March 6th, 2013
Warren Buffett released his 2012 letter to investors on March 1, 2013. As usual, he provides a number of brilliant insights into his investing methodology. A number of sites have already posted their summaries or key quotes. However, I noticed that some of the main takeaways that I took from the letter weren’t being mentioned. As a result, I put together the following list that highlights, in my opinion, the most important points that he brought up.
1) The US economy is not headed for a recession in 2013.
Although he’s not known for his macroeconomic prognostications, Warren Buffett doesn’t expect the US economy to experience a meaningful slowdown. He states, “Unless the U.S. economy tanks – which we don’t expect – our powerhouse five should again deliver higher earnings in 2013.” The economic recovery has been unusually weak but the disconnect between the equity markets and the underlying economy remains in place. In my view, the disconnect is undoubtedly due to the extraordinary measures taken by the world’s central bankers. As David Rosenberg of Gluskin Sheff recently stated, “The US Fed has always been important in influencing trends in the financial markets, even if the economic effects have been far less dramatic. This influence has actually strengthened in recent times to the extent that the correlation between the Fed’s balance sheet and the direction of the stock market, which was barely 15% before all these rounds of quantitative easings began four years ago, is 85% today.” With the Fed remaining super accommodative it’s unlikely the US economy heads into another recession in 2013.
2) Warren Buffett is happy to be a minority shareholder.
In the 2012 letter, Buffett states the following: “At Berkshire we much prefer owning a non-controlling but substantial portion of a wonderful business to owning 100% of a so-so business. Our flexibility in capital allocation gives us a significant advantage over companies that limit themselves only to acquisitions they can operate.” Buffett has continuously emphasized that when you purchase a stock you’re purchasing partial ownership of a business. Even minority shareholders should approach investing in a company from the perspective of an owner. What exactly is an owner perspective? It means that you take the long view when you approach your investments. You’re not bothered with the daily gyrations of the market but realize that over the long-term great businesses continue to grow and their share prices generally follow.
3) Don’t try to time the market.
Market timing has become something of pseudo science. There are all sorts of technical indicators and analysis that people use to try and forecast short-term directions in the market. Buffett’s investing success clearly negates the emphasis placed on trying to time the market. Buffett explains, “Since the basic game is so favorable, 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.” Buffett’s approach can be distilled down to the basic idea of buying high quality companies based on high returns on investor capital at cheap valuation levels. It sounds so simple, but is so devilishly difficult to implement. As investors we try to make things overly complicated. In my view the simpler the investment process the better the results. If you focus on buying high quality businesses at cheap valuation levels, you’re on the right path to success in investing.
4) Money for nothing and your “float” for free.
Warren Buffett has profited immensely from managing the float of his insurance businesses. Insurance companies essentially receive premiums upfront and payout claims at a later date. From the time a cash flow is received as a premium and ultimately paid out as a claim, it can be used for investment purposes by the insurance company. As Buffett highlights, “This collect now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit.” The following table shows that Berkshire’s float has grown immensely over the years.
As long as total operating expenses and total claims are below 100% of premium income in his property and casualty (P/C) business, Buffett benefits from the use of free money to invest. Unfortunately, many P/C insurers attempt to follow this model to its logical conclusion and end up making poor underwriting decisions, which lead to losses. Additionally, most P/C insurers don’t have anyone as skilled as Buffett making investment decisions. Regardless, the impact of “float” on the compounding of Buffett’s wealth over time is undeniable.
5) Even the greatest ever can be caught in a value trap.
In general, cheap stocks are usually cheap for a reason. One of the toughest skills to learn as a value investor is how to avoid value traps. Buffett explains that even he still gets caught occasionally by a value trap. He states, ‘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.” In my view, the best way to avoid value traps is to only purchase shares in businesses with economic moats. A business with a durable competitive advantage has a higher probability of outperforming its peers and growing its earnings over time. If you have to choose between quality and cheap, always opt for quality in terms of your investments.