- I’ll go through the everlasting wisdom Buffett gives us within his latest letter to shareholders.
- His short sentences say so much that many miss the key ideas: accounting & investing, optimism, M&A, debt, patience, and long-term risk.
For some, there isn’t much to look forward to during February’s cold but if you’re an investor, you wait a whole year for Buffett’s annual letter to shareholders.
The first thing is that Berkshire’s results are published on Saturday so that we can all go through the results in peace. His letter is filled with investing wisdom that it’d be a shame to miss it by just skimming through the letter.
Today, we’ll dig deeper into what the carefully selected, rather short sentences tell us about investing in the current environment.
Accounting GAAP & Investing
The first point touched on by Buffett is an accounting issue:
“The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line. Berkshire owns $170 billion of marketable stocks (not including our shares of Kraft Heinz), and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire’s “bottom-line” will be useless.”
I would add here that using stock screens might seem to be the easiest way to go when analyzing a stock, but such tools will only point out the obvious. When something is obvious in investing, it is usually also fairly priced.
On the other hand, the new accounting rules will give opportunities to those who dig deeper. If next quarter, due to a market correction, BRK’s earnings are negative $20 billion and the PE ratio turns negative, that will definitely have an effect on investors through a plethora of negative headlines. Try to keep your head cool and go beyond the numbers.
Further, one should be very careful when discussing adjusted earnings because management likes to omit whatever isn’t recurring in their opinion. This creates even more distortion especially as forward estimated earnings exclude all adjustments.
So the message is clear, understanding accounting, the language of business, is the key to being a successful long-term investor.
Buffett never fails to mention his buying criteria which are all well-known:
“In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.”
However, it’s interesting that he didn’t manage to find investments that meet them:
“That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.”
So are you an optimistic purchaser? The key behind my question and Buffett’s statement is that investors seem to have forgotten that the market, the economy and nature, all work in cycles. This leads to overly optimistic earnings estimations that exclude recessions and include constant future growth. Constant future growth is something we have never seen in the past so be careful with that.
If you fell into that trap, don’t worry, most corporate managers fell into it too as the M&A scenario is getting ridiculous.
Mergers & Acquisitions – M&A
“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.
“Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase. Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size. Investment bankers, smelling huge fees, will be applauding 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.”
When managers get optimistic and lose a cool, cyclical perspective, it usually leads to lots of pain down the road. When the optimistic expectations are not met, impairments follow, debt covenants are breached and a downward spiral quickly becomes a black hole. Be careful to get out of such companies that do aggressive acquisitions before this cycle ends. One hint on what to watch for is debt.
“The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed. At Berkshire, in contrast, we evaluate acquisitions on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual business would generally be fallacious (leaving aside certain exceptions, such as debt dedicated to Clayton’s lending portfolio or to the fixed-asset commitments at our regulated utilities). We also never factor in, nor do we often find, synergies.”
So be careful when the management focuses on synergies over time or on earnings improvements thanks to debt.
Now, you might wonder, what should one do if there are no businesses that meet conservative criteria? Well, doing nothing is an option they don’t teach at school but when it comes to investing, it’s one of the key virtues.
Prudence & Patience
If you are a long-term investor, it’s time to be prudent:
“Despite our recent drought of acquisitions, Charlie and I believe that from time to time Berkshire will have opportunities to make very large purchases. In the meantime, we will stick with our simple guideline: The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.”
The best way to be prudent is to be patient and stash your cash, exactly like Buffett is doing. He now has $116 billion invested in Treasuries. This also means that he partly follows the all-weather portfolio strategy too. You can read more about that in my all-weather article where a big chunk would be assigned to Treasuries in this market.
Investing is inherently simple but it goes against our nature.
Profitable investing means doing nothing most of the time, or even more boring, just checking whether investments meet the criteria. So if you want to bore yourself, see no excitement at all, you might become a great investor and the above 5 rules will help you. If you seek excitement and action, you must learn how to be a speculator which is also possible but requires much more time and effort than investing.