Triumph of the Optimists: Berkshire Hathaway’s 50th Annual Letter

Most assuredly, America’s best days lie ahead of it. That is the refreshingly optimistic message that CEO Warren Buffett maintains in Berkshire Hathaway’s annual letter to shareholders released today.

Buffett has been writing such highly anticipated letters for 50 years and this year’s offering is no disappointment. Oozing with Buffett's rationality, calmness and decisiveness, it is a must read for anyone looking for guidance in the financial markets.

Here are some of its highlights:

On America:

Charlie and I have always considered a “bet” on ever-rising U.S. prosperity to be very close to a sure thing.

Indeed, who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita U.S. output has sextupled. My parents could not have dreamed in 1930 of the world their son would see. Though the preachers of pessimism prattle endlessly about America’s problems, I’ve never seen one who wishes to emigrate (though I can think of a few for whom I would happily buy a one-way ticket).

The dynamism embedded in our market economy will continue to work its magic. Gains won’t come in a smooth or uninterrupted manner; they never have. And we will regularly grumble about our government. But, most assuredly, America’s best days lie ahead. (Page 7)

On Building Berkshire’s Per Share Intrinsic Value:

Charlie and I hope to build Berkshire’s per-share intrinsic value by

(1) constantly improving the basic earning power of our many subsidiaries; (2) further increasing their earnings through bolt-on acquisitions; (3) benefiting from the growth of our investees; (4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and (5) making an occasional large acquisition. We will also try to maximize results for you by rarely, if ever, issuing Berkshire shares. (Page 7)

On Berkshire’s Performance:

Since 1970, our per-share investments have increased at a rate of 19% compounded annually, and our earnings figure has grown at a 20.6% clip. It is no coincidence that the price of Berkshire stock over the ensuing 44 years has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both sectors, but our main focus is to build operating earnings. (Page 8)

On Investing:

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are Riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions.

That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

…

If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).

…

Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.” (Page 19)

On Berkshire’s Acquisition Criteria:

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),

(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),

(3) Businesses earning good returns on equity while employing little or no debt,

(4) Management in place (we can’t supply it),

(5) Simple businesses (if there’s lots of technology, we won’t understand it),

(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown). (Page 23)

On The Next 50 Years At Berkshire:

First and definitely foremost, I believe that the chance of permanent capital loss for patient Berkshire shareholders is as low as can be found among single company investments. That’s because our per-share intrinsic business value is almost certain to advance over time. (Page 34)

Since I know of no way to reliably predict market movements, I recommend that you purchase Berkshire shares only if you expect to hold them for at least five years. Those who seek short-term profits should look elsewhere. (Page 34)

I believe the chance of any event causing Berkshire to experience financial problems is essentially zero. We will always be prepared for the thousand-year flood; in fact, if it occurs we will be selling life jackets to the unprepared. Berkshire played an important role as a “first responder” during the 2008-2009 meltdown, and we have since more than doubled the strength of our balance sheet and our earnings potential. Your company is the Gibraltar of American business and will remain so. (Page 34)

The bad news is that Berkshire’s long-term gains – measured by percentages, not by dollars – cannot be dramatic and will not come close to those achieved in the past 50 years. The numbers have become too big. I think Berkshire will outperform the average American company, but our advantage, if any, won’t be great. (Page 36)

On The Future CEO Of Berkshire:

To further ensure the continuation of our culture, I have suggested that my son, Howard, succeed me as non-executive Chairman. (Page 36)

Character is crucial: A Berkshire CEO must be “all in” for the company, not for himself. (I’m using male pronouns to avoid awkward wording, but gender should never decide who becomes CEO.) He can’t help but earn money far in excess of any possible need for it. But it’s important that neither ego nor avarice motivate him to reach for pay matching his most lavishly-compensated peers, even if his achievements far exceed theirs. A CEO’s behavior has a huge impact on managers down the line: If it’s clear to them that shareholders’ interests are paramount to him, they will, with few exceptions, also embrace that way of thinking. (Page 36)

