A Look at Warren Buffett's Annual Letter

One of the highlights of a serious investor's year is the release of Warren Buffett's annual letter to the shareholders of Berkshire Hathaway (BRK.A 0.64%) (BRK.B 0.54%). His latest letter was released at the end of February, with its usual assortment of pithy quotes and interesting insights into the market.

Listen in to this week's episode of Industry Focus: Financials to hear Gaby Lapera and John Maxfield discuss Buffett's recently released missive. Among other things, John talks about his favorite quote from the letter, and what Buffett may have been hinting at when he wrote it.

A full transcript follows the video.

This podcast was recorded on March 6, 2017.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today, on Monday, March 6, 2017. My name is Gaby Lapera, and joining me on Skype is John Maxfield, banking specialist. Hi! How are you?

John Maxfield: I'm good! How are you doing, Gaby?

Lapera: Very good! I heard it was your birthday on March 3! Happy birthday!

Maxfield: Thank you. I was telling you before the show. I'm not one of those people who thinks I'm old, because I don't. I'm 37, full disclosure. But I have found it to be true that the older you get, particularly as you approach 40, birthdays are less and less of a thing to celebrate.

Lapera: I'm also a March birthday person, my birthday is on March 17, which is St. Patrick's Day. Fun fact for a lot of people out there who don't realize this -- saints' days don't move around because they're Catholic feast days. So St. Patrick's Day is the same day every year. A lot of people think it's the third Thursday of the month or something, but no, it's March 17 every year, just like St. Valentine's Day is Feb. 14 every year. You're welcome, everyone who has ever had a question about that.

Maxfield: Mark that off on trivia next time.

Lapera: But no, I'm turning 28 in two weeks. That's two years closer to 30.

Maxfield: Oh, you're a spring chicken, Gaby. You have your whole life ahead of you.

Lapera: Oh, man. Speaking of someone who has had a very long life, Warren Buffett. Exciting news from Omaha this week. He released his long-anticipated investor letter that he does every year. That is something that's ... I don't know how to describe it. It's like the Great American novel of American investing that gets written every year. If you look back at past ones, it's just this beautiful collection of investing wisdom from one of the best investors ever.

Maxfield: If not the best.

Lapera: I know you were really excited about this, Maxfield.

Maxfield: I was. I think that's a great way that you framed it. It's not just that it's, maybe, the most valuable document that has ever been written about investing, which, I think it is, but it's a living document. He's adding to it each year. So we can not only see what he says each year, but we can see how his thought process evolved. For an individual investor, you just couldn't have a more valuable document to study than his letters.

Lapera: That's so true. For all you millennials out there, it's like Harry Potter for investing, except it doesn't end. At least I make myself laugh, and you, which is good. So one of the things that characterizes this letter is that the first page always has all the returns that Berkshire has had since 1965, when Buffett took over Berkshire. Do you want to expound a little bit on what's going on there?

Maxfield: Let me start out with a slightly different thing. One of the things that when the letter comes out, somebody like me reads immediately. Other people in the media industry do the same thing. What you're doing is looking for those pithy quotes, or what he has to say about stuff like the American economy or stuff like that. But I think one of the things that's really important, it's not only that investors should read his letter -- I honestly think that investors should always read his letters -- but it's also about how you read them. You don't want to just fall into that habit of going through and superficially picking out the favorite pithy quote that he had to say, or the five awesomest quotes that he had to say, or what he had to say about politics or the American economy. You really want to sit down and switch your thought process from that instinctual system one, which is how they refer to it in behavioral finance, into more of that calculated, slower thought process, where you're actually thinking and analyzing it. When you think about Warren Buffett, I think it's really important that while we can all sit around and say, "This guy is the most successful investor," I mean, as far as I know, and I've read quite a bit about investing, he's the most successful investor over such a long stretch of time of all time. But that doesn't mean that you should suspend your critical thought process even when reading Warren Buffett's letters.

