I’m not going to regurgitate the letter to my readers, as there are ample news articles doing that already. Instead I think readers will get more out of commenting on the importance of what he says. Even then, there is way too much to comment on in an article, so I have selected a few noteworthy items. I STRONGLY encourage everyone to read the letter firsthand on their own. As always the information if you accept it “as is” and understand what he is trying to tell you is priceless, literally. His wisdom & principles, has and probably will continue to, help me and others who listen to him produce more than satisfactory investment returns.
– The first page of the letter shows a table of Berkshire’s corporate performance since 1965. The table indicates that Berkshire’s performance has not increased every single year without a decline. Like any company there are years that are better than others, and years where the company is affected by economic downturns. This is something people need to understand. People should not expect a company to be totally immune to economic downturns, nor should they expect a company’s performance to continually perform and output results that are better than the previous years. Small business owners know this fact of business life, but most stock investors do not understand it. Buffett states that the net worth declined to $11.5B, a per-share book value decline of 9.6% of both Class A and Class B stock. He mentions that 2008 was the worst year for both the company and the S&P500 index.
Understanding of Economics, Business Fundamentals:
– He describes the economic & business environment in 2008, that produced a “paralyzing fear” and severely impacted people, governments, the financial system, corporations, and the world countries. He does this in a very folksy and easy to understand manner to give us a good feeling of how significant the affects are. He describes the reasons behind the current mess which involved “borrowers who shouldn’t have borrowed being financed by lenders who shouldn’t have lent.” This is important because people need to understand current economic & business environment and how it has changed, in order to understand how it affects Berkshire’s 2008 results, but also in order to understand how it provides the company with opportunities. He points out the chain of fundamental mistakes made by governments, corporations, and people in general.
– He reminds us that neither he nor his partner Charles Munger can predict which years the economy or stock market will rise or decline. However, their main goals are always business related, regardless of whether the economy is doing well or not. They are focused on maintaining liquidity, maintaining & increasing sources of earnings/income, widening the “moats” of their businesses, expanding/nurturing their operating managers to perform and deliver results.
– Buffett mentions that the market value of many securities and bonds that are held are suffering a significant market price decline. However, they are not bothered by it like the general population is. This is because they only worry about the price at the time they pay for it, making sure it is a good discount. They care about the every day business, because they never intended to sell them for a long time. They see declines as opportunities to increase their positions. People general tend to do the opposite, jumping in and out of investments and always worrying about the market price. He again states one of the most important lessons he learned from Ben Graham who taught him that “‘Price is what you pay; value is what you get.'” He likes “buying quality merchandise when it is marked down.” It is simply amazing that very few people follow this. That combined with sell-offs and time horizons that are way too short for investments, have caused the general population to realize massive losses. Investors must have long enough time horizons on their investments, so that when purchased at low prices, they are given enough time to produce results.
– It is very important to note that Buffett explains that investments fell from $90,343 per share of Berkshire to $77,793, due to a decline in market prices and not sale of stocks or bonds. The letter also makes a note to mention that Starting “in 1979, accounting rules required insurance companies to value the equity securities they hold at market rather than at the lower of cost or market”. This is something that Buffett makes clear as not being the true value, but Berkshire has restated results to conform to the reporting rules. Investors should do well not think in the same manner as the reporting rules, as they aren’t meaningful for an investor.
Berkshire’s insurance business:
– On Berkshire’s insurance businesses, Buffett and Charlie are very enthusiastic, and explain why it is an “economic powerhouse”. A year ago, Buffett said that the insurance business would not enjoy the same past performance results of the most recent years. People took this in a negative way after interpreting it to mean that the insurance business would suffer and lose money. But Buffett never once said that, he just stated the obvious, that the company wouldn’t perform as stellar as it did before (due to the special circumstances that produced those results), but it didn’t mean that the insurance unit would not perform well or profit. Why people say he says things he didn’t is beyond me.
– On investments, he notes that Berkshire made large investments that would not be available in normal market conditions, that would add to annual earnings as well as possibilities for capital gains. He also sold some investments (Johnson&Johnson, ConocoPhillips, P&G) that he would normally “have preferred to keep”. Note these are the same investments that analysts and naysayers were lashing out at 2 weeks ago because they didn’t produce any immediate results, or didn’t know the reason behind the selling. Buffett never says that they would produce results immediately, but always intends for them to add significantly to the bottom line. Again, people have been coming up with their own ideas of what his investment should be doing. We should be reminded that most analysts, fund managers, individual investors, etc, do not have the qualification to call his investments as failures, as no one is able to come close to producing the investment returns he has, nor do they know what his intentions are. Most people measure the performance of Buffett’s investments using their own scoring method (the same flawed one they use for themselves), while he uses a totally different one. Most usually check to see if his stock holdings have declined in market price during difficult economic times. He is regarded by them as having made good investments if his stock prices are holding up, and poor if they declined. However, this is absurd, simply because Buffett does not expect them to do well in the short term (during such times) when he purchases the investments.
– Buffett also admits some investment mistakes, namely the investment in “ConocoPhillips stock when oil and gas prices were near their peak”, costing Berkshire several billion dollars. However, we should pay careful attention that he mentions that he believes “the odds are good that oil sells far higher in the future than the current $40-$50 price”. Two other purchases in Irish banks rounded up his mistakes.
