Buffett: Indexing the Best Choice for Investors Large and Small

Berkshire Hathaway (BRK.A) (BRK.B) chairman and CEO Warren Buffett extolled the virtues of low-cost index funds and American dynamism in his annual letter to shareholders, released Saturday morning along with the firm's 2016 results.

The letter comes ahead of the May 6 annual meeting (better known as Woodstock for Capitalists). Morningstar's Berkshire analyst, Gregg Warren, will be one of the three analysts, in addition to financial journalists and shareholders, asking questions at this year's meeting. Morningstar will have live coverage of the event throughout the day. The meeting will also be live streamed on Yahoo Finance, for investors who can't make the trek to Omaha.

Buffett's Indexing Bet
Buffett devoted a large part of the letter to trumpeting the virtues of low-cost indexing, as his now famous bet with Protégé Partners' Ted Seides that an S&P 500 index fund would beat a basket of hedge funds over the 10 years starting in 2008 comes to a close. With the finish line in sight, Buffett writes that there is "no doubt" that the index fund will be victorious. Through last year, the hedge funds turned in a 2.2% compound annual return vs 7.1% for the index fund.

Buffett's argument for indexing boils down to what he calls a simple equation. "If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win."

Beyond costs, he says that identifying a manager who can beat the market over time is also a challenging feat. Buffett writes he's only managed to do that "ten or so" times and that it is hard to know if a manager is just lucky or good. And the personal desire of managers to take on more money to boost their fees can "cause investing success to breed failure." Or put another way, "What is easy with millions, struggles with billions (sob!)."

Given his call in the letter to erect a statue in honor of Jack Bogle, it should come as no surprise that when asked for advice, he tells investors big and small, to buy a low-cost index S&P 500 fund. His friends with more modest means usually follow his suggestion, but "none of the mega-rich individuals, institutions or pension funds has followed that same advice when I've given it to them."

Why do the wealthy reject his advice? Buffett points to two drivers. First, professional consultants would be committing "career suicide" if they told their high net worth clients "year after year, to keep adding to an index fund replicating the S&P 500." Second, the wealthy think their money "should buy them something superior compared to what the masses receive" and that makes it hard to "meekly [sign] up for a financial product or service that is available as well to people investing only a few thousand dollars."

When a Downturn Comes, Bring Washtubs Not Teaspoons
As has become standard in Buffett's letters, he praises the American economic system as "miraculous." He writes that, "this economic creation will deliver increasing wealth to our progeny far into the future. Yes, the build-up of wealth will be interrupted for short periods from time to time. It will not, however, be stopped. I'll repeat what I've both said in the past and expect to say in future years: Babies born in America today are the luckiest crop in history."

Buffett also thinks this will economic dynamism will also translate to good investment returns. "American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that."

Although Buffett doesn't directly address current market valuations, he does provide some advice for investors worried that prices are too lofty.

He expects that "the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks" and that "no one can tell you when these traumas will occur – not me, not Charlie [Munger], not economists, not the media." But when the scary period does eventually come, investors need to remember that "widespread fear is your friend as an investor, because it serves up bargain purchases" and that "personal fear is your enemy."

And when that downturn comes, Buffett wants to make sure you know that Berkshire will be ready like it was in 2008. "Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it's imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do."

Valuation Matters for Buybacks
Whether Berkshire should return more capital to shareholders either via a dividend or a more aggressive buyback program is always a hot topic of conversation, and Buffett addressed it again in this year's letter. He is proud that for the last two years Berkshire was "first among American businesses in the dollar volume of earnings retained" and that they hope these reinvested dollars will earn their keep. He clearly thinks Berkshire can still profitability deploy the capital it has coming in every year.

Buffett also reiterated that the only time he'll buy back shares is when they're trading below 120% of book value and that buying them back at higher prices would destroy value for remaining shareholders. He remains baffled that other companies don't take valuation into consideration and suggested that before when discussing repurchases, "a CEO and his or her Board should stand, join hands and in unison and declare, 'What is smart at one price is stupid at another.'"

Notably though, Buffet praises the repurchases at some of Berkshire's equity holdings (calling out Bank of America (BAC) by name) writing, "we very much like this behavior because we believe the repurchased shares have in most cases been underpriced."

Who Will Replace Buffett?
There was no big news on the question of who will take over Berkshire after Buffett. He once again showered praise on Berkshire Hathaway Reinsurance Group's Ajit Jain writing, "If there were ever to be another Ajit and you could swap me for him, don't hesitate. Make the trade!". And showed his confidence in his investment managers Todd Combs and Ted Weschler as they now each independently manage $10 billion and Buffett generally only learns about their moves by "looking at monthly trade sheets."

Hello Regulators
Berkshire owns several businesses that are highly regulated from BNSF railroads, to Berkshire Hathaway Energy to the mortgage lending at Clayton Homes. And portions of the letter, as has been the case in the past, were clearly targeted to the regulatory audience. From extolling that their Iowa utility's "rock-bottom prices add up to real money for paycheck-strapped customers" to highlighting that "Clayton also has long had programs that help borrowers through difficulties," Buffett is trying to send a message that Berkshire is a good corporate citizen. However, there was no discussion of the scandals that plagued Wells Fargo (WFC) in 2016. Expect that to be one of the top questions at the meeting in May.

Click here to read Buffett's full 2016 letter to shareholders.