In this "What's Up, Bro" segment from the episode of Motley Fool Answers, Alison Southwick and Robert Brokamp -- with some help from Scott Phillips of The Motley Fool Australia -- consider the most interesting takeaways from Warren Buffett's latest letter to Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) shareholders.
Following his suggestions may not make you a billionaire, but his reflections on the nature of risk, asset allocation, when to buy, debt, and buying on margin should guide you toward the future you're trying to reach by investing.
A full transcript follows the video.
This video was recorded on March 6, 2018.
Scott Phillips: What's up, Bro?
Robert Brokamp: Well, there's this guy in Omaha who writes a letter. Yes, so Warren Buffett's annual letter, highly anticipated every year, came out toward the end of February. It's many pages long, but I came away with four takeaways that are sort of financial planning, investing related. I'm sure, Scott, you have some thoughts. But I'll start with No. 1 and that is the wind is at investors' backs and for two reasons.
The opening paragraph of the letter has been basically following the same format for 30 years. Just the numbers change. It begins this year with Berkshire's gain in net worth during 2017 was $65.3 billion. However, in the next paragraph he points out that only $36 billion of that came from operations. The other $29 billion just came because of the new tax law. A lot of investors have been thinking [about the new changes in tax law] -- which among other things lowered the tax rates for corporations -- and how that is going to affect my investments.
Buffett addresses it right out of the gate in the letter and says that basically it almost doubles the amount that they can contribute to their growth in net worth. And that's just the beginning. Many companies are going to see the same sort of boost to their bottom lines because of the new tax law, so that's one way that investors have the wind at their backs. He didn't use that phrase talking about taxes, but he did use that phrase in another context. That is a recurring theme with Buffett.
He pointed out that he and his partner, Charlie Munger, don't look at their stocks as tickers that you buy and sell based on what a pundit says, or whether it's up or down, or what the market is doing over the first few months of the year, like in this year where the market has been suffering significant volatility. They see it as basically being partners in long-term businesses. He said that is basically the wind at the back as a typical equity investor in America.
Now, I assume in Australia, you sort of feel the same way in that over the long term, clearly when you look at it you've got the wind at your back.
Phillips: Yes, you've got it, Bro. The Australian market -- Australia is kind of like America's little brother. Joe Magyer, our colleague, who some of your listeners may know was here as well, this week, and he was talking about the fact that America and Australia, we're kind of cousins. We had the same parent in the U.K. way back in the day. You guys separately a little more violently than we did, but in any case, kind of same idea. So, we are very similar as an economy, as people, as markets. Absolutely. I like to call it democratic capitalism and the power of that is just amazing. We have very much the same sort of systems and laws in entrepreneurship that you guys have, here.
Brokamp: Right. That brings us to No. 2 and that is bonds are actually riskier than stocks when you look over the long term. And there are different ways to define risk. Buffett in the letter defined it as "investing is an activity in which consumption today is foregone in an attempt to allow for greater consumption at a later date. 'Risk' is the possibility that this objective won't be attained.'"
And he said if that is your definition of risk, investing in so-called risk-free bonds is actually not going to get you to where you want to be, mostly due to pretty low returns, as well as the loss of purchasing power during inflation. Certainly, in any given year, as he points out, the stock market is riskier than bonds, but if you're looking at it over a longer time frame, it's actually riskier to be in bonds, because you're not going to be able to meet your goal.
He pointed out in his letter that over all of the 43 10-year holding periods since he's been in charge of Berkshire since 1965, in all of those 10-year periods, the market has been up more than it has been down. That does not mean, by the way, that over all those 10-year periods the S&P 500 has made money, and there have been a couple where it's lost money and those are actually relatively recent periods that ended in 2008 and 2009. There have been several where when you look over a 10-year period, the annualized returns were in the low single digits, so it's not been great, but over the long span of history, when you look at 10 years or longer, you're more likely to make money than not.
Alison Southwick: No. 3.
Brokamp: No. 3. You might take that to conclude that you should put all your money in the stock market. All in. But actually, that's not Warren Buffett's advice. At the end of 2017, Berkshire held $116 billion in cash and U.S. Treasury bills which is up from $86 billion at the end of last year. Actually, they're building up their cash hoard. Why is that? On the one hand he's saying it's silly to be investing in these low-returning, fixed-income investments. On the other hand, they keep building up this big pile of cash.
