Lessons from Warren Buffett’s Annual Letter to Shareholders

Last week, Warren Buffett’s letter to his shareholders was available online.  His letters are always a great read, and they provide insight into his views on investments.  This post will be dedicated to some of the wisdom and humorous quips an investor can glean from his letter.

“Today, I would rather prep for a colonoscopy than issue Berkshire shares.”

Warren Buffet, 2016 letter to shareholders, page 4

Buffett’s reason to not issue shares is a result of past experience.  The examples he cites in the letter include buying Dexter shoe and General Re by issuing Berkshire shares.  Dexter shoe is the most painful decision as Buffett notes that the company’s stock promptly went to zero.  The shares he issued to purchase the company gave the Dexter sellers $6 Billion in Berkshire shares by the end of the year.

The lesson that Warren takes from this experience is to purchase his investments in all cash.  More importantly, for an investor reading his letter it identifies that one of the best investors in the world has a long memory of his mistakes.  The Dexter fiasco happened in 1993 and he is mentioning it in his 2016 letter to shareholders as a lesson learned.

“To recap Berkshire’s own repurchase policy: I am authorized to buy large amounts of Berkshire shares at 120% or less of book value because our Board has concluded that purchases at that level clearly bring an instant and material benefit to continuing shareholders. By our estimate, a 120%-of-book price is a significant discount to Berkshire’s intrinsic value, a spread that is appropriate because calculations of intrinsic value can’t be precise.”

Letter, pg 7

After a rant against companies that repurchase their shares at an inflated price, Warren identifies Berkshire’s repurchase policy-120% of book value.  His preceding words identified that too many boards today repurchase shares of their stock with no hard numbers on which price is an appropriate price to pay.  This is ridiculous, because price would be the first thing management would consider if looking at an acquisition.

This line of thought provides two lessons that an investor can use-watch your managements and set the appropriate price in hard numbers.  Watch the management of the companies that you purchase and make sure that they are making rational decisions.  They should not be following the crowd to simply buy back shares if the company stock price is inflated.  This would be wasting shareholder funds on a poor endeavor.  Having a hard test for their numbers is a great way to find the value of a company in the market.

“Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.”

“I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant.”

Letter, pages 24-25

Warren identifies the best advice he can for investing-use low fee vehicles that match the market.  In my opinion, this is the simplest way to go with investing.  Match the market through a low cost index fund.  If you are not interested in looking at specific positions and digging deep – then purchase an index fund that attempts to match the S&P 500 and call it good.  Correction, if you are over 10 years from needing the money, purchase an index fund that matches the S&P 400 and call it good.  My reason is that the S&P 400 typically outperforms the S&P 500 but it will be more volatile than the S&P 500.  You can read more in the post below.

Investment Plans, Part 3: ETF example

In conclusion, Warren Buffett’s letters are great for anyone aspiring to be a successful investor.  If you would like to read his whole letter in its entirety you can find it here.  I leave you with my personal favorite quote from his letter, it is an adage he used when talking about how Wall Street managers separate their customers from money:

“When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”

-Letter, pg 25

Investment Plans, Part 3: ETF Example

“Now, what should happen when you make a mistake is this: You take your knocks, you learn your lessons, and then you move on. That’s the healthiest way to deal with a problem… You know, by the time you reach my age, you’ve made plenty of mistakes. And if you’ve lived your life properly — so, you learn. You put things in perspective. You pull your energies together. You change. You go forward”

– Ronald Reagan regarding the Iran-Contra Scandal

This quote begins this week’s post because it is how I felt about the results of my analysis of a stock investment strategy.  I hope you find the following data useful.  This is a result of over 2,000 data points and my submission of the

This graph shows how an investor would apply their capital over the past ten years in IJH, a mid-cap ETF.  The green represents the weekly closing price of the ETF.  The blue indicates the monthly shares purchased from the ETF under the Dollar Cost Averaging (DCA) method.  Finally, the yellow represents the number of shares purchased under the Price/Volume method (PV) discussed last week.

The inputs into this model are as follows:

  1. The DCA method invested a set amount the first Monday of each month over the ten years.
  2. The DCA method invested the full amount of the investment funds, this is a bit unrealistic because an ETF would require the purchase of at least one full share.  However, this was used to develop the chart because many investors use the DCA method in their personal investment accounts and their investment accounts with their employers.  The reader should note that many employers deposit their investment funds into a holding account until a set date and then apply it into their preferred investments.
  3. The DCA method determined the amount of money to be used by the PV method.
  4. The PV method invested 2.55% of the total investment balance each time the market dropped on high volume and the next week’s share prices included a 2.5% discount to the previous week’s close.  This allows the investor to place an order at the conclusion of the past week at a discount and only purchase if the market drops to that price level.
  5. A buy and hold method was used as a base line investment style.

