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

Dow over 20,000 and overpriced

The last two weeks we experienced the Dow Jones Industrial Average (DJIA) topping 20,000 for the first time in history.  This milestone was inevitable, but at the current time and price multiple it is too high.  This week’s post will look at it from a different perspective, what are people saying about this historic rise in DJIA prices?

Say what you will about the ultimate importance of the Dow reaching this big round number, but it certainly got there in a hurry. The 9% the Dow has added since Election Day is the sort of move that is usually reserved for market rebounds after big tumbles as opposed to when it was already in reach of its record high. – Justin Lahart, Dow 20000 Means Stocks are Pricey, WSJ.com

Even if I understood quantum mechanics, this (rally) wouldn’t make sense but oh well. Rally on!! – Heath Anderson WSJ.com forum

So what’s the alternative to stocks? Bonds, paying zilch if they’re solid and a few percent if they’re not (do you really want to lend to Chicago?) Real estate? REITs seem to be taking it on the chin with more mall defaults on the way according to an article today. Individual property? That’s more sunk illiquid capital for a long-term spec bet than most investors can stomach.

I guess there’s always unicorn farms.” – John Rogitz, WSJ.com forum

Yes. P:E’s are above the levels pre dot.bomb and pre derivative/housing crash. And the Dow is jiggered by removing losers and inserting winners. Celebrating a single index is like sacrificing goats to make it rain. – Marty Anderson, WSJ.com forum

It’s really disappointing how the markets can react to perceived opportunities/disappointments in the future without knowing any specifics. Premature ejaculations never really result in material benefits. Can’t we wait until specifics are delivered? Does business award bonuses for ideas that never see the light of day? – Bob Schafer, WSJ.com forum commenting on the fast run up of financial stocks since the election (up between 15-36% in the last few months).

The Trump trade seems to be an excuse to overprice the companies in the stock market.  When the DJIA passed 10,000 for the first time, the phrase irrational exuberance was used to describe the market.  The metric then passed the 10,000 mark over 30 times before crossing 20,000.  The Trump trade is all focused on what he is planning to do, and very little on what he will actually do.  The market seems to think that his policies will be very one-sided and only include upside opportunities.  For over three months, the market appears to only be considering the upside potential.  Several articles this week indicated that Wall Street is taking its cues from Washington.  Until earnings and more importantly cash flows begin to catch up, I think that the markets will be more volatile.  Therefore, I am currently maintaining 50% of my investment accounts in cash and cash equivalents.  Consider Warren Buffett:

Be fearful when others are greedy and greedy when others are fearful

Stock Market Forecast 12/17/2016

Stock market value determination is fundamental to an investor interested in purchasing portions of the market at a reasonable price.  Forecasting is an important part of any active investment style.

“The cost of a thing is the amount of what I will call life which is required to be exchanged for it, immediately or in the long run.”
― Henry David Thoreau, Walden

The time spent understanding a situation is the ‘life’ Thoreau mentions in the preceding quote.  When considering the cost required to value the market, lets look at ways that capitalize on the amount of time required in exchange.  This post will discuss a little wisdom from Benjamin Graham, some analyst reports one might consider, and some current trends in the news.

A Thought from Ben Graham

Benjamin Graham used the price to earnings (P/E) ratio to identify when a security was over priced or priced at a discount.  A simple way to look at this is to compare the P/E ratio’s current level to that of the security’s average.  When the P/E is lower than the historical average P/E, then Graham proposed that the price of the underlying security is trading at a discount.  Historical data that identifies the monthly average P/E of the S&P 500 to be roughly 15.60 (from data found on www.multpl.com).  This is the average of over 100 years’ of data.  Note that over the past 20 years this average is trending upward.  This indicates that if the S&P 500 drops below a P/E of 15.60, then it is at an appropriate entry price.  The S&P 500’s current P/E ratio of 24.98 (found on wsj.com) would indicate that the average is about 60% overpriced.

Professional Advice

Professional services share their perspective of where they expect the market to be heading.  My personal favorite is the Value Line Investment Survey, but there are others to consider.  Warren Buffet was once quoted stating that he liked the S&P report.  These companies that do this type of work are not all the same so if you are using their information make sure it is from a reputable organization.

Value Line’s weekly report indicates the anticipated price change for the stocks in the Value Line survey will be over the next five years.  The highest expected five year return was 185% during the financial crisis, last week it was 35%.  Value Line uses a proprietary arithmetic formula for its calculation and the investor will have to pay for such advice-or get access to it at a local public library.  Most public libraries will have this in their section on investing.

The S&P Capital IQ Outlook report is another paid service.  This report is free to those with a TDAmeritrade account.  The S&P outlook for 2017 states that the current bull market is the second most expensive market top since WWII with a trailing (meaning the last 12 months) P/E of more than 25x! The Outlook report also points out that the S&P 500 fell an average of 2.7% during the first year of a new Republican president.  The report states that only once did the year following the election of a new Republican president end with a gain.  Finally, S&P predicts that this market will continue to stay ‘aloft’ through the next year.

The Argus Market Watch Report is also free with an account from TDAmeritrade.  This report compiles several different analysts and provides a diary of a 12-month forecast for the S&P 500.  This forecast puts the price of the S&P 500 to be somewhere between 1,800 and 2,250.  The S&P 500 is currently trading just over the high end of this range.  Argus does not appear to have updated this range since December 2015, making any confidence in this prediction low and leading the reader to question how current it is.

These agencies can be wrong they provide predictions because their customers ask for it.  In fact there exists a strong argument to anyone wanting to lay some blame of the financial crisis at various rating agency’s feet.  They also use words that try to make their predictions less clear like the S&P report use of the word aloft.  However, they do give a good idea of the sentiment that is current in the market and most of their customers want to see the logic behind such predictions.

Current News

Stories in the news talk of the way people are piling in on the purported “Trump trade”.  The “Trump trade” is the price jump that occurred in the US stock market after the election.  This price jump was sharp and had very few losses over the past few weeks.  This indicates that the index may be overpriced.

Assessment

My experience with P/E ratios, professional advice, and news articles teaches me that this data needs confirmatory evidence.  The evidence I considered for this post causes me to conclude that the stock market is currently trading at a premium.  This post ends with my personal assessment of the S&P 500 price expectation in the next six months.  Confidence level: MODERATE, I assess that the S&P 500 has a 70% chance of retreating at least 10% (or to $2,033.07) at some time in the next six to twelve months.  Note: this assessment is my attempt to identify market prices over the given period, I use this type of conclusion for my own investing. Before you commit funds to any investment or trade, I encourage you to do your own analysis of the investment vehicles you are looking at.

ACTION ITEM: What price changes do you think will happen in the stock market over the next six months to a year?