Buffett's Latest Letter

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.

Understanding Buffett's Vanguard Portfolio
Buffett repeated his standard investing advice for most investors: own a broad cross-section of U.S. firms through an S&P 500 Index fund. Dollar-cost average into it. What's new is he disclosed that his will offers the same advice to the trustee who will manage his wife's assets: 90% in a Vanguard S&P 500 index fund and 10% in short-term government debt.

This ain't your standard index-fund portfolio. It's even more extreme than the radically simple three-fund portfolio popular with the most devout passive investors.

He suggests owning only U.S. stocks, a preference he's expressed almost his entire career. Why not European, Japanese, or emerging-markets equities? I think it boils down to a strong belief in American exceptionalism. He treats U.S. stocks as a sure thing over decades-long spans, a view that many financial economists reject. From what I can piece together from his writings and interviews, Buffett thinks America's strong rule of law, democratic institutions, meritocratic system, entrepreneurial culture, abundant human capital, and ample financial and natural resources create a near-unsurmountable qualitative advantage over other countries. In other words, America has a moat.

I share Buffett's belief that America is endowed with unusual attributes that encourage human flourishing and prosperity--and that these attributes will be around for a long time. History shows institutions, the mechanisms by which a society organizes itself, are highly persistent. Careful work by many economists suggests institutions can exert an effect on economic growth even centuries later. Daron Acemoglu, Simon Johnson, and James A. Robinson wrote an influential paper in this genre showing how different colonization strategies by Europeans in the 17th to 19th centuries can explain a good chunk of the variation in per capita income we see in former colonies today.[4] Given the myopic nature of markets, I find it highly plausible that investors persistently underestimate the long-term advantages of sound institutions.

This is not to say Buffett would disapprove of international-equity exposure under all or even most circumstances. He has bought at least one speculative small-cap Chinese stock and has ventured abroad plenty of times. He has even written long-dated put contracts on developed-markets stock indexes (but no emerging-markets stock indexes), so he is probably not opposed to passively owning stocks in countries with the rule of law and rational business cultures.

Where Buffett really breaks with conventional wisdom is his advice to not own too many bonds, at least as a static allocation. His advice is almost the exact opposite of finance professor and lifecycle investing expert Zvi Bodie's recommendation to invest almost everything in inflation-protected bonds--even at today's near-zero real yields--and use options and Long-Term Equity Anticipation Securities, or LEAPS, to get leveraged equity exposure. While Bodie's advice is not mainstream, all he's done is take the prevailing lifecycle investing paradigm to its logical conclusion.

Buffett's advice is grounded in a simple appeal to history. Bonds denominated in paper currencies have lost purchasing power over time pretty much everywhere; equities, as claims to streams of real cash flows, have grown their purchasing power over decades, through calamitous wars, pandemics, and bouts of hyperinflation, though at the cost of gut churning price volatility. To Buffett, U.S. equities are "certain" propositions if held for long enough, making them less risky than bonds for long-horizon investors. However, Buffett is wired differently than most of us. He is comfortable thinking only about the future streams of cash flows an asset will generate, independent of what the market thinks of the asset today. Market volatility has little effect on his happiness--in fact, I think he genuinely enjoys bear markets. Most investors don't have such odd utility functions. Their utility functions look like the ones posited by the eggheads' lifecycle investing models. Buffett also has little need for liquidity; he manages sums so large any reasonable liquidity buffer is tiny in relation to total portfolio size--hence only a 10% allocation to bonds for the sizable estate he'll be leaving his wife.

If you have a big portfolio, enough liquidity to tide you over whatever the market throws at you, and perverse mental wiring, feel free to knock yourself out and dump all your bonds. The rest of us should own more than Buffett suggests.

A Few Key Facts Go a Long Way
When Buffett says intelligent investing is simple but hard, he means it. He describes two real estate investments. In 1986, he bought a 400-acre farm from the FDIC sight unseen, taking advantage of depressed prices in the aftermath of a farmland bubble. He admits he knew nothing about operating a farm. His due diligence amounted to asking his son how many bushels of corn and soybeans the farm would produce and what normal operating costs would be, and using those facts to calculate a conservative estimate of the farm's earnings yield, which he figured to be 10%. He also identified free upside in the potential for price appreciation in soybean and corn.

In 1993 he joined some friends in buying a commercial building next to New York University, again sight unseen after a real estate bubble popped. His analysis was simple: The yield of 10% was reasonable and NYU wasn't going away. He also identified some free upside potential: A big tenant rented 20% of the building for only $5 per square foot while other tenants averaged $70. Once the big tenant's lease expired earnings would shoot up (and they did). Of course, Buffett has the knack for making extraordinarily shrewd investments sound simple. One might be skeptical that Buffett's analyses in these instances were actually that simple.

OK, let me recount an anecdote that will dispel any illusions that the Sage of Omaha is above simple investment ideas. In 2004, Buffett's broker at  Citigroup (C) gave him a big book containing one-sheet summaries of South Korean stocks, which were trading at extremely low valuations at the time. Buffett went through it in an afternoon looking for companies trading at low valuation multiples like price/earnings and price/book. He picked out 20 to 25 in boring industries and put $100 million in them. An example is Daehan Flour Mill Co., which had 25% market share of wheat flour in Korea and was trading at a P/E of 2. If your financial advisor admitted he bought 25 low-P/E stocks based on one-page summaries, averaging 10 minutes of research on each one, you would probably fire him. The lesson here is if you know the few facts that truly matter, you don't need to conduct elaborate analyses to obtain excellent investment results.

1) Noah Buhayar. "Buffett Sets Fresh Goal as Berkshire Misses Five-Year Target." Bloomberg, March 1, 2014.

2) Warren Buffett. "1960 Letter to Buffett Partnership." July 1961.

3) Warren Buffett. "The Ground Rules." Jan. 18, 1963.

4) Daron Acemoglu, Simon Johnson, and James A. Robinson. "The Colonial Origins of Comparative Development: An Empirical Investigation." American Economic Review, 2001.

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