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Buffett's Latest Letter

A hodgepodge of my thoughts on Buffett's shareholder letter.

Samuel Lee, 03/18/2014

A version of this article was published in the March 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.

Warren Buffett's latest letter to shareholders of Berkshire Hathaway BRK.B came out on March 1. It's excellent. Every serious investor should read the whole thing. I've pulled out a few interesting nuggets to elaborate upon.

Changing Yardsticks?
The first thing I did on the morning of March 1 was fire up my tablet to download and read the letter. I was a bit groggy, so I ended up rereading the following passage three times or so to make sure my brain wasn't playing tricks on me:

"Over the stock market cycle between year-ends 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."

In the past, Buffett measured Berkshire's book value growth against the S&P 500 over rolling five-year periods. This year broke his streak. He did not acknowledge this fact. He cited six-year performance instead.

I think he made a mistake. Technically, he did not change his yardstick of per-share book-value growth (itself a proxy for intrinsic value). However, making a big deal out of rolling five-year returns and then citing six-year returns with nary a word of explanation leaves a poor impression, if only because Buffett has set the standard for intellectual honesty so high. Bloomberg ran an article titled "Buffett Alters Yardstick After Berkshire Falls Short of Goal." It was quickly (and quietly) retitled "Buffett Sets Fresh Goal as Berkshire Misses Five-Year Target."[1]

This isn't the first time Buffett has seemingly changed his targets. In a July 1961 letter to his limited partners, Buffett wrote, "First, one year is far too short a period to form any kind of an opinion as to investment performance...My own thinking is much more geared to five year performance, preferably with tests of relative results in both strong and weak markets."[2] A couple of years later, he set a more stringent test: "If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market."[3] Keep in mind Buffett was writing to the limited partners of a tiny, concentrated, activist hedge fund. It might be overly harsh to hold him to a three-year performance standard piloting the supertanker that is Berkshire. (It's worth noting Buffett compensates his lieutenants Ted Weschler and Todd Combs based on three-year returns versus the S&P 500.)

I think we can put to rest any worries that Buffett was trying to pull a fast one. His ideal standard has long been to measure performance over a market cycle, as his letters from over 50 years ago show. The five-year period covering 2008-13, trough to peak, definitely counts as a "speculative explosion in a bull market." A peak-to-peak measurement period is more sensible than arbitrary rolling periods, particularly when comparing assets with very different betas. I think it should be the main period over which managers are assessed. Many managers who have posted phenomenal results over the past few years will likely post equally phenomenal losses when the cycle turns.

Samuel Lee is an ETF Analyst with Morningstar.

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