Last weekend, Warren Buffett released his annual letter to shareholders. I look forward to this event every year. It is a lot like if your favorite author released a new book every year, or your favorite band released a new album. This letter is one of the purest and most consistent sources of great investment wisdom, and is available at no cost. Mr. Buffett does not try to advise on which way the market might swing this month or year. Instead, he just focuses on how he goes about the business of allocating capital to businesses that offer a high likelihood of delivering great returns over a long period of time. If you have not yet, I strongly recommend you read it. Here is the link.
While I have read it every year since 2006, (and read many of the back letters also) I have not yet done any commentary on it. I have had a practice of simply reading the letter and maybe finding a couple quotes that I want to pull out and store for later. This year, however, I thought instead of just sending out the link to a couple of my friends and contacts, I would provide some of my thoughts with it. Let me know what you think.
“Charlie and I encourage bolt-ons if they are sensibly priced. (Most deals offered us most definitely aren’t.) These purchases deploy capital in operations that fit with our existing businesses and that will be managed by our corps of expert managers. That means no additional work for us, yet more earnings for Berkshire, a combination we find highly appealing. We will make many dozens of bolt-on deals in future years.”
Berkshire Hathaway is famously known for not paying a dividend to their shareholders. The reason for this is that the core competency of Warren Buffett and his Vice-Chairman, Charlie Munger, is smartly deploying capital for a return. Why would you give money back to shareholders if you’re best skill is getting returns on money you invest? Both Warren and Charlie do a great job explaining how capital can be put to its best use. The above quote is another example of how they deploy capital which is probably better than giving back to shareholders for them to go put in a bank somewhere.
“At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss cost and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained.
Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors.”
I have to offer a hat tip to Josh Brown, of The Reformed Broker blog, on this one. He cited this same excerpt for a post he did for Fortune and drew many of the same conclusions. A link to his article is here. While the quote specifically refers to the insurance business, the parallels to general intelligent investing are many. Do you know the scenarios which can cause losses to your portfolio? Is the level of potential losses more than the portfolio can reasonably bear given its cash flow needs? Are you willing to walk away from an opportunity to earn a large return if the risks are too high? Warren outlines the importance of discipline in the insurance business – intelligent investors would do well to heed these lessons as well.
“A few, however – these are serious mistakes I made in my job of capital allocation – have very poor returns. In most of these cases, I was wrong in my evaluation of the economic dynamics of the company or the industry in which it operates, and we are now paying the price for my misjudgments. At other times, I stumbled in evaluating either the fidelity or the ability of incumbent managers or ones I later appointed. I will commit more errors you can count on that. If we luck out they will occur at our smaller operations”
Even the greatest investor in the world recognizes he is inescapably prone to errors. No investor can have a perfect batting average. The really great ones, however, recognize this fact and focus on limiting the impact these can have on their portfolios. Diversification, margins of safety, and due diligence should be top of mind at all phases of the investment process.
There are, of course, many more lessons which we can draw from the Warren’s letter, but you will have to go in and read those for yourself.
Until next time….
“Call this Noah’s Law: If an ark may be essential for survival, begin building it today, no matter how cloudless the skies appear.” – Warren Buffett
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