Investors have pored through the penned words of Warren Buffett in search of nuggets of wisdom nestled within Berkshire Hathaway’s shareholder letter. This year was no different, and the latest annual letter included new elements that illuminate the way investors think.
This year’s letter does however, include a few recurring themes that Warren Buffett have highlighted previously. One of them is the significance of share buybacks. Another centres around the criticality of Berkshire’s float, which is the capital available for deployment into investment securities that is derived from its insurance business.
Nonetheless, Here are seven key points to take away from Buffett’s 2023 annual letter to Berkshire’s shareholders:
1. It takes just a few winners to work wonders. Buffett uses Apple Inc. (NASDAQ: AAPL)and American Express Company (NYSE: AXP) to illustrate that behind the majestically successful image of Berkshire today lies many unremarkable investment calls. The company made far more average purchase decisions than spectacular ones. Yet, the disproportionately huge upside of these gems lifted the performance of the overall portfolio. Munger echoes this point, stating that one does not need to own a lot of things in order to get rich. Sensational accomplishment often hinges on that few big winners, provided that major crippling mistakes are avoided.
2. Market dislocation is always present. Buffett purports that efficient markets exist only as a theory and the behaviours of market participants can only be comprehended retrospectively. Coupling this with the establishment of public markets means that there is always value out there waiting to be discovered. He contrasts this with acquiring entire or majority stakes within a business, an endeavour that usually commands a high premium that is hardly justifiable. Thankfully, such takeovers are beyond the reach of retail investors like us anyway, and the opportunities accorded by publicly traded shares should suffice in paving the road to profit.
3. Size and diversification matters. Berkshire is the proud owner of behemoth corporations that are well-diversified across a plethora of industries. In this case, Buffett alludes to the S&P500 and so we use market capitalisation as a proxy for size. Larger businesses are preferred due to obvious advantages. This could be due to them enjoying higher market shares, reaping economies of scale, and having greater alignment with a country’s economic future. The last point about alignment could result in favourable regulatory tailwinds such as the recent Bipartisan CHIPS and Science Act.
The next point pertains to the importance of diversification. Apart from risk reduction, larger institutions can share resources which translates to benefits. Take for example intangibles like reputation, which is more effectively exploited in multidivisional organizations than through the free market. Of course, one needs to weigh size advantages against the flipsides of being too large.
4. Risk remains a fundamental consideration for investors. Risk and return are two sides of the same coin; hence, risk management is crucial for all investors. Even well-regarded investment heavyweights like Berkshire have their fair share of safety margin, such as holding substantial liquid assets and staying clear of ill-advised and ill-timed cash drawdowns. Buffett further asserts that Berkshire’s CEO will always be the Chief Risk Officer. Along a similar vein, investors ought to select businesses where management has ‘skin in the game’. This could be in the form of insider ownership, senior employees’ compensation tied to stock options, or value-accretive insider buying (beware of value-destructive share buybacks). All these increase alignments between management and shareholders..
5. Be skeptical of firms that beat estimates. Buffett cautions investors to be wary of corporates manipulating earning figures and beating market expectations. For instance, the distinction between Berkshire’s operating earnings and GAAP earnings emphasise the pitfalls of focusing on GAAP figures. Harvard Business Review provides extensive reasons about the increased use of non-GAAP numbers. The long and short is that investors must understand what type of earnings are most relevant to the business they are analyzing. Beyond accounting, executives may be incentivised to dress financial statements in fanciful ways that do not breach the law but are nevertheless misleading. One example is intentionally understating figures so that future targets become easier to beat. Sieving out earnings misrepresentation is a difficult endeavour but one that is sure to pay off.
6. Patience can be learned. This one comes from Munger, who affirms that ‘having a long attention span and the ability to concentrate on one thing for a long time is a huge advantage’. To assess a company’s investment attractiveness, one needs to understand how a company conducts its business. The process requires time and energy, which may be limiting resources to many retail investors, thereby encouraging speculation activities where one ‘invests’ based on hearsay or before conducting thorough due diligence. Going into a state of intense concentration (otherwise known as ‘flow’ or ‘being in the zone’) alleviates the stress that learning puts on the mind and body. Investors can immerse themselves in erudition while losing a sense of time and feel as they find the experience intrinsically rewarding. Deep learning can also be applied in other areas of life, making it a worthwhile skill to practise indeed.
7. Change is the only constant. Using the example of railroad stocks, Munger recounts how he previously disliked railroad stocks but ended up being an investor in four major railroad companies. He further adds that being slow to recognize change beats not acknowledging change at all. This also reverberates with another point he mentioned about the need to constantly learn in order to become a great investor. To be a constant, you have to change.
For those interested in reading Berkshire Hathaway’s 2022 shareholder letter, you can click here.
Enjoy the read!