Friday marked one of my favorite days of the year! What was the occasion you ask? It wasn’t a holiday, a birthday, or even a day off from work. No, Friday was the day that Berkshire Hathaway’s annual report was published, including Warren Buffett’s letter to shareholders. For the investing geeks of the world, it was a second Christmas. Every year the Oracle of Omaha starts his annual report with a letter which goes over the events of the past twelve months in plain, simple English. It’s laced with great investment advice and perspective, and all the folksy charm that 80 years of Midwestern living can bring. This has become required reading for anyone who takes the stock market seriously, and it is easy to see why; over any given five year period, Mr. Buffett’s company has never underperformed the S&P 500 index (see page 103 of the annual report – link above).
What makes Mr. Buffett’s letter so important and enlightening is not just his talent and track record. Those do help, but there’s a lot more to it than that. I don’t simply love these letters because Warren Buffett has been such a success. There are a lot of very successful investors out there who regularly write to investors. No, what makes Warren Buffett’s letters so important is the way he writes them. His attention is always on his investors, whom he calls partners. He always points out his own mistakes, and takes time to praise his managers. As a result, the letter is not just educational, it also serves as a model – this is how good managers regard the stockholders: as their employers and as the company’s owners.
In this year’s letter, Mr. Buffett stuck to his standard themes, and gave a quick snapshot of how the company has been doing. Candidly, I think he sold himself a bit short. He expressed a great deal of frustration in that he was unable to land a major acquisition in 2012 despite numerous efforts. His luck may have turned around with the recent purchase of the H. J. Heinz company, and reportedly he isn’t done hunting for elephants. He did mention that he was unable to grow the book value of Berkshire Hathaway at a faster rate than the S&P 500, and thus he considers the company’s performance sub-par. Still, he expressed optimism for the future, and pointed out that the two men he has selected to manage Berkshire’s portfolio once he retires (Todd Combs, and Ted Weschler) both crushed the general market, and even left Mr. Buffett himself in the dust (that last bit was printed in slightly smaller font than the rest of the letter).
Buffett also reminded his partner-investors that owning a stock, any stock, is not about a sheet of paper, or a blip on TD Ameritrade’s webpage. When you own a stock you own something real and tangible. You own a share of a company, and that carries several important implications. When the company profits, you own a share of that profit. Whatever assets the company owns or controls – those are yours. No matter what the market may say about their price, you have something tangible that has a real value, and you should not part with it for less than that value. The market price of stocks (including Berkshire) moves up and down at a dizzying pace, but that doesn’t change the real, long-term value of what those stocks represent.
Buffett did make one economic prediction – he pointed out that if the US economy tanks, and everything truly goes to Hell, Berkshire Hathaway will be in trouble. Berkshire buys companies that generate cash flow, and if cash completely stops flowing in America, all of Berkshire’s investments will degrade quickly. However, he also made a prediction – that the American economy will not stop working. There may be recessions and depressions in the future (in fact, you can bet there will be), but the capitalist engine of America will keep moving forward. Buffett is fond of pointing out that over the last century, we endured the Great Depression, several recessions, and multiple market crashes and corrections. Through it all though, America has grown at fantastic rate. He sees no reason to believe that in the future, things will be any different.
The basic philosophy and plan behind investing has remained the same for almost 50 years at Berkshire, and that comes through in the letter. As an investor, reading it is a great way to take a step back from all the adrenaline-inducing headlines on marketwatch.com (generally a great resource) and reflect on what really is important in an investment. Every day there are headlines about big moves being made by various companies and hedge-fund managers, what Ben Bernanke is going to do next year, how the weather and the price of corn will effect GE’s manufacturing. All of it is very exciting, and (for some people) entertaining. None of it changes the fundamental thesis of a good investor: if you pay less than something is worth, you will be satisfied with the results, no matter what color tie the President of the United States is wearing.
