatest challenge.

3) Berkshire's two most important businesses are insurance and utilities, sectors that "produce earnings that are not correlated to those of the general economy."

4) Buffett and Munger are value investors and contrarians. Warren says "When investing, pessimism is your friend, euphoria the enemy" and "Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down" and "Beware the investment activity that produces applause; the great moves are usually greeted by yawns." Words to live by.

5) Housing - Berkshire has exposure to the mortgage and housing market by virtue of its ownership of Clayton Homes, the largest company in the prefab home market. Buffett says "Enjoyment and utility should be the primary motives for [home] purchase, not profit or refi possibilities. And the home purchased ought to fit the income of the purchaser." And "an honest to God down payment of at least 10% [I think 20%] and monthly payments that can be comfortably handled by the borrowers income. That income should be carefully verified."

6) History as a predictor of the future - "If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians."

7) Quants - "Beware of geeks bearing formulas."

8) Lean and mean organizations - "BHAC: Who, you may wonder, runs this operation? While I help set policy, all the heavy lifting is done by Ajit and his crew. Sure they were already generating $24 billion of float along with hundreds of millions of operating profit annually. But how busy can that keep a 31-person group? Charlie and I decided it was high time for them to start doing a full day's work." Wow. I'm stunned. And now I have something other than Craigslist to use as an example of a lean and mean profit generating machine.

9) Bubbles and Panics - "The investment world has gone from underpricing risk to overpricing it." And "When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the US Treasury bond bubble of late 2008 may be regarded as almost as extraordinary."

10) Derivatives - "Derivatives are dangerous" and "When Berkshire purchased General Re in 1998, we knew we could not get our minds around the book of 23,218 derivative contracts, made with 884 counterparties. So we decided to close up shop. Though we were under no pressure and we operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: "I liked you better before I got to know you so well."

11) Risk and Responsibility - "It is my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault."

I'll stop there because I really like lists with eleven entries. It's a quirk of my personality. All you have to do is read Warren's letter (or even my cliff notes version) to understand why he's the best investor of the past century. Common sense married with a native understanding of markets and value is what produces the returns at the top of this post. Everyone who invests and manages money for a living can take a lot away from Berkshire Hathaway and Warren and his partner Charlie.

Disclosure: None

Comments

[headlocal:]

Fred - tasteful number, stopping at 11 entries.

My favorite number is 17, as in how many waves makes a perfect session, the number of syllables in a haiku, etc. e.g. reformatting Ted Levitt:

The future belongs to those who grasp possibilities the quickest.

and, from Onassis:

The key secret of business is to know something nobody else knows.

Mar 02 03:44 AM

[Dean M:]

He seems to have produced his exceptional results in this decade by mostly avoiding the dot com bust, other than that feat he seems to have more or less tracked the index in the 2000s. And now he is a little late to the realization that things are really bad. And his line about geeks bearing formulas, that is really getting tired.

Mar 02 04:16 AM

[Moon Kil Woong:]

Hmmm, on derivatives I wonder how Citibank feels, lol. Obviously, the public hates it more and more already and doesn't even really know it yet. The trillions of dollars of derivatives losses are still hiding off their balance sheet.

Even Wells Fargo who is crying with their $3 trillion as they complain Roubini (who didn't directly infer they have over $100 billion in losses) is wrong. They of course say they have over $40 billion in losses and will hold them to maturity. In actuality, holding them to maturity exposes them to potential more losses not less. So what are we suppose to do? Feel more secure they are still gambling like Nick Leeson after they already lost. Apparently, they never learn until they go bankrupt. Why should they, they get paid multi-million dollars salaries as long as they deny everything. And the dumb public keeps bailing them out.

Mar 02 05:44 AM

[Mad Hedge F...:]

TT fd c “If you have been playing poker for a half an hour, and you don’t know who the patsy is, it’s you,” said Warren Buffet.

Mar 02 09:29 AM

[robert.b.fe...:]

CITI (C) Bank of America (BAC) and to a lesser extent Wells Fargo (WFC) have been turned in to zombie banks because of an unholy alliance with the FED which tried to protect bond holders and share holders of institutions which should have been allowed to fail. This was accomplished by coercing them and promising to back stop thier losses with tax payer money if they would buy up these institutions. Unfortunately the FED failed to realize the enormity of the losses and now is having difficulty executing the plan that they created. Should they go in now and wipe out the bond holders and share holders they were trying to protect? Should they create a bad bank by purchasing the bad paper and quarentining it which was King Paulsen's original idea and may have actually worked. Or should they continue dumping good money after bad until there is no money left? With an estimated $400T worth of bad paper on the global ballance sheets or about 12 times the world GDP that really is a possibility.

