This guest post on Warren Buffett Letter To Shareholders: Rock Band ACDC was submitted by The Broken Leg Investment Letter subscriber Xavier Hill. The thoughts and opinions expressed here are those of the author and may not reflect those of anybody else at Broken Leg Investing. Article image (Creative Commons) by markusspiske and niekverlaan, edited by Broken Leg Investing.
On the 24th of February the Berkshire Hathaway annual letter to shareholders was released and it did not miss. Perhaps one of the best yet, it combines the acid tongue of Charlie Munger, the business insights of Buffett, and the writing wit of Oscar Wilde. Why does this years rate as one of the best? What can it tell investors about today’s market? And why is Berkshire Hathaway’s approach to investing the same as legendary rockers Peter Gabriel and ACDC’s approach to making music?
Buffett’s annual letter to shareholders is a must read for deep value investors, like a shortened version of the Berkshire Hathaway AGM that you can read whenever you have the time. As I was reading it, I heard Peter Gabriel’s “Sledgehammer” come over spotify and the parallels were uncanny.
Peter Gabriel, who had a string of music hits in the 80’s and 90’s both as a solo artist and as part of the band Genesis with Phil Collins, was once asked why his music was never considered fashionable. He responded that “whilst my music has never been in fashion, the benefit of that is it has never been out of fashion either.” Similarly when the Young brothers from AC/DC where interviewed and were questioned as to why all their songs sound the same, Angus Young said “it’s like baking a cake“ and that they just follow a recipe. Unlike other big groups who change their style with the times (i.e Madonna, or who could forget the god awful “Pop” by U2), they change their style for no one, but they still keep their formula relevant to today’s market.
It is clear that the Berkshire Hathaway recipe will never change and in markets trading at record highs, the principles of value investing, while never in fashion, can never go out of fashion. Like most deep value investors, I am very cautious in today’s high price market and this year’s annual letter to shareholders is full of warnings for today’s deep value investor.
CEO’s, Boards, Parents And Teenagers
With record low interest rates Buffett is clearly worried about boards - fuelled by cheap debt - instructing CEO’s to go on the hunt for acquisitions of questionable businesses at even more questionable prices. As Buffett says:
Why the purchasing frenzy? In part, it’s because the CEO job self-selects for “can-do” types. If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.
Buffett in the annual letter to shareholders goes on to say what he has always said about valuing a business and his views of Wall Street but updated to today’s world:
Investment bankers, smelling huge fees, will be applauding (acquisitions) as well. (Don’t ask the barber whether you need a haircut.) If the historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint.
It is still the same message as it was 50 plus years ago. Investors need to be skeptical of Wall Street and should always look to use basic calculations to determine an asset’s value, and not rely on the false precision of a spreadsheet.
As Buffett wryly notes whilst the rest are falling over themselves to get deals done, ”the less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.”
I feel this is the key message for deep value investors in this year’s letter. In today’s environment we must exercise greater prudence than ever before.The siren song of Wall Street is so tempting yet it must be ignored.
As a coupe de grace to the practices of Wall Street, in the annual letter to shareholders Buffett gives all the gory details of his winning bet against Wall Street.
Bet Pays Off. The Power Of Psychology
Buffett’s bet with Protégé Partner’s fund of funds that an S&P 500 index ETF would outperform any group of hedge funds over a 10-year period finished on the 19th of December 2017. Under the terms of the bet, the names of the funds involved are not made public. However these funds charge 2.5% on the principal alone every year so they make money even when investors lose. This meant Buffett was always going to win and the result is remarkable. A 36% final return vs 126%. The table below shows just how comprehensively Buffett won.
Buffett rubs much salt into this gaping wound and then repeats the same message he has given throughout his incredible career.
The bet illuminated another important investment lesson: Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.
The annual letter to shareholders devotes much time to the importance of investor psychology and reading between the lines I feel it is clear Buffett is steeling investors for troubles ahead.
He writes about the 4 major bear markets Berkshire has experienced, that this is normal and investors must be psychologically prepared for big bear markets (refer to the table below).
The annual letter to shareholders goes as far as to recite the famed poem If by Robert Kipling to illustrate the importance of psychology:
“If you can keep your head when all about you are losing theirs . . .
If you can wait and not be tired by waiting . . .
If you can think – and not make thoughts your aim . . .
If you can trust yourself when all men doubt you . . .
Yours is the Earth and everything that’s in it.”
With Buffett seeing the current market as fully priced, too much debt fuelled acquisition, quoting poets and devoting so much prose to the importance of investor psychology, the hidden message I believe is clear. There is likely a bear market ahead, though nobody knows when.
Now more than ever, deep value investors need to be psychologically prepared for a down turn. Though just as Buffett is not selling any of his businesses in today’s market, neither should we. For no matter how cheap or expensive a market becomes, there are always stocks that outperform and it is our job to carefully look using the 7 core principles of deep value investing to find them. Few of these stocks exist in the traditional markets of the US or the UK and even fewer exist amongst large capitalisation companies. You often need to look further afield and very hard, or alternatively you can just check Broken Leg Investing!
This years’ Berkshire Hathaway annual letter to shareholders is one of the best I have read. As I read it I felt calmer as I question today’s stock prices. Buffett’s transparency is refreshing in today’s purposely opaque world of investing, whilst his writing skills and wit make it fun to read. The end of the letter re-affirms my belief that the principles of value investing are just as relevant today as they have always. Though in today’s market of all of the tenants of value investing we need to honour, psychology is looming as the most important of all.
For true Buffettologists you can live stream Berkshire’s AGM from 8:45 am US Central Time.