Key assumptions that may change future application of these methods:

  1. During these ten years, the market had the financial crisis associated with the housing bubble.
  2. This market drop was significant and occurred in the first half of the investment application period.
  3. The investor would require financial stability in order keep the money invested in any of the methods.

Results of these methods are as follows off of a $100,000 investment:

  1. The DCA method purchased a total of 1063.608 shares and the ending value of the investment not including dividends was a respectable $174,570.01.
  2. The PV method purchased a total of 1,392 shares and the ending value of the investment not including dividends was an amazing $225,888.18!
  3. Placing the entire $100,000 into the ETF at the beginning of the ten years purchased 1,226 shares and the ending price not including dividends was $201,223.38.

Conclusions:

  1. Technical investing can add value to your portfolio.
  2. This metric does not seem to be as successful for investment amounts smaller than roughly $20,000.  This is probably due to the economy of scale involved with the larger investment values.
  3. The PV outperformed the tried and true and widely accepted DCA by a gain of more than 58%.
  4. A complete application of investment funds doubled the investment over a ten year period.

The most surprising of these conclusions for me was the first.  I have spent most of my life thinking that technical investing is like reading tea leaves.  This was a very surprising result to me and makes me want to question some of my other mindsets with respect to investing.

ACTION ITEM: Determine what will be the best investment plan for you-DCA, PV or buy and hold.

 

Investment Plans, Part 2

Investment plans can benefit from being quite simple. In last week’s post, we discussed the simple no-hands approach called dollar cost averaging.  This is a great way to get average results.

Average people take average actions.  Average actions bring average results. – Average is an Addiction, Deborah Dubree, Chapter 6

This post will discuss a possible way to get better than average results.  Business schools teach that the best way to make money in the stock market is to buy low and sell high.  Then the business students that go on to tell the world that the best way to make money in the stock market is to dollar cost average.  I think that this is good advice but lacks the thought process to make great advice.  This post will include my opinion of what might be considered as great advice.

Exchange Traded Funds vs Regular Index Funds

In the last post, if you took the second action item, you would have looked at the ETF IVV and the Index Fund SVSPX.  The table below shows some of the performance and other distinguishing data of the two funds.  Consider that IVV and SVSPX returned approximately the same amount over the past five years.  They also had the exact same top 10 holdings at the time of this writing.  The key differences one should consider is the investment amount required and the ability to use options.

Fund SVSPX IVV
Description SSgA S&P 500 Index Fund N Class iShares Core S&P 500 ETF
Category Large Blend Large Blend
Expense Ratio 0.16% 0.04%
Sales Load with TDAmeritrade Account No Load No Load, commission free trading available
Fund Type Regular Index Index ETF
Average Asset Market Capitalization 76.8B 77.2B
Costs over 5 years 0.56% 0.39%
Minimum investment (Initial/Additional) 10000/100 NA/NA
Options available? No Yes
Market return (2012) 16.03% 16.06%
Market return (2013) 32.14% 32.30%
Market return (2014) 13.50% 13.56%
Market return (2015) 1.27% 1.30%
Market return (2016) YTD as of 12/3/2016 5.73% 5.91%

How can an individual capitalize on these index funds?

Thankfully, the business schools out there were very helpful-they said to buy low!  Here is a simple way to purchase shares of a regular index fund at a low price, it is not full proof but over time should improve one’s return.  It seems to work best with an ETF because the investor can purchase at a set amount shares based on what they want to risk like the dollar cost averaging technique, but it could work with a regular mutual fund as long as you can meet the minimum requirements.

Plan 2: Price Change with High Volume ETF investing.

Criteria:

  1. When the weekly price of the Index ETF declines.
  2. The volume of the Index ETF for the week exceeds its 50 day moving average.
  3. Purchase Index ETF shares the next week at a 2.5% discount from the closing price of the mutual fund after that week of high volume decline.
  4. Only purchase at a set percentage of cash available for investing, like the equivalent of 1-3 month’s investment account contribution or 2-5% of a windfall over several months.

Purchasing in this manner will improve the chances of buying low like the business schools out there love to advertise but seem to give little direction on how to do this.  You should note that this method will mean that you invest during some of the scariest times of the market.  It would have placed a purchase during the market downturn associated with the housing bubble in two consecutive weeks at least twice for an ETF I tested it on.  This means that the investor would be purchasing shares during some of the most volatile parts of that crisis and they would have to be disciplined enough to purchase a second time when the market fell the subsequent week after considerable losses the week before.  Most investors would consider this a gut wrenching probability; however, it seems to outperform the dollar cost average approach by a significant margin.