Mar 02 11:06 AM

[Mad Hedge F...:]

Warren Buffet and his managers feel like “hungry mosquitoes in a nudist camp.” So he revealed in his annual letter to investors in Berkshire Hathaway (BRK/A). I love it! This gem is an absolute must read for anyone in the markets. Although Buffet massively outperformed the indices, book value fell 9.6%, the worst performance since he took the helm in 1965. He admitted he did some “dumb things”, like adding to his holding in Conoco Phillips (COP) at the absolute top in the oil market and the expense of safer stocks like Johnson & Johnson (JNJ). If you analyze his balance sheet and income statement, you can see the method to his madness. He only increased his net equity exposure by $1.3 billion. Much of his new investment when into high guaranteed return instruments, like 10% preferred in Goldman Sachs (GS) and General Electric (GE). He has greatly improved the long term cash flow of BRK/A is the expense of a short term hit to book value. Moves like this justify his “Sage” appellation.

Mar 02 11:56 AM

[Mad Hedge F...:]

I love this letter. Warren Buffet and his managers feel like “hungry mosquitoes in a nudist camp.” So he revealed in his annual letter to investors in Berkshire Hathaway (BRK/A). I love it! This gem is an absolute must read for anyone in the markets. Although Buffet massively outperformed the indices, book value fell 9.6%, the worst performance since he took the helm in 1965. He admitted he did some “dumb things”, like adding to his holding in Conoco Phillips (COP) at the absolute top in the oil market and the expense of safer stocks like Johnson & Johnson (JNJ). If you analyze his balance sheet and income statement, you can see the method to his madness. He only increased his net equity exposure by $1.3 billion. Much of his new investment when into high guaranteed return instruments, like 10% preferred in Goldman Sachs (GS) and General Electric (GE). He has greatly improved the long term cash flow of BRK/A is the expense of a short term hit to book value. Moves like this justify his “Sage” appellation.

Mar 02 12:02 PM

[Mark Sigal:]

If Buffett wants to do penance for his 2008, I'd like to nominate him for Recovery Czar. After all, he is the gold standard in terms of being smart, reasoned, clear/understandable and straight in all things finance.

Plus, he is appropriately folksy; he could explain concepts/strategy to the American people in plain English and be a public face for the Recovery team, as rhetoric matters in times like these.

Who better than Buffett to help restore confidence in our financial system (and provide sanity check on key decisions behind re-work of same), something I blogged about in:

Warren Buffett for Recovery Czar (bit.ly/joMx7)

Check it out.

Mark

Mar 02 02:31 PM

[Marianthi:]

Instead of "Beware of geeks bearing formulas" should be beware idiots misusing and misunderstanding formulas as even the "geeks" know that the formulas are not perfect representations of the real world. Other than that, some good stuff there, with an attitude of accountability I like.

Mar 02 05:43 PM

[Amitabha Mu...:]

I myself have an investment company and my idea is to take it to a very high level within coming seven years. Instead of making one time big investment I am making continuous monthly investment in a big unit linked insurance company. Even with huge erosion of stock prices my total investment hardly lost any ground and it will grow nine fold as the index rises. I find

Mar 03 12:25 AM

[Amitabha Mu...:]

I find Buffet's advice not so remarkable as any good investor will think in a similar way. The fact that he started much earlier has much to do with his total wealth. But then what I am trying to achieve is to go to a towering height involving as many associates as possible who would also become super rich as the years roll by. All my investments are from borrowed money and if I can reach the height that I aspire then millions of people will be involved.

Mar 03 12:33 AM

[Alan Skoreyko:]

Yes it is easy to call a man worth 50 billion an ordinary investor. maybe you are more suited to mad money then Berkshire.


On Mar 02 04:16 AM Dean M wrote:

> He seems to have produced his exceptional results in this decade
> by mostly avoiding the dot com bust, other than that feat he seems
> to have more or less tracked the index in the 2000s. And now he is
> a little late to the realization that things are really bad. And
> his line about geeks bearing formulas, that is really getting tired.

Mar 08 12:28 PM

[BIGBRAIN:]

He was born with a cluster of genetic traits that superbly suited him to a life of investing.....Most of the rest of us, did not hit that particular genetic jackpot.
BUT, we can rent his genius and the genius of others......how wonderful that is !

Mar 08 03:22 PM

[silver-bug:]

Warren's mistake - if you could call it that.. is that he is a buy-and-hold guy. But when you're getting a good solid cashflow from his businesses, who cares if he takes a temporary hit on the book value? Cash may be king temporarily, but Cash FLOW will allow you to live on, and survive the bad times.

Mar 08 10:09 PM