Lapera: Not at all. I think one of the best things I picked up from college, and that helped me get successfully through grad school, was marking up every single thing that I read. I know this must drive librarians crazy, and I'm so sorry about this -- I only do this to books that I actually own, but I take a pen or pencil and I mark every page. So every time that someone says something interesting or something I want to fact-check later, I circle it, I have my own little set of symbols and notations for what I think is actually going on, and at the end of each chapter, I like to give a little summary of the most important points. And at the end of the book, I go back and write down what I thought the best things were, or what were things that I disagreed with, and think on them some more.

Maxfield: Yeah. It's funny, when you were explaining that, there are a lot of people who talk about the process of reading, and a lot of really good readers apply a very similar process to that. So, now, let me answer your first question, Gaby. On the very first page of Warren Buffett's letter, it compares the performance of Berkshire Hathaway since 1965, which is the year that he actually took over the company, until today, and it looks at the performance of Berkshire Hathaway, both the growth and book value per share, the growth in its market value of its actual shares on the exchanges, and it compares that to the S&P 500. And what I love about this first page is, the law of compounding returns, one of those things that is so difficult to get your brain around, because it's just a difficult thing to define. Albert Einstein, who I think we can all agree was a pretty smart guy -- right, Gaby? Do you agree that Albert Einstein is smart?

Lapera: Sure, he's OK. 

Maxfield: Yeah. He calls that the Eighth Wonder of the World. So Albert Einstein says this is a difficult concept to understand. But the first page on Warren Buffett's letter really drives home, even if you can't understand it, how incredibly powerful compound returns are. Let me put this into perspective. Over that 52-year stretch, Buffett has averaged a 20.8% annualized gain on Berkshire Hathaway stock. Now that's an annualized gain. Over that entire period, he's earned nearly a 2 million percentage return on his investors money. What that translates into is, a $10,000 investment in Berkshire Hathaway in 1965 -- which, if you factor inflation into the equation, that's basically enough to buy a BMW 5 Series, a nice car but nothing ridiculously fancy -- that transformed that amount of money into $88 million, i.e., generational wealth for most families.

Lapera: That's crazy.

Maxfield: Isn't it? It's just such a good example. And the other thing that really drives this point home about the power of compounding returns -- to put that in perspective, while Buffett has returned to 2 million percent over that time period, the S&P 500 has returned 12,700%.

Lapera: That's also very impressive.

Maxfield: It is, but it's like a rounding error when you look at it compared to Warren Buffett's returns. So that second point is, even small differences in percentages over an extended stretch of time, when those returns compound, can result in a huge difference. Let me give you an example from that first page. The per-share change in Berkshire's book value per share is an annualized gain of 19%. But the same, like I was saying, the market value of its actual shares is 20.8%. So a 1.8% difference. Over that stretch of time period, that transforms that 2 million percent return all the way down to 884,000% return. So just, on a yearly basis, even though it's less than a 2% difference, over the stretch of that 52-year time period, you're looking at a 1.1 million percentage difference. The point is, compounding returns is something that you want to grasp onto as an investor and take advantage of to the greatest extent that you can.

Lapera: Yeah definitely. Let's talk a little bit more about the returns. One of the things you can see is that there's something going on with Berkshire's returns. They're going down over time. It looks like it's tracking the S&P 500. And Buffett explains why in the shareholder letter.

Maxfield: Right. That 19% annualized return on their book value, what's interesting is, that's over that entire 52-year stretch. But if you actually break it down and chart out Berkshire's returns on an annualized basis, what you see is that you start super-duper high in the 1970s, way over the S&P 500, like 20% over the S&P 500, but then they come down gradually. So if you look at a five-year average difference between the S&P 500 and Berkshire's premium returns, it's actually dipped into negative territory three out of the last five years. So the question is, what's going on here? Has Buffett lost his sense of touch? The answer is no, that's not what it has to do. The answer is that Berkshire has become, because of Warren Buffett's success, because of his prudent capital allocation, has become such an enormous company that in order for him to continue generating those ridiculous returns that he did 40 years ago, he has to earn $60 billion. Let me give you the exact math. He has to earn $54 billion each year at Berkshire Hathaway in order to maintain that 19% annualized growth rate. So the returns are going down dramatically, but it's not because Buffett doesn't know what he's doing anymore by any stretch of the imagination. It's just because Berkshire has gotten to be so enormous.

