There are few things more valuable for serious investors to read each year than Warren Buffett's annual letter to the shareholders of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B).
His letter for 2016, released early Saturday morning, is no exception. In it, Buffett covers his usual range of subjects, from the performance of Berkshire Hathaway and its operating units, to the future prospects of the United States, to advice for corporate executives and individual investors.
The whole letter is worth reading -- it is, after all, less than 30 pages long. But for those of you who want to view the highlight reel, here are my five favorite takeaways from Buffett's latest shareholder letter.
Warren Buffett, the chairman and CEO of Berkshire Hathaway. Image source: The Motley Fool.
1. On market panics
A growing number of high-profile investors and institutions have begun to issue warning signs that stocks are approaching unsustainable levels, following the market's surge in the wake of the presidential election.
Prominent hedge fund managers such as Ray Dalio and Seth Klarman have both touched on this in the past month, and the chief U.S. equity strategist at Goldman Sachs, David Kostin, wrote in a recent report that "financial market reconciliation lies ahead."
Buffett both buys this line of thinking and doesn't. While the market is certain to experience major declines, it's impossible to predict when they'll occur, he notes in this year's letter. At the same time, Buffett urges investors to look at these as opportunities to -- as he's said in the past -- be fearful when others are greedy:
The years ahead will occasionally deliver major market declines -- even panics -- that will affect virtually all stocks. No one can tell you when these traumas will occur -- not me, not Charlie [Munger], not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: "We spend a lot of time looking for systemic risk; in truth, however, it tends to find us."
During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively financed American businesses will almost certainly do well.
2. On share buybacks
One of the hottest topics in the corporate world over the past few years concerns share buybacks. Tepid economic growth and lagging confidence have led companies to allocate excess earnings not into business investments, but rather into share repurchases.
In theory, there's nothing wrong with this, as stock buybacks are just another avenue for companies to return capital to shareholders. Done at the right price, moreover, they add value to existing shareholders' stakes. But in practice, as Buffett notes in this year's letter, companies tend to ignore this nuance, preferring instead to repurchase stock irrespective of price:
Assessing the desirability of repurchases isn't that complicated.
For continuing shareholders ... repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. ... Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.
It is puzzling, therefore, that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed. That certainly wouldn't be the case if a management was buying an outside business. There, price would always factor into a buy-or-pass decision.
When CEOs or boards are buying a small part of their own company, though, they all too often seem oblivious to price. Would they behave similarly if they were managing a private company with just a few owners and were evaluating the wisdom of buying out one of them? Of course not.
My suggestion: Before even discussing repurchases, a CEO and his or her board should stand, join hands, and in unison declare, "What is smart at one price is stupid at another."
3. On competitive advantage
If there's one thing I've learned from reading Buffett's letters, it's about the critical importance of competitive advantage. A company with a competitive advantage over others in its industry can continuously grow its market share while simultaneously earning superior returns.
And no competitive advantage is stronger than efficiency. A company that operates at a lower cost base than its competitors has the world at its fingertips, so to speak. It can underprice other companies in its industry, capturing many of their customers, and still generate wider margins and thus higher profitability.
As Buffett explains in this year's letter, Berkshire Hathaway's auto-insurance unit, Geico, offers a real-life demonstration of these forces in action:
Auto insurance is a major expenditure for most families. Savings matter to them -- and only a low-cost operation can deliver those. ...
Geico's low costs create a moat -- an enduring one -- that competitors are unable to cross. As a result, the company gobbles up market share year after year, ending 2016 with about 12% of industry volume. That's up from 2.5% in 1995, the year Berkshire acquired control of Geico. Employment, meanwhile, grew from 8,575 to 36,085.
Geico's growth accelerated dramatically during the second half of 2016. Loss costs throughout the auto-insurance industry had been increasing at an unexpected pace and some competitors lost their enthusiasm for taking on new customers. Geico's reaction to the profit squeeze, however, was to accelerate its new-business efforts. We like to make hay while the sun sets, knowing that it will surely rise again.
4. On accounting red flags
Buffett prides himself on being a straight shooter. He calls things how he sees them and doesn't try to inflate the performance of Berkshire Hathaway through accounting adjustments that exclude temporary, but nevertheless real, costs, as so many companies do nowadays when reporting "adjusted earnings."
The 86-year-old billionaire has taken issue with this practice in the past, and he does so again in this year's letter:
Too many managements -- and the number seems to grow every year – are looking for any means to report, and indeed feature, "adjusted earnings" that are higher than their company's GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of "restructuring costs" and "stock-based compensation" as expenses.
Charlie and I want managements, in their commentary, to describe unusual items -- good or bad -- that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting "adjusted per-share earnings" makes us nervous. That's because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be "helpful" as well. Goals like that can lead, for example, to insurers underestimating their loss reserves, a practice that has destroyed many industry participants.
Charlie and I cringe when we hear analysts talk admiringly about managements who always "make the numbers." In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.
5. On holding periods
If you scan the list of Berkshire Hathaway's major stock holdings on Page 19 of Buffett's latest letter, there's a glaring absence: Wal-Mart (WMT 1.51%).
At Berkshire's 2003 annual meeting, Buffett was asked what his biggest mistake was in recent years. His response: "Wal-Mart." As he went on to note: "I set out to buy 100 million shares of Wal-Mart at a [pre-split price of] $23. We bought a little and it moved up a little, and I thought maybe it will come back a bit. That thumb-sucking has cost us in the current area of $10 billion."
Two years later, in 2005, Buffett tried to remedy this matter by establishing a major position in the discount retailer. By 2016, Berkshire's stake in Wal-Mart was worth nearly $6 billion.
But that stake is no more, causing some investors to question Buffett's sincerity when he said in the past that he and Munger's favorite holding period is "forever." But as Buffett clarified in this year's letter, this rule applies to the whole companies that Berkshire owns, not its stakes in marketable securities:
Sometimes the comments of shareholders or media imply that we will own certain stocks "forever." It is true that we own some stocks that I have no intention of selling for as far as the eye can see (and we're talking 20/20 vision). But we have made no commitment that Berkshire will hold any of its marketable securities forever.
Confusion about this point may have resulted from a too-casual reading of Economic Principle 11 on pages 110-111, which has been included in our annual reports since 1983. That principle covers controlled businesses, not marketable securities. This year I've added a final sentence to No. 11 to ensure that our owners understand that we regard any marketable security as available for sale, however unlikely such a sale now seems.
That rounds out my five favorite lessons from Buffett's 2016 shareholder letter. But let me repeat: If you're a serious investor who's intent on getting better at the craft, there are few better ways to do so than digging into the Oracle of Omaha's letters yourself.
