Warren Buffett shares his wisdom

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  • Berkshire Hathaway CEO Warren Buffett

    Berkshire Hathaway CEO Warren Buffett


Regular readers of this column know that I am a big fan of Warren Buffett. As a shareholder of Berkshire Hathaway, I am always pleased to get my copy of the annual report. Inside I know I’ll find Buffett’s letter to the shareholders which always contains gems of advice. This year didn’t disappoint.

The following are some of his selected quotes with my comments:

Warren is still bullish on America and has chosen to ignore the recent flurry of negative news.

To quote: “There was a lot of hand-wringing last year among CEOs who cried ‘uncertainty’ when faced with capital allocation decisions (despite many of their businesses having enjoyed record levels of both earnings and cash). At Berkshire, we didn’t share their fears, instead spending a record $9.8 billion on plant and equipment in 2012, about 88 percent of it in the United States.

“That’s 19 percent more than we spent in 2011, our previous high. Charlie and I love investing large sums in worthwhile projects, whatever the pundits are saying. We instead heed the words from Gary Allan’s new country song, ‘Every Storm Runs Out of Rain.’ We will keep our foot to the floor and will almost certainly set still another record for capital expenditures in 2013. Opportunities abound in America.”

Warren also is not a big fan of market timing and believes uncertainty will always be with us. The risk, according to Warren, is NOT being invested. This has definitely been the case for those who have sat on the sidelines for the past five years.

“A thought for my fellow CEOs: Of course, the immediate future is uncertain; America has faced the unknown since 1776,” said Mr Buffet. “It’s just that sometimes people focus on the myriad of uncertainties that always exist while at other times they ignore them (usually because the recent past has been uneventful). American business will do fine over time. And, stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favour. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320 percent increase that materialised despite four costly wars, a Great Depression and many recessions. And don’t forget that shareholders received substantial dividends throughout the century as well.)

“Since the basic game is so favourable, Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of ‘experts,’ or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.”

Insurance is Berkshire’s core operation. Warren usually makes some interesting comments on the industry that tend to be very prescient and candid.

He said: “If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money — and, better yet, get paid for holding it. That’s like you’re taking out a loan and having the bank pay you interest. Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous in most years that it causes the P/C industry as a whole to operate at a significant underwriting loss …. There are a lot of ways to lose money in insurance, and the industry never ceases searching for new ones.”

It has always struck me as odd on how the insurance industry often talks about “discipline” in pricing and underwriting when it tends to have a poor track record in doing just that. Warren explains:

“There is very little ‘Berkshire-quality’ float existing in the insurance world. In 37 of the 45 years ending in 2011, the industry’s premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of the average return realised by American industry, a sorry performance almost certain to continue.”

This coincides with an extensive research report I read back in September of 2011 from Citigroup which found that from 1975-2010 the P/C industry only generated five years of positive underwriting income. The deficit, according to the report by Keith Walsh, was $457 billion over that 35-year period.

Obviously, current yields cannot subsidise or overcome these types of losses today.

Warren makes this very clear: “A further unpleasant reality adds to the industry’s dim prospects: Insurance earnings are now benefiting from ‘legacy’ bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years — and perhaps for many years beyond that. Today’s bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over.”

What is true for the insurance industry doesn’t necessarily apply to every firm. Some have commendable track records on underwriting profits such as Berkshire which has done so for ten consecutive years. In his typical down-to-earth and simply style, Warren gives some advice:

“At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained.

“Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, ‘The other guy is doing it, so we must as well,’ spells trouble in any business, but none more so than insurance.”

Warren had some words of encouragement for the newspaper industry. Especially local ones like The Royal Gazette!

“Newspapers continue to reign supreme, however, in the delivery of local news. If you want to know what’s going on in your town — whether the news is about the mayor or taxes or high school football — there is no substitute for a local newspaper that is doing its job. A reader’s eyes may glaze over after they take in a couple of paragraphs about Canadian tariffs or political developments in Pakistan; a story about the reader himself or his neighbours will be read to the end. Wherever there is a pervasive sense of community, a paper that serves the special informational needs of that community will remain indispensable to a significant portion of its residents … We do not believe that success will come from cutting either the news content or frequency of publication. Indeed, skimpy news coverage will almost certainly lead to skimpy readership. And the less-than-daily publication that is now being tried in some large towns or cities — while it may improve profits in the short term — seems certain to diminish the papers’ relevance over time.”

Finally a few simple quotes worth repeating:

“More than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain-hunting, with results ranging from tolerable to terrible … Of course, a business with terrific economics can be a bad investment if the price paid is excessive.

“But wishing makes dreams come true only in Disney movies; it’s poison in business.”

If you haven’t already, I suggest you get your hands on a copy of this letter. Much can be learned from this wise financial sage and your financial literacy will be greatly enhanced. Here is the link to the full letter:

http://www.berkshirehathaway.com/letters/2012ltr.pdf

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Published Apr 8, 2013 at 8:00 am (Updated Apr 7, 2013 at 6:40 pm)

Warren Buffett shares his wisdom

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