Lapera: Yeah, think about it this way. Think about when you are first learning how to do a sport. Say it is soccer, which I don't really know that much about. Just minimal increases in your knowledge make you a much better player. Once you become the best player in the world, it takes a lot more knowledge to increase your performance as a player. It's the same thing with the company, except with returns. If you're a really small company, minor acquisitions or purchases or decisions can have a huge impact on how much return you get. The bigger you get, the bigger the changes you have to make to increase your performance. It's the same thing, which is something that I think a lot of people don't realize. They're like, "You're bigger, so you should be able to make more money," but it actually makes it harder to outperform what you did in the past. Sure, you are making more money as a whole, but as a percentage, it's not as much.

Maxfield: Yeah. And you know, when you see that chart, and I wrote an article about this, where you see the line comparing Berkshire's returns to the S&P 500, when you see that it's come down, it's now basically a little bit above the S&P 500 on a five-year average basis, a little bit below that or right around it, you know what this has led me to believe? Berkshire, at some point, it's going to get so big that it's just not going to be able to find enough places to invest its capital. And one of the things that Berkshire has always done, because Buffett is such a good capital allocator, is that it has retained all of its earnings. His thought process is, "If we retain our earnings, I'm going to make more on that money for our shareholders than if I returned it and they invested it elsewhere." But the situation this is putting Berkshire in is that may not be the case anymore, because it's gotten so big and it basically mimics the S&P 500 now. The S&P 500, in many cases, may even be better. I think there's an argument there. What that would lead one to believe is that there could be a point here where Berkshire pays a dividend, where that is the rational thing, and Buffett can't get around the fact that he's not going to be able to beat the S&P 500 the same that he has in the past.

Lapera: Yeah. I know he had something to say about buybacks, and I know that's where a lot of people's minds go to when they think about extra capital for companies. What did he have to say about buybacks?

Maxfield: Right. That's actually a great tie-in. There's two ways to return money. You can return it in dividends or you can return it in buybacks, by buying back stocks. And Buffett has been pretty tough on buybacks in the past. Let me give a little bit more context on this buyback conversation. Because of business confidence and consumer confidence and the slow-growth economy that we're stuck in, what a lot of businesses have been doing is, they've been taking all their earnings and, as opposed to reinvesting lot of those into business investments, because they don't see the return on those and they don't want to raise their dividend a whole bunch because then they're stuck at that rate forever more, they've been using buybacks as a pressure-release valve. The problem with that is, as you know, we're in the midst, maybe at the end, we're somewhere in this huge bull market where stocks have gone way up, so these companies are spending all this money on buybacks and buying back their shares at these really high values. The problem with doing that is, if you buy back at too high of a value, the company is actually destroying value. They're destroying value on a per-share basis. Just like if you as an individual investor paid too much for a stock. So Buffett has come out in the past and said, "Berkshire isn't going to do that. Berkshire would only buy back it stock if it trades for below 120% above its book value." But in his most recent letter, he has a really aggressive conversation about the fact that a lot of companies, while buybacks aren't necessarily good or bad as a general rule, a lot of companies in their application of the buybacks are wasting a lot of their shareholders' money.

Lapera: Yeah. It's definitely a really interesting conversation, and something that people should look at with other companies when they're thinking about buying. Is management responsible with buybacks? Because there is a point where Buffett will buy back shares of Berkshire Hathaway, but that's when he thinks Berkshire is being completely undervalued by the market, and not just because we have all this extra money and we don't know what to do with it. I want you to do one thing for me before we get on to the next Buffett thing, which is, pick out a quote that really stood out to you in this letter, and tell me about it.

Maxfield: Oh my God, I'm so glad you asked me that. We didn't prep for this ahead of time, but I have one for you, Gaby! It's your lucky day, it's your birthday a week and a half early!

Lapera: Thank you; this is what I've always wanted!