– Regarding the price of oil, I believe the reasons for his belief lie in the world’s heavy dependency on it and its various by-products for both fuel and other applications, as well as the debasement of paper based assets & fiat money. My personal belief is that although in the short term oil prices are low, it will reach much higher prices, along with the price of gold. Although I don’t particularly like that outcome, I do believe such events will occur 5-10 years down the road, or unfortunately sooner. I explain some background information surrounding that issue, and what it may mean in my July 15 2008 article “How The Financial Crisis Will Affect The US Dollar, Inflation, Gold, and Oil Prices“.
– Buffett explains the importance and reasoning behind each of his investment moves in this letter. He also does well to mention the worst case scenario for the derivative investments he made, that the majority simply do not understand and perceive as high risk. Obviously Buffett who is known not to be a big risk taker and makes the simpler and easier investment choices, does not believe the moves he made were risky, (or that the worst case scenario has a high enough probability of occurring). Because the majority do not understand why they aren’t risky he dedicates a large portion of his 21 pages to explaining the derivatives. Unfortunately, many do not comprehend the true risks, as they don’t have the same understanding of the instruments used that he does. Investing requires a deep & solid understanding of the specific investment, as well as the economics behind the investment itself.
– We should realize Buffett makes mistakes, but we shouldn’t be quick to call any moves mistakes until he says they are. The reason is we don’t know the background information (reasoning, time horizon, purpose, plan, etc) behind the investment moves until he tells us.
Economic cycles :
– “Never forget that our country has faced far worse travails in the past” and “Without fail, however, we’ve overcome them.” Buffett describes the American resilience and reminds us of the numerous challenges America has overcome. But no matter which decade, people always tend to think the crash they experience are so different that the problems cannot be fixed. The economic cycles are just that, periods of great productivity increase always followed by periods of great decline. Why? The economy is based on human activities, which by default are influenced by human behavior. People tend to become greedy, over confident, complacent, exploiting, selfish, etc, and ignore risks until its too late. This always occurs and increases during the good times. But by the same token, people tend to be hard working, co-operative, kind, compassionate, intelligent, creative, determined, and cautious. This always occurs during the very challenging times. The results of human behavior drives the economic cycles (ups & downs). Although it make time, the American and world economies will recover.
Risk & Return:
– “When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.” Buffett’s position on risk & return has always been low risk and high return. He refuses to take on unnecessary increased risk for higher potential profits, that may or may not be realized. In most cases the realization would be lower profits or investment losses, simply because the actual risks (not perceived ones) would be high enough and likely enough to cause problems for the investment. This obviously necessitates doing your homework to determine & assess actual risks.
– “Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering.” As an example, in Canada, there are already pension problems. Canadian pension fund Caisse de depot et placement du Quebec, lost $39.8B in 2008 alone. Canada’s public sector pension plans are typically guaranteed by the government, which means taxpayers will likely pay for correcting the mistakes made by the funds. Caisse de depot’s losses were primarily due to a currency hedging program and investment in asset-backed commercial paper that went wrong. OMERS (pension for Ontario municipal employees) reported an $8B loss for 2008. Other pensions such as Alberta’s teacher’s pension received billions to help with losses. Unprecedented losses at public sector pensions along with problems from collapsing housing prices, losses in RRSPs, and a wave of retiring/recently-retired baby boomers, pose serious fiscal problems.
– Unprecedented government bailouts to the financial, industrial, manufacturing & public sectors add to the mounting government debts which in turn eventually accelerates the dilution of the American dollar. Buffett notes that clinging to cash equivalents or long-term government bonds at present yields is not a good idea if continued for long periods. “commentators proclaim ‘cash is king,’ even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.” He states that all this government bailout brings unwelcome aftereffects. “Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.” This is likely due to the issue on the debasement of fiat money. In the same July 15 2008 article I mentioned earlier, I also describe some of the related inflation problems due to the debasement of fiat money. Again, I personally don’t really want to see such an environment occur, but as investors what we like and what we think will happen must be two separate conclusions. In addition to items mentioned in that article, Real Return Bonds or RRB funds, and stocks with increasing dividends, are some ideas for an investor to consider in order to curb the inflationary effects on their investment portfolio. One other note to remember is that governments usually raise interest rates to try and curb inflation. So with very high inflation, very high high interest rates will follow.
I’ll leave you with one other quote from his letter that an investor should already know well:
“We never want to count on the kindness of strangers in order to meet tomorrow’s obligations”.
– Basically you can only count yourself for your future. Something sellers of mutual funds and fund managers would not like to hear.
You can view the official document releases from the Berkshire Hathaway website:
Although we can try to follow and copy people like Warren Buffett and their investment moves, it is much better to start learning the thought process, and understand why he makes such investments. We should learn what criteria he uses, how he determines acceptable risk levels, etc. It will make us better investors, as well as help us understand exactly his reasoning as he explains in his letter to shareholders and annual reports.
Buffett’s teacher/mentor Benjamin Graham’s classic book The Intelligent Investor is a must read for followers of Warren Buffett, and one of the best investment book I ever read. It is a great starting point for investing, particularily in paper investments such as stocks. It is available online from Amazon.ca/com. I have placed a link to the specific version/edition that I recommend below. There are a few editions out, but this one has the Introduction and Appendix written by Warren Buffett (informative extra commentary). Chapters/Indigo is sold out at the moment but I added a link to the audiobook. However, I find having it in textual format is better for referencing.
Thanks & Happy Investing!
The Investment Blogger!