Few people wait with bated breath so they may read an annual shareholder letter. Very few people, however, craft so fine a shareholder letter as Warren Buffett.
Mr. Buffett has served as the Chairman of Berkshire Hathaway since the 1960′s, and during that time has become America’s most well known – and most successful – investor. In this year’s shareholder letter, Mr. Buffett highlights his firm’s financial success in the first paragraph:
“The per-share book value of both our Class A and Class B stock increased by 4.6% in 2011. Over the last 47 years (that is, since present management took over), book value has grown from $19 to $99,860, a rate of 19.8% compounded annually.” (emphasis supplied)
Investment professionals are drawn to Mr. Buffett because of his knowledge of value investing. Investors envy his near 20% annualized return track record. I suggest, however, that everyone would benefit from reading Mr. Buffett’s letters, including those from past years. The home-spun wisdom offered by Mr. Buffett applies to investing particularly, business broadly, but also to life in general.
Just this year, for example, I was taken by the following nuggets from Mr. Buffett:
1. “Buy commodities, sell brands.”
Mr. Buffett explains that this “has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886 and Wrigley since 1891.”
Simply: buy goods cheaply, develop a brand about them, sell them for more.
2. Great companies create cash flow.
Mr. Buffett trumpets the “float” created by Berkshire Hathaway’s various insurance operations – namely, premiums paid by insurance customers creates cash that Berkshire Hathaway gets to invest and profit from while waiting to pay claims. A CFA charter is not needed to see that you would rather receive interest (own bonds, have savings, etc.) then pay interest (have debt, etc.).
Businesses – and families – that have net positive levels of cash flow succeed.
3. Lower stock prices can be more beneficial.
Mr. Buffett, when talking about volatile stock prices says: ”If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.”
If you are still working and are consistently saving, lower stock prices mean you can buy more shares – period.
4. To achieve real positive returns, you must outdistance taxes and inflation.
Mr. Buffett offers the following about Treasury returns: “For tax-paying investors like you and me, the [purchasing power] picture has been far worse. During the [past] 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and [inflation] would have devoured the remaining 4.3 points.”
Investments limited to fixed income likely create a loss of real purchasing power – for this reason, even our most elderly investors need to consider an equity exposure in their portfolio.
5. Gold creates nothing, and pays no dividend.
Mr. Buffett explains the perils of investing in gold in a few paragraphs better than I can summarize – here is his take in its entirety: “[A] major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.
This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.
The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.
Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”
In short – commodities are a vital part of a diversified portfolio; however, neither Mr. Buffett nor Swendiman Wealth Strategies, Inc. will be driving to Fort Knox soon.