Maxfield: So in the conversation of the letter, in the very beginning of it, the first two paragraphs of Buffett's conversation -- and when you're a guy like Buffett, he is so smart, he knows how to order his letters. So there is significance to where in the letter certain things fall. And the closer to the beginning, they're probably pretty important. So he spends the first two paragraphs talking about this fact that, because they're getting so big, their returns aren't going to blow out of the market every year like they used to. But then, in the third paragraph, after teeing that up, he talks about the fact that, what you're going to see with Berkshire is that our returns are going to be lumpy. There are going to be some years where we have huge returns. It's in this context that he says this quote. "Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it's imperative that we rush outdoors carrying wash tubs, not teaspoons. And that we will do." So, what he's basically saying is that, "Look, we have accumulated an enormous amount of cash," and I don't have it off the top of my head, but, tens of billions of dollars' worth of cash that they're waiting to pool in on investments. And basically, what he's saying is, at this point, now, they're just waiting for that opportunity.

Lapera: Yeah. Which will maybe give them a little spike above the S&P 500.

Maxfield: That's exactly right. But it also speaks to where Buffett's brain is at, in terms of what he's thinking about the market. We know that the market has corrections regularly. Warren Buffett is basically saying, "I'm waiting for a very large correction." So you can work backwards from that.

Lapera: Yeah, which will be really interesting. Maybe some of these gains that we've seen, the "Trump bump" as some people are calling it, might be washed away. But that's also just the nature of the market. One last thing I wanted to touch on with Buffett before we move on to our next topic is, I don't know if you remember this, but back in 2008, Warren Buffett made this bet with some hedge fund managers, saying that he bet them the S&P 500 would outperform the hedge funds over a 10-year period. And whoever won, so, whoever's moneymaking device went up in a greater percentage over the course of the 10 years, would pay $1 million to a charity of their choice. And we are nearing the end of that. There's only one year left in that competition.

Maxfield: Yeah, we have one year. To recap, Buffett has basically said, "Nine years ago, I bet a hedge fund manager that a selection of hedge funds that they choose can't beat the S&P 500." So now, fast-forward to today, one hedge fund manager took him up on that offer, selected five hedge-fund funds of funds, that's a hedge fund that invests in other hedge funds, so that gives you even greater diversity, which would presumably give you a better chance to beat the S&P 500. The best of the five funds that this manager selected is up 62.8% since the bet was made. The S&P 500 is up by 85.4%. And that was the best group, by far. The other ones are like 2.9%, 7.5%, 8.7%, and 28.3%.

Lapera: That's so rough.

Maxfield: Yeah. And it just goes to show, and he talked extensively about this in the letter, maybe these investors -- the rate structure for hedge funds, they pay a ton of money for these things -- maybe there isn't as much value there as people think.

Lapera: Yeah, and this is a big thing that Warren Buffett is about, and The Motley Fool, to some extent, too. If you don't have time to closely monitor your investments, consider investing in the S&P 500. It will probably get you a better rate of return over time for much cheaper than a hedge fund, without the potential pitfalls of owning individual stocks. But yeah, I bet those hedge fund managers are kept up at night by this bet.  

Maxfield: Yeah, but you know what I love about this? Buffett is basically telling people, "Look, complicated investing isn't necessarily the best investing." The Motley Fool, we're a company that speaks to individual investors that don't have all the money and sophistication to pour into developing models and doing all of these things. And what this shows is, you don't need that to compete in the markets in a competitive way. It's just a reassuring thing for investors, and it's something that I think investors should really listen to, and take that advice.

Lapera: Yeah. So on the back half of our show, I don't know if you remember doing this, I don't know if our listeners remember this, we had a stock face-off series of shows a couple weeks ago, where Industry Focus hosts and analysts talked about some stocks that they liked, and I agreed that at the end of it that I would buy stocks if I liked them, and if they had done a good job selling me on it and I did a good job convincing myself that I actually wanted to buy them. So I wanted to talk a little bit about which stocks I actually ended up buying. I will say that before I decided to buy, I looked at all the fundamentals, and all of them looked very good on every company, which you might expect, because Industry Focus hosts and analysts were the people who had picked the companies. So I'm going to talk to you about some of the qualitative things that helped me make my choice. As you remember, Maxfield, you and Jordan Wathen, you actually pitched JPMorgan Chase (NYSE: JPM), and Wathen pitched Moody's (NYSE: MCO). I ended up picking JPMorgan Chase, and the reason basically comes down to the weight that both of these companies behaved during the financial crisis and the period leading up to the financial crisis. JPMorgan Chase did a great job of managing its risk, and Moody's was one of the reasons that the financial crisis happened, one could say, and that has made me not trust them very much in the long term. And I'm not really sure that they have fixed the problems that caused them to mislabel certain securities. So, JPMorgan Chase was my winner there. And I felt like, as the Financials host, I have to own at least one bank. I felt like I was cheating listeners by not owning at least one bank.

