The National Weather Service says there's virtually no chance the drought in California will end by spring. And yes, we should all care. Specifically, there's a 0.1% chance the state will receive enough rain to qualify as an "average" wet season.
But you know what else has a 0.1% chance of ever happening? You and me matching wits and investing prowess with Warren Buffett. He's arguably one of the best investors of all time - and as a result, one of the richest people in the world. Of course, we're still smart enough to learn a thing or two from him. And thankfully, he's more than willing to teach us via his annual letter to shareholders of Berkshire Hathaway Inc. (NYSE:BRK.B). Just like his last 50 or so, it's a must-read for every investor.
Not only does it contain nuggets of timeless investing wisdom, but thanks to Berkshire's sprawling enterprise - spanning from railroads, utilities, and homebuilders to insurance, sneakers, and ketchup - it also contains timely revelations into the current state of the economy and the market.
Perhaps the most shocking revelation of all is the fact that the Oracle of Omaha was upstaged by both potential heirs to his investment management throne…
"In a year in which most equity managers found it impossible to outperform the S&P 500, both Todd Combs and Ted Weschler handily did so… I must again confess that their investments outperformed mine. (Charlie says I should add 'by a lot')."
So has Buffett lost his Midas touch?
Hardly! Even if we include his "underwhelming" performance in 2013 in relation to his protégés, Buffett has increased Berkshire's book value at a staggering rate of 19.7% compounded annually over the last 49 years. I highly doubt Mr. Combs, Mr. Weschler, or any of us will ever be able to make a similar boast. So we all stand to learn a thing or two from Mr. Buffett. With that in mind, here's a rundown on the 10 most shocking and important revelations from this year's letter…
~Buffett Shocker #1: Small Caps Are Where It's At!
If you continue to refuse to take my advice to keep betting on small caps because of their superior fundamentals, consider Warren Buffett's words of wisdom: "Our many dozens of smaller non-insurance businesses earned $4.7 billion pre-tax last year, up from $3.9 billion in 2012. Here, too, we expect further gains in 2014."
~Buffett Shocker #2: The End of America is NOT Nigh!
Ever since the Great Recession, fearmongers attempted to convince us that the era of American dominance is over, that our capitalistic system is teetering on the brink of utter and complete destruction.
Buffett's response? Fat chance! Or in his words, "Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?" I certainly can't. If you prefer to keep things on a more quantitative level, Buffett asks, "Who has ever benefited during the past 237 years by betting against America?" I can't think of anyone, can you?
Add it all up, and Buffett contends that "America's best days lie ahead." (I agree.) And he plans to put his money where his mouth is, too. "Though we invest abroad, as well, the mother lode of opportunity resides in America." We'd be well served to do the same. Unless, of course, you're convinced it'll be different this time…
~Buffett Shocker #3: Tenths of a Percent Matter, Too
Too often we get caught up trying to uncover big winners - investments that go up hundreds and hundreds of percent. But Buffett reminds us not to overlook tenths of a percent…
"Ponder this math: For the four companies in aggregate [American Express, Coca-Cola, IBM and Wells Fargo], each increase of one-tenth of a percent in our share of their equity raises Berkshire's share of their annual earnings by $50 million."
The corollary for individual investors comes in with expenses. Reduce them, even by a few tenths of a percent over time, and the gains add up. Or as Buffett puts it later in his letter (emphasis mine), "The 'know-nothing' investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results."
~Buffett Shocker #4: Never Be Fully Invested
Even with cash yielding next to nothing, Buffett recommends keeping a stockpile on hand. Why? So you can put it to work to earn an above-average return when the opportunity presents itself. Or in his words, "Tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy."
~Buffett Shocker #5: Don't Ignore Your Critics… Embrace Them!
As I've warned before, we're prone to confirmatory bias. That is, only seeking out information that jives with our own beliefs. To truly be successful investors, we need to learn to embrace contradictory viewpoints. Buffett's actions reveal that he agrees. When writing about the upcoming shareholder meeting, he said, "We will again have a credentialed bear on Berkshire. We would like to hear from applicants who are short Berkshire."
Why bother? Because entertaining critics' opinions and analysis serves a vital purpose… It either strengthens our convictions on our investment, leading us to increase our stake and earn larger returns. Or, more importantly, it reveals the error of our own analysis, allowing us to exit the position without suffering a major loss.
~Buffett Shocker #6: Bet on the Urge to Merge
In the last year, many of Berkshire's subsidiaries engaged in a growth-via-acquisition strategy. As Buffett writes, "Our many subsidiaries are regularly making bolt-on acquisitions. Last year, we contracted for 25 of these… These transactions ranged from $1.9 million to $1.1 billion in size."
Notice the deal size? They're all small caps. More importantly, Buffett reveals that this urge to merge is guaranteed to continue. "Charlie and I encourage these deals… Many more of these bolt-on deals will be made in future years." If Buffett is encouraging and betting on more small-cap M&A activity in the future, we should, too.
~Buffett Shocker #7: Mistakes Happen, Plan Accordingly
Even the Oracle of Omaha gets it wrong! When discussing his various investments in companies, Buffett reveals that a few "have very poor returns, a result of some serious mistakes I made in my job of capital allocation. I was not misled: I simply was wrong in my evaluation."
Buffett also confesses that these mistakes won't be his last: "I have not… made my last mistake in purchasing either businesses or stocks."
The key takeaways for us? First, plan on getting it wrong from time to time, and plan accordingly. By that I mean, position size. As Buffett shares, his "serious mistakes" involved "relatively small" positions. Doing so is the only way to minimize the impact of our stupidity.
Second, be proactive about reducing the number of mistakes. Here, too, Buffett offers up timely advice: "Call Charlie." That is, his partner, Charles Munger. In other words, we shouldn't be afraid to get a second opinion on any investments we're considering.
And remember, as Buffett writes, "A business with terrific economics can be a bad investment if the purchase price is excessive." So always insist on buying at attractive valuations.
~Buffett Shocker #8: Live Debt-Free
Dave Ramsey is the king of encouraging debt-free living for consumers. I'm a believer, too. And so is Buffett, apparently. He writes, "We will always maintain supreme financial strength, operating with at least $20 billion of cash equivalents and never incurring material amounts of short-term obligations."
If we learned anything from the financial crisis, it's that too much debt kills. Literally. We'd be wise to mitigate that risk entirely by demonstrating some "supreme financial strength" of our own. Specifically, by paying off our debts and stockpiling some cash for emergencies (i.e., irresistible buying opportunities).
~Buffett Shocker #9: Bottom's Up!
Too many people try to figure out what's going on in the world before investing. Buffett offers up an alternative - ignore it! When talking about two of his smartest investments, he writes (emphasis added), "What the economy, interest rates, or stock market might do in the years immediately following - 1987 and 1994 - was of no importance to me in making those investments… We have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions."
Put simply, bottom-up analysis is the only thing that matters over the long run. We need to spend the majority of our time on it, instead of trying to discern the direction of countless macroeconomic variables.
~Buffett Shocker #10: Mute the TV
In reference to the talking heads, Buffett writes, "When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment: 'You don't know how easy this game is until you get into that broadcasting booth.'"
In turn, Buffett believes that listening to the predictions emanating from the boob tube is a "waste of time." So mute CNBC - until Buffett, and occasionally yours truly, comes on, of course. (All right, at least when he comes on.)
If you're even more courageous, go ahead and cancel your cable service completely.
That's it for today. Rest assured, there's much more wisdom to be gleaned from Buffett's letter to shareholders. If you haven't already, I encourage you to read it in its entirety.
Disclosure: No positions