There are two reasons for that. One of them is in the letter Buffett says it makes sense to buy stocks at the right prices. In the letter he basically said we cannot find bargains at this point. All the deals they looked at last year -- the prices were just too high. They're willing to sit on cash and wait for better prices.
And then the other part is basically an emergency fund, and he cited the fact that in 2008 and 2009, when many people were panicking, even some of the biggest banks were finding someone to lend them money because they had such a cash crunch. Berkshire was able to say, "OK, we'll lend you money" because they had the money, and they want to be in that position, so some sort of macroeconomic event isn't going to cause them to go begging to a bank.
But it's also important to remember that Berkshire is largely an insurance company. Buffett estimated in the letter that in any given year, there's a 2% chance that there could be a mega catastrophe that costs $400 billion dollars. To put that in context, he estimated that the hurricanes from last year that affected Texas, Puerto Rico, and Florida cost $100 billion. So, he's saying there's a 2% chance in any given year that we could face a catastrophe four times as expensive, but because Berkshire's an insurance company, they have to have that money on hand to cover those claims.
He said elsewhere that he thinks most people should have about 10% of their assets in Treasuries. That's what he actually lays out for his wife in his will if he dies before her -- that 10% of her money should be in short-term Treasuries.
Southwick: And Bro's final takeaway.
Brokamp: And the final takeaway is to avoid debt. He talks about it first of all again so that you don't have to go crawling to the banks. But also, you should not be borrowing money to invest, which is basically buying stocks on margin. I bring this up because that's one of the possible reasons why we've seen volatility this year. It's what happens when you borrow money to buy stocks.
When the stock goes down, the broker [either A, asks you for more money or B, sells your holdings]. It's a bit of a snowball. He highly recommends that you don't do that, and he cites four examples of where Berkshire's stock dropped approximately 50% throughout his history. You never know when that's going to happen.
The irony of this is that according to FINRA, margin debt is at the highest level it's ever been. Almost two-thirds of $1 trillion has been borrowed to buy stocks. It's a potential risk for many of those people, but it's a potential risk for all of us. To the degree that margin debt is causing some of this volatility, we could see more of it in the future.
Southwick: You're saying margin debt for people, but I imagine it's mostly institutions. Or is it mostly individuals?
Brokamp: That's a good question. I don't know how it breaks down, but there's no question that there are a lot of people out there borrowing money to invest.
Brokamp: Very scary.
Phillips: Oh, and those market positions, too, where you see that happen. The higher the market goes, the more people pile into leverage, which is exactly the wrong thing to be doing. We talk about being contrarian investors or, to Bro's point, making sure you find good value before you buy. As the market goes up, the optimism takes off. The exuberance takes off, so they'll borrow more because the shares are higher. They'll borrow more because shares are higher, and they borrow more, and then shares are lower.
And to Bro's point, when it falls 50%, the bank comes knocking. You could lose effectively all your equity or a very large chunk of what you started with just because you chased the market. Optimistic exuberance does tend to correlate with higher share prices, which ironically, to throw out a Buffetism, you want to be greedy when others are fearful and fearful when others are greedy. Margin borrowers tend to get greedy when people are greedy, and that's exactly the wrong way to go about it.
Southwick: Buffett said in his letter that the wind is at investors' backs, which means it's a good time to be an investor. Is that essentially what he's saying? If we're taking the greedy when fearful, fearful when greedy, at some point he needs to say that the wind is not at our backs, but he never does.
Brokamp: I think there's a bit of a contradiction in the letter. He's saying we cannot find deals, so we are not going to invest.
Southwick: But the wind's at our back.
Brokamp: Right. On the other hand, he wants the average investor to just keep holding on through the ups and downs, and I think that, in the end, is the difference when you are a Buffett who has demonstrated the ability to deploy cash in a smart way. Be happy sitting on cash when you can't find a bargain and then be gutsy enough to deploy it when bargains abound. Like in 2008 and 2009 for the people who were gutsy to be buying stocks back then, as opposed to pulling money out of the market makes total sense. But I think what he's saying is for the average investor, don't try to do that. Buy stocks gradually with your 401(k) or whatever and just hold on for the long term.