Maxfield: Let me say something really interesting that I learned the other day about the rating agencies. Earlier in the week, I was on the phone with a CEO of one of our really large banks. And he told me that the ratings agencies are his single most important constituents. Above shareholders, above the board of directors, above regulators, above customers, above analysts. And I thought, "Wow, that's such an interesting point." Sorry, that's just a random thing, but I thought you would find it interesting.

Lapera: Yeah, that's definitely very interesting. And who knows, maybe my opinion about Moody's will change eventually, when I have more money to invest. But for now, I could only pick one, and JPMorgan Chase was my choice.

Then, in the American Outdoor Brands (NASDAQ: AOBC)-versus- [Anheuser Busch InBev] (NYSE: BUD) faceoff, I ended up going with American Outdoor Brands, mostly because I thought their umbrella business model was really interesting, the fact that they were getting into more technical things that they could do, they were buying these companies that had a lot of niche expertise, and they have a lot more room to grow versus the AB InBev of beer, which is basically a giant monolith of beer.

For healthcare, threw a little bit of a curveball, I ended up buying both [Gilead Sciences] (NASDAQ: GILD) and Illumina (NASDAQ: ILMN), because I think both of them have a lot of potential. Illumina, I really wish I had one of their machines when I was doing my master's work, I could have done so many very interesting things. But, alas, I was a lowly grad student without access to one in a lab. And Gilead, I think, has a lot of room to grow, and it's a little undervalued at this point. 

[8point3 Energy Partners] (NASDAQ: CAFD) versus [General Electric] (NYSE: GE), I went with GE because the energy space, frankly, scares me, and I understand what GE does. I'm still not 100% sure what 8point3 does. For Shopify (NYSE: SHOP) versus Facebook (NASDAQ: FB), unfortunately I couldn't buy either of them. Remember, if you will, that I mentioned that The Motley Fool has a great number of trading restrictions. We have trading restrictions on both Shopify and Facebook because we are using them for some unknown internal purpose, at least to me. But for the record, I would have bought Shopify, because I think their story was the more compelling of the two, even if their fundamentals work, perhaps, not as compelling. But yeah, that's what I ended up picking. If you guys have any questions about why, go ahead and ask me. I don't know that I'll be able to answer them satisfactorily to you. I hope you guys enjoyed that week, I got a lot of feedback saying that you did, and maybe we'll be able to do something like that again in the future. Maxfield, thank you very much for joining us, and happy birthday again.

Maxfield: Thank you very much, always a pleasure, and happy birthday in advance for you.

Lapera: Oh, thank you very much. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Obviously, I have a great deal of interest in the stocks that I just mentioned. Definitely don't buy those based solely on what you've heard from me. That would make me feel very bad, especially because I checked my portfolio this morning and it was a lot of red, and that's a very sinking feeling that has not yet risen from my gut. Also, I have this book in the studio that I've actually been using it to silence the clink of my cup as I put it down on the table; it is Buffett: The Making of an American Capitalist, by Roger Lowenstein. Since we talked about Warren Buffett today, this is a great book. You should go ahead and buy it and not just use it to stop your mug from making noise when you set it down on the table. Contact us at [email protected], or by tweeting us @MFIndustryFocus. If you want to talk to us, I would love to hear you talk. Thank you very much to Austin Morgan. I missed you last week, Austin.

Austin Morgan: I was having fun, not here. I was hanging out in Nashville, and it was awesome.

Lapera: Well, in that case, I don't feel bad for you at all, and I don't miss you anymore. But thanks for being today's producer. And thank you to you all for joining us. Everyone, have a great week!