ACTION ITEM: This week’s action item is for you to test this hypothesis on your own and find mistakes in it.  I would love to hear if you find this method working or if you find it not working.  Pick an index fund and determine how this method stands up over time in your opinion.

Investment Plans, Part 1

After we understand investing risk, the next thing to focus on are ways to limit our exposure to it. To limit our exposure, we use an investment plan. Let’s identify the main elements of an investment plan. An appropriate plan will consider the uncertainty that Kahneman described in the following quote.
What hindsight does is it blinds us to the uncertainty with which we live. That is, we always exaggerate how much certainty there is. Because after the fact, everything is explained. Everything is obvious. And the presence of hindsight in a way mitigates against the careful design of decision making under conditions of uncertainty.
– Daniel Kahneman; 2002 Nobel Prize winner in Economic Sciences; Emeritus Professor, Princeton University (WSJ CEO Council; Wall Street Journal, R2; 22 November 2016)

Savings program

A savings program should constantly place new funds into your investment portfolio and prevent the need to take money out of it. Many individuals help provide ways to improve this portion of our lives and a deep dive into their work is beyond the scope of this post. However, you can look them up if interested-Dave Ramsey and Suze Orman come to mind. The principles that one should focus on are these: lower your monthly outflows to free cash for personal savings by reducing debt obligations, create and maintain a rainy-day fund in an accessible savings account of at least three months’ expenses, and only then put money into an account for long term investment purposes.

When considering an investment savings program, make sure that the recurring savings is appropriate for your situation. One facing unstable employment should reconsider saving a large portion of their income unless they already have the security of a rainy-day fund. The more stable our situation became, the more we tried to push this number up. The goal is to commit between 10-15% of our household take home pay into an investment account after the rainy-day fund is completed.

ACTION ITEM: Before reading on, if you haven’t already started some form of recurring savings plan and you don’t have income issues-I implore you to set up a recurring deposit into some investment account. This account can be savings that will be used for real estate investment, stock investment, small business investment or paying down debts to free additional cash. However, this is so important to your investing future that if you don’t do anything else recommended in this blog, I will consider our interaction a success if you act now and commit to a recurring savings plan and follow it for the rest of your life.

Where and when to put funds to work

The first place to consider putting this money is into an employer funded retirement account like a 401(k) or other tax sheltered account. This is important because most employers will match a certain percentage of your savings commitment find out what this commitment is and make sure that the amount you contribute will take maximum advantage of their match program. The maximum match allows you to get immediate return on your investment that is usually unparalleled in any investment for example, some employers match 100% of contributions made into their 401(k). This is free money and typically is the equivalent of a raise for merely participating in the employer’s retirement account.

An employer’s retirement account may have poor options for the investor and it is important to note this when you participate. If this is the case with your employer-that they place their funds into accounts that are not as investor friendly as one would like, then take advantage of their match and then place the rest of your savings into a self-directed, tax-sheltered account like an Individual Retirement Account (IRA). Finally, if you leave that employer, make sure that you roll that money into a personal, self-directed IRA.

The past couple of decades have confirmed that one of the most simple and effective strategies is to match the market return of the S&P 500 by investing in Index funds. Ironically, this strategy was lauded by Benjamin Graham mentor to some of the greatest investors of our time like Warren Buffett and his partner Charlie Munger. Graham suggested that for the individual investor that does not have the time or perhaps the desire to pick individual stocks the best way to participate in the stock market would be to purchase shares of an index fund, thus bringing us to the first strategy one should consider.

Plan 1: Purchase shares of an index fund that matches closely the performance of the S&P 500 index using dollar cost averaging. Dollar cost averaging means that the investor places the same amount of money into a mutual fund periodically allowing purchase of more shares during market downturns and limiting exposure to purchasing shares when the market is up. This is the best set up and forget model and returns an adequate appreciation of principal for the investor.

ACTION ITEM: Become familiar with various mutual funds. A great place to start is an index mutual fund. The ticker symbols SVSPX and IVV are for index mutual funds you may find interesting. SVSPX is an actively managed mutual fund that attempts to track the performance of S&P 500. IVV also attempts to track the performance of the S&P 500 but differs as an exchange traded fund or ETF. Both index funds have pros and cons. When looking at the two funds, consider the differences they possess. How did they perform with relation to the S&P 500 and to each other? What are the fees associated with each fund?