My successor will need one other particular strength: the ability to fight off the ABCs of business decay, which are arrogance, bureaucracy and complacency. When these corporate cancers metastasize, even the strongest of companies can falter. The examples available to prove the point are legion, but to maintain friendships I will exhume only cases from the distant past. (Page 37)

If our non economic values were to be lost, much of Berkshire’s economic value would collapse as well. “Tone at the top” will be key to maintaining Berkshire’s special culture. (Page 37)

All told, Berkshire is ideally positioned for life after Charlie and I leave the scene. (Page 37)

On Why Berkshire Under Buffett Did So Well:

Only four large factors occur to me:

(1) The constructive peculiarities of Buffett,

(2) The constructive peculiarities of the Berkshire system,

(3) Good luck, and

(4) The weirdly intense, contagious devotion of some shareholders and other admirers, including some in the press. (Page 41)

This Woman's Story Can Make You A Better Entrepreneur

Pick up a book about Warren Buffett and it will most likely include a chapter or at least a passage on the significance of Rose Gorelick Blumkin. But who was Mrs. B? Was she the 99-year-old woman whom Buffett had to impose a noncompete agreement on when he purchased her business? Or was she the illiterate woman who was inducted into the Greater Omaha Chamber of Commerce Business Hall of Fame alongside Buffett? Or was she the 4 foot 10 inch immigrant with the business story that Buffet described as “unparalleled”? Mrs. B was certainly all these things, but perhaps more importantly, her story sheds some light on three common qualities possessed by successful entrepreneurs.

1) Discontent

Entrepreneurship is closely related to invention, yet the road to invention is paved with discontent. Innovators and business visionaries experience their surroundings with an acute dissatisfaction with the status quo and a strong desire to improve things. Although not an “inventor” in the way we may understand it today, from a young age, Mrs. B refused complacency and dreamt of a better life.

Mrs. B. was born in 1893 in a small village near Minsk in czarist Russia. She and her seven brothers and sisters slept on straw in a single room home. From the age of 6 she helped her mother in a small grocery store. She also lived through constant persecution from the Cossacks against the Jews yet learnt from her mother that begging was undignified. Her parents couldn’t afford school and thus she never saw the inside of a classroom. Instead, at 13 she walked into a dry goods store and convinced the owner to hire her. By 16 she was running the store supervising five married men. Nevertheless, she remained unfulfilled and focused on her dream of escaping to America and succeeding in business. She married Isodore Blumkin in 1914 who soon after left to America and she was unable to accompany him. In 1917 when Europe was in crisis she took her chance and boarded the trans-Siberian railroad. At the Chinese frontier a Russian guard stopped her and she convinced him to let her pass by saying that she was buying leather for the army and upon her return she would give him a bottle of vodka. She made it through Manchuria to Japan and six weeks later landed in Seattle aboard a small transpacific boat.

Tip: Don’t get comfortable. Instead of accepting every aspect of your life as a given, question things and be curious as to whether there is another way.

2) Persistence

Although many entrepreneurs have an idea, dream or vision, most won’t have the persistence and toughness to push on in the face of seemingly insurmountable obstacles. Mrs. B had the strength of character that made her willing to fail.

In 1919, after having reconnected with her husband they settled in Omaha with her parents and siblings under the same roof. To support their meager existence Mrs. B sold furniture out of their basement and her husband ran a pawnshop on the main floor. In 1937, at the age of 44 Mrs. B managed to save $500 to rent a store front and dubbed it Nebraska Furniture Mart. Her motto was to “sell cheap and tell the truth.” Local brand name manufacturers considered her low prices bad for business and thus refused to supply her. Yet Mrs. B pushed on and traversed the nation buying large retailers’ excess merchandise for a hair above cost and bootlegged it back to Nebraska to sell in her store. Banks refused to extend credit and laughed at her in light of her illiteracy and lack of experience but this only fueled her fire and pushed her to work 7 days a week, 52 weeks a year without a day off. One carpet manufacturer went so far as to bring her to court alleging that her low prices violated fair trade laws. Yet these were simply speed bumps on her journey towards becoming the largest furniture store in the country.

Tip: Once you have your idea, dream or vision be relentless in its pursuit. All successful entrepreneurs have been able to overcome the odds so why can’t you?

