Warren Buffett released his annual letter to Berkshire Hathaway (NYSE:BRK.B) shareholders on Saturday. While Berkshire shareholders and anyone with a serious interest in investing might consider reading the whole thing, here are some highlights of Warren's wisdom.
On Berkshire's intrinsic value: "As I've long told you, Berkshire's intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That's why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount."
On Berkshire's performance in this cycle: "Over the stock market cycle between yearends 2007 and 2013, we overperformed the S&P. Through full cycles in future years, we expect to do that again. If we fail to do so, we will not have earned our pay. After all, you could always own an index fund and be assured of S&P results."
On investment and operating performance: "Since 1970, our per-share investments have increased at a rate of 19.3% compounded annually, and our earnings figure has grown at a 20.6% clip. It is no coincidence that the price of Berkshire stock over the 43-year period has increased at a rate very similar to that of our two measures of value. Charlie [Munger] and I like to see gains in both sectors, but we will most strongly focus on building operating earnings."
On the Heinz deal: "Though the Heinz acquisition has some similarities to a 'private equity' transaction, there is a crucial difference: Berkshire never intends to sell a share of the company. What we would like, rather, is to buy more, and that could happen."
On Berkshire's elephant herd: "With Heinz, Berkshire now owns 8 1⁄2 companies that, were they stand-alone businesses, would be in the Fortune 500. Only 491 1⁄2 to go."
On Berkshire's "Powerhouse Five": "MidAmerican [Energy] is one of our "Powerhouse Five" -- a collection of large non-insurance businesses that, in aggregate, had a record $10.8 billion of pre-tax earnings in 2013, up $758 million from 2012. The other companies in this sainted group are BNSF [Railway], Iscar, Lubrizol and Marmon. Of the five, only MidAmerican, then earning $393 million pre-tax, was owned by Berkshire nine years ago."
On Berkshire's insurance operation: "Berkshire's extensive insurance operation again operated at an underwriting profit in 2013 -- that makes 11 years in a row -- and increased its float. During that 11-year stretch, our float -- money that doesn't belong to us but that we can invest for Berkshire's benefit -- has grown from $41 billion to $77 billion. Concurrently, our underwriting profit has aggregated $22 billion pre-tax, including $3 billion realized in 2013."
On investing in the U.S.: "Our subsidiaries spent a record $11 billion on plant and equipment during 2013, roughly twice our depreciation charge. About 89% of that money was spent in the United States. Though we invest abroad as well, the mother lode of opportunity resides in America."
On the U.S. as a long-term bet: "Charlie and I have always considered a 'bet' on ever-rising U.S. prosperity to be very close to a sure thing. Indeed, who has ever benefited during the past 237 years by betting against America? If you compare our country's present condition to that existing in 1776, you have to rub your eyes in wonder. And the dynamism embedded in our market economy will continue to work its magic. America's best days lie ahead."
On being beaten by his portfolio managers: "In a year in which most equity managers found it impossible to outperform the S&P 500, both Todd Combs and Ted Weschler handily did so. Each now runs a portfolio exceeding $7 billion. They've earned it. I must again confess that their investments outperformed mine. (Charlie says I should add 'by a lot.') If such humiliating comparisons continue, I'll have no choice but to cease talking about them."
On Todd Combs' and Ted Weschler's roles: "Todd and Ted have also created significant value for you in several matters unrelated to their portfolio activities. Their contributions are just beginning: Both men have Berkshire blood in their veins."
On Berkshire's "Big Four" stock investments: "Berkshire increased its ownership interest last year in each of its 'Big Four' investments -- American Express, Coca-Cola (NYSE:KO), IBM (NYSE:IBM) and Wells Fargo (NYSE:WFC) ... And, if you think tenths of a percent aren't important, ponder this math: For the four companies in aggregate, each increase of one-tenth of a percent in our share of their equity raises Berkshire's share of their annual earnings by $50 million."
On growth opportunities in energy: "From a standing start nine years ago, MidAmerican now accounts for 7% of the country's wind generation capacity, with more on the way. Our share in solar -- most of which is still in construction – is even larger."
On GEICO's competitive advantage: "When I was first introduced to GEICO in January 1951, I was blown away by the huge cost advantage the company enjoyed compared to the expenses borne by the giants of the industry. That operational efficiency continues today and is an all-important asset. No one likes to buy auto insurance. But almost everyone likes to drive. The insurance needed is a major expenditure for most families. Savings matter to them -- and only a low-cost operation can deliver these. GEICO's cost advantage is the factor that has enabled the company to gobble up market share year after year. Its low costs create a moat -- an enduring one -- that competitors are unable to cross."
On Berkshire's "hidden" stake in Bank of America: "Berkshire has one major equity position that is not included in the table: We can buy 700 million shares of Bank of America (NYSE:BAC) at any time prior to September 2021 for $5 billion. At yearend these shares were worth $10.9 billion. We are likely to purchase the shares just before expiration of our option. In the meantime, it is important for you to realize that Bank of America is, in effect, our fifth largest equity investment and one we value highly."
On his $893 million investing error: "Most of you have never heard of Energy Future Holdings. Consider yourselves lucky; I certainly wish I hadn't. The company was formed in 2007 to effect a giant leveraged buyout of electric utility assets in Texas. The equity owners put up $8 billion and borrowed a massive amount in addition. About $2 billion of the debt was purchased by Berkshire, pursuant to a decision I made without consulting with Charlie. That was a big mistake. Unless natural gas prices soar, EFH will almost certainly file for bankruptcy in 2014. Last year, we sold our holdings for $259 million. While owning the bonds, we received $837 million in cash interest. Overall, therefore, we suffered a pre-tax loss of $873 million. Next time I'll call Charlie."
On watching the playing field: "With my two small investments [Note: Buffett is referring to a farm and a New York commercial real estate property], I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field -- not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays."
On ignoring market chatter: "Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment: "You don't know how easy this game is until you get into that broadcasting booth.")
On speculation as a losing game: "If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
On investing in stocks as you would in a farm: "If 'investors' frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties. Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm."
On the folly of panic selling: "During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And, if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well. Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?"
On a simple test for stock selection: "When Charlie and I buy stocks -- which we think of as small portions of businesses -- our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings -- which is usually the case -- we simply move on to other prospects."
On investing for the nonprofessional: "I have good news for these nonprofessionals: The typical investor doesn't need this skill. [Note: Buffett is referring to the ability to forecast a business' future earnings power.] In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners -- neither he nor his 'helpers' can do that -- but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal."
On the simplest, best investment strategy for individual investors: "My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I've laid out in my will. ... My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions or individuals -- who employ high-fee managers."
On avoiding market (mis)timing: "The 'when' [of investing] is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs' observation: "A bull market is like sex. It feels best just before it ends.") The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs. Following those rules, the 'know-nothing' investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results."
On the best investment he ever made: I learned most of the thoughts in this investment discussion from Ben's [Graham's] book The Intelligent Investor, which I bought in 1949. My financial life changed with that purchase. ... For me, the key points were laid out in what later editions labeled Chapters 8 and 20. (The original 1949 edition numbered its chapters differently.) These points guide my investing decisions today. ... Of all the investments I ever made, buying Ben's book was the best (except for my purchase of two marriage licenses).