5 Points from Warren Buffett's 2010 Shareholder Letter
Warren Buffett is a legend in the investing world. The chairman of Berkshire Hathaway (BRK-B), he has amassed a fortune of over $60 billion dollars, using his company as a vehicle for investing in stocks, fixed income instruments, and buying entire businesses. As of the last list, he was the 2nd richest man in the world according to the Forbes 400. Berkshire has evolved from a textile mill in the northeast into a huge conglomerate, with operations ranging from car insurance (GEICO) to underwear (Fruit of the Loom) to paint (Benjamin Moore) and now railroads (Burlington Northern). Moreover, some of Warren's stock investments, such as his positions in Moody's (MCO), Coca-Cola (KO), and Gillette (now Proctor & Gamble PG) are textbook examples of buying quality at bargain prices. Berkshire's performance has been remarkable - since 1965, the company has grown book value at an annualized 20.3%, vs. the S&P 500's 9.3% annual gain, outperforming the market in 39 of those 45 years (Berkshire underperformed in 2009).
So it is with bated breath that value investors await his annual letter to shareholders. These have been Warren's principal method of passing his wisdom along to the general public, on everything from how he chooses stocks to his outlook on the near future. Entire books have been written from the content in his letters - for example, The Essays of Warren Buffett (review) is an organized compilation of the wisdom from these letters. Let's take a look at 5 points from his 2010 letter to shareholders and see what nuggets we can apply to stock investing.
For those interested, you can find my review of the 2009 letter here.
1) Berkshire Invests Conservatively
This year's letter again illustrates a core principal of the Berkshire investing style: conservatism. As Buffett notes, "our defense has been better than our offense", and looking at the performance chart, Berkshire's best years in terms of outperforming the S&P 500 has come when the index has posted its largest declines. Likewise, the company's worst years have come when the S&P has seen big gains. 2009 was an example of the latter. While the index rose 26.5%, Berkshire's book value grew 19.8%, trailing by 6.7%. On the other hand, in 2008, when the index plummeted 37%, Berkshire fell just 9.6%.
Buffett again lays out the principles for investment. Berkshire invests only in businesses that have a reasonably predictable profitability level for decades. Growth is good... but a strong economic moat is better. Warren brings to point growth industries in the past such as autos, aircraft, and televisions, that grew as industries but were so competitive that no individual companies prospered.
Finally, he mentions that Berkshire will never rely on government generosity to survive downturns. The company's $20 billion in cash costs the company to carry (it earns very little in interest), but it provides a massive cushion during downturns.
The lesson we can take? Always keep the competitive picture in mind and not be solely focused on growth, and always have a cash cushion aside from your investment portfolio for hard times.
2) The Adverse Effects of Size on Investment Returns
Buffett has been warning of this for many years, and again in 2010 he reminds shareholders that Berkshire cannot be expected to meet its past returns going forward, simply because of the size that the company has grown to. In his own words, "huge sums forge their own anchor". It is exceedingly difficult to invest billions and earn high returns - there simply are not enough opportunities.
The Burlington Northern buy is an example of the difficulties created by size. Buffett still readily admits that "the best businesses by far... continue to be those that have high returns on capital and that require little incremental investment to grow". A railroad certainly doesn't fit that criteria, but Berkshire has to be more lenient with their standards to find acceptable opportunities. Buffett believes that BNSF provided an opportunity to invest a large amount of capital ($44 billion) at an acceptable rate of return. But it won't be the rates of return the company has been able to generate in the past.
The lesson? As individual investors, we are lucky. The sums of money we invest are small enough to take advantage of virtually any opportunity available and make a difference. This is why we should always look at small-cap stocks, and always focus on high return on capital with low capital expenditure requirements when analyzing a potential investment.
3) Be Aggressive when Market Conditions Permit
Not that long ago, plenty of investors had a certain smugness about being in cash during the market's nadir last March. Wonder how they feel now after it has roared back 65%? Buffett himself regrets not making more investments during the intense market fear that he states is the investor's best friend. His thoughts are easily summed up in two statements - one plain English and one a "Buffett-ism":
"Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance."
"When it's raining gold, reach for a bucket, not a thimble."
The lessons here certainly don't need any interpretation.
4) On Equity Issuance in Acquisitions
Every year there is usually a more elaborate analysis of some business management aspect relating to something that happened at Berkshire over the past year. This year, Buffett goes into depth regarding new equity issuance to complete an acquisition. Berkshire issued 95,000 new shares (6.1% dilution) to complete the Burlington deal, which Warren said he and partner Charlie Munger enjoyed "about as much as we relish prepping for a colonoscopy".
One of the biggest mistakes managers make in issuing equity to complete a deal is valuing the cost in current market value. Buffett argues that the cost should be calculated at the intrinsic value of the shares. This would prevent giving away more of the company via underpriced equity. He even advocates hiring two investment bankers - one to argue for the deal (a given) and another to argue against the deal. There are several paragraphs on this, and I found it to be one of the more interesting parts of the letter.
The lesson? Be wary of managers that like to give away undervalued stock. This includes doing secondary offerings at prices below a reasonable fair value calculation.
5) Keep It Real
At 79, Buffett still has his sense of humor. A few other select gems from this year:
As a way to cure the housing inventory glut: "speed up household formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers"
On walking out during the shareholder's Q-and-A: "If you decide to leave during the day’s question periods, please do so while Charlie is talking. (Act fast; he can be terse.)"
And, the last request of shareholders planning to attend the meeting: "P.S. Come by rail.".
The lesson? Enjoy what you do and have fun... you only live once!