An important thing to note with Warren Buffett’s letter is how humble he stays. Without question, Buffett is one of the smartest guys walking around today. His perspective on success in business makes him an excellent manager and stock picker. He isn’t afraid of what the market says about his decisions – he has enough confidence in his own judgment to wait out the swings in market value that are bound to happen with his stocks. Despite his brilliance and his record, he does not talk down to his investors. He speaks clearly and plainly about everything that is going on at Berkshire Hathaway. This is true throughout the entire annual report, but is especially easy to see in his letters. He makes a real effort to show his investors clearly what is going on at their company. He also speaks about investors as the company’s owners. This may not sound like a big deal – by definition the investors do own the company. However, because investors in a public company are not present every day, the way the owners of most small businesses are, management often forgets that they are supposed to serve investors, not the other way around. Any time a company’s management forgets that they are employed by stockholders, that spells doom for the investors (see: Enron). While Buffett and his partner Charlie Munger do have control of Berkshire Hathaway’s stock, they still treat the shareholders like his employers.
This is most evident with the list of mistakes that Buffett goes over. The very first thing he does in his letter is own up to anything that went wrong. As I said earlier, this year he mentioned two major disappointments. First – the company’s book value did not increase at a pace to keep up with the S&P 500. Then he goes on to own that “failure” (Berkshire did add $24 Billion to its book value, so failure is a strong word). He completely accepts responsibility for trailing the market in general. In his eyes, his job is to add intrinsic value to the company at a rate that beats the market, and this year he didn’t pull that off. Second – he accepts responsibility for failing to make a major acquisition in 2012 (Heinz was purchased this year, not last year). Both he and Charlie have been trying to make large purchases in order to make effective use of Berkshire’s huge cash reserves. 2012 was a frustrating year for them.
I appreciate Mr. Buffett’s candor in acknowledging the goals that he missed. However, looking at his entire performance he has succeeded as a manager. He still runs an excellent business and has refused to give up on his value investment principles. In the long run, I think that Buffett will continue to produce excellent returns. What I like about his admission to these shortcomings is how honest and humble they are. He does not shift blame to his employees, market conditions, or managers at companies he tried to buy out unsuccessfully. The buck stops at his desk, and he makes no effort to shirk that responsibility. I can deal with a down year or two (especially if a down year involves a 30%+ increase in the stock’s market value), if I believe in the integrity of the company’s management. Buffett oozes integrity. I guess I’ll just have to settle with a 30% gain… oh well…
I strongly encourage all of you to take a look at this year’s letter by clicking here. It’s only 6 pages (the rest of the annual report follows) and should be required reading for anyone with even a distant interest in the stock market. If you have time, take a look at the first 24 pages – Mr. Buffett uses this space to explain the basic principles of how he runs his businesses, and includes some details about his various operations (such as definitions of a float and an underwriting profit in insurance). I frequently use his old letters to investors as a reminder of the attitude good management should have when communicating with shareholders. Too much of a focus on the market value of the stock – bad sign. Claiming that economic conditions are responsible for the lack of progress in business – bad sign. Using too much fancy, meaningless jargon to confuse investors – bad sign. Denying any mistakes were made – definitely a bad sign. Treating investors like normal people, and having enough integrity to own up to whatever went wrong – that’s what I look for.
Come back again next week to see another stock analysis. Then, in two weeks, I’m going to begin a four-part series of articles. Some of my friends have pointed out that while I mention some basic investment principles when writing, I haven’t taken any time to actually define my own investment style or identify how I developed my valuation principles. Those are probably things I should make explicit, so here’s the plan; first – an article giving the basic outline of how I look at stock valuation, and who inspired that view. Spoiler alert: their names are Benjamin Graham, Warren Buffett, and Peter Lynch. The next three parts will all be introductions to each of those men, and how they looked at buying stocks. Don’t worry, I’ll keep doing my analyses every other week!
Keep those suggestions coming. It helps me procrastinate actually coming up with my own ideas.
A Filosopher in Phinance 
Great post! Except now I just spent the last half-hour reading Buffett’s letter instead of doing my work. How dare you make me do that.