Phillips: That's it, Bro. If you can be Buffett, be Buffett. If you can't, dollar-cost average, because it's kind of the next best thing.
Southwick: And guess what? You can't be Buffett. Maybe you can be David Gardner. If you're David Gardner.
Brokamp: By the way, I'm a Berkshire shareholder...
Phillips: As am I for this question.
Brokamp: And over the last five or 10 years it's been about the same as the market which, when you think of that, that's not an awesome investment. Not a horrible investment. When you look at the fact that he's still sitting on so much cash and still matching the market or slightly beating it, that's pretty impressive.
Phillips: About a quarter of the company's market cap is now in cash, so he's basically running 1.5 times as fast to keep up at a company level because of all that cash.
Southwick: But we talked about this in last week's episode -- about the risk of staying in cash so heavily.
Brokamp: Right. Well, I thought about that. I'm sure someone looked at it and said, "What if Buffett, every time he couldn't find individual bargains, just used some of his cash for an S&P 500 index fund and then sold the index fund if he found a bargain." Because of the insurance company aspect, he does have to have a lot of cash on hand. I'd be curious what those returns would look like, but he's happy to sit there and have so much in cash waiting for a solid bargain.
Southwick: I'm also curious about what percentage of his returns come from what sources. Because if you look at the actual companies that Berkshire Hathaway owns, it's like Dairy Queen? Brooks Running?
Brokamp: Fruit of the Loom.
Southwick: See's Candies. Are you out of your mind?
Phillips: Yeah. The Oriental Trading Company.
Southwick: Like Oriental Trading Company? I'm sorry. I wouldn't invest in these companies, but they show them off at the shareholders' meeting, and it's kind of fun, I guess, to have actual products there.
Phillips: I may possibly have a pair of Brooks with Warren Buffett's face on them.
Southwick: Which I would kill... I think Mike Olsen has like a little running jacket from the Warren Buffett 5K that they do.
Phillips: There you go.
Southwick: I'm like, "I would murder you for that jacket." It's so adorable. It's got this little cartoon of Warren Buffett on it. Ach! So cute. The letter gets so much attention when it comes out. And usually I feel in the past we've had more definitive takeaways, whereas this letter, at least from hearing your take on it, [has me] scratching my noggin. I guess it isn't a barnstormer of a letter this year for me.
Brokamp: I would say that it is particularly good reading given what we've seen in the market this year. As we speak today, it's the second day of March and the Dow is already down like 800 points so far this month. In situations like that, if you're getting nervous it's a great letter to read, both in terms of feeling comfortable about the long term, but also feeling comfortable with maybe having a little bit of cash on the side.
Phillips: I've got to say that for any investor who's slightly new to being better at investing, start with Buffett's consolidated letters, whether you buy the book and read the letters, themselves. Give yourself an education. That's how you learn this stuff. After that it's kind of like going to church.
Brokamp: That is so true.
Phillips: Read the letter or go to the annual meeting. I've done both a couple of times. It's the preacher up front saying, "Now don't forget." Like this is the thing. Like, "Yeah, yeah, we know, we know." In a positive way. In the sense that sometimes it just helps. You walk away from those meetings, walk away from his letters going, "That's why I remember that thing."
Buffett's line -- he talks about leveraging in one particular part and Bro's already touched on that and he uses a version of this quote every time, but he says [and Charlie Munger] that both of us believe it is insane to risk what you have and need in order to obtain what you don't need. It's pretty common-sense logic, right? And then out there somewhere else -- was it two-thirds of $1 trillion, Bro, in margin loans. And so, we know that's right. And to hear that again and again, it's like, "OK, OK. Good point, good point." When I feel like I'm starting to think maybe that one makes sense. Maybe I should go and take a flyer or risk over here. But no, just remember that at the front pew of the church, the preacher is pointing at you saying, "You know? Lift your game. That's kind of the story."
Southwick: You two are going to start going door to door saying, "Excuse me, ma'am. Do you have time to hear about the good story of Warren Buffett?"
Phillips: This is Brother Boomerang and Brother Bro.
Southwick: You'll get far with that accent, though.
Phillips: We are here to show you...
Southwick: Don't underestimate his accent.
Brokamp: Totally. I'll just be the pretty face. You do all the talking.
Phillips: The Gospel of Warren.
Brokamp: If you find a pretty face, we're in trouble.