3) Focus

Most successful entrepreneurs are able to recognize their strengths and use them to develop a mission. Once they embark on this mission their focus doesn’t waver. In Mrs. B’s case, Buffet described this phenomenon as “native genius” or the ability to stay focused on one’s area of expertise. We can’t be good at everything and those who are able to identify their strengths and focus on them stand the best chance of success.

One question Buffet always asked himself when evaluating a business is how comfortable he would feel having to compete against it, assuming that he had ample capital, personnel, experience in the same industry etc. When it came to Mrs. B’s business he felt that he would rather “wrestle with grizzlies” than compete. She was good at what she did and her business was strong because her formula was irresistibly simple and executed to perfection. She bought in volume, kept expenses at the minimum and passed on the savings, typically selling at only 10 percent above her costs. This strategy worked in the beginning and it stayed constant until the end.

Tip: Take the time to identify your strengths. Focus on them and don’t look back.

Was The Market's Terrible January A Prelude To A Weak 2015? Does It Matter?

2015 began with one of the worst months for the stock market with the Dow Jones Index (NYSEARCA:DIA) falling 3.7% while the S&P 500 (NYSEARCA:SPY) Index suffered a decline of around 3%. This poor performance was linked to several dark clouds hanging over investors. The main themes are:

1) Global GDP growth is faltering

In January the IMF cut its forecast for global growth by 0.3 percentage points to 3.5% this year and 3.7% next year. Japan has slipped back into recession, Europe is on the brink of recession, the developing world is facing commodity-linked headwinds, Russia's economy is in shambles and China is experiencing its slowest growth in a quarter century. Some point to the United States as a bright spot in the world economy citing its strong GDP growth relative to other countries, yet it should be remembered that Q4 GDP missed expectations dragged down by slowing business investment.

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8 Things Worrying Investors Now

2015 began with one of the worst months for the stock market with the Dow Jones Index falling 3.7% while the S&P 500 Index suffered a decline of around 3%. This poor performance was linked to several dark clouds hanging over investors. The main themes are:

1) Global GDP growth is faltering

In January the IMF cut its forecast for global growth by 0.3 percentage points to 3.5% this year and 3.7% next year. Japan has slipped back into recession, Europe is on the brink of recession, the developing world is facing commodity linked headwinds, Russia’s economy is in shambles and China is experiencing its slowest growth in a quarter century. Some point to the United States as a bright spot in the world economy citing its strong GDP growth relative to other countries yet it should be remembered that Q4 GDP missed expectations dragged down by slowing business investment.

2) Loss of confidence in central banks

Central banks all over the world have brought interest rates down to ultra low levels and have embarked on massive monetary stimulus programs. Yet these unprecedented measures, meant to be short-term solutions to fight a collapse in the financial system and a descent into deflation, have remained in place far longer than central banks had envisioned. Instead, these programs have not caused any meaningful increase in the flow of money that was meant to ignite spending and investment. Inflation has not picked up and amazingly central banks everywhere are stepping up their efforts by further slashing rates and increasing bond buying programs.

3) Global trade is in decline

We live in a highly interconnected world and cross border trade remains a key GDP growth driver. According to the International Monetary Fund, between 1996 to 2007 world trade volumes grew by an average of 7 percent a year but since, 2010 volumes have only grown by 4 percent.

4) Global debt is still at a record high

It would appear that we have not seen the last of excessive debt wreaking havoc on the financial sector. According to last fall’s Geneva Report, commissioned by the International Centre for Monetary and Banking Studies interest rates across the world will have to stay low for a “very, very long” time to enable households, companies and governments to service their debts and avoid another crash. The report finds that total world debt (government, corporate and household) is at a record 212 percent of gross domestic product as of the end of 2013, up from 174 per cent in 2008. Furthermore, some countries like the U.S and the UK have swapped private sector debt for public sector debt and in other countries like Canada and emerging markets, household debt has reached unprecedented levels.

5) The employment situation looks weak

Productivity has been poor, labor force participation rates are low and most alarmingly, wages have not been growing. In fact, for most US workers, real wages have barely budged for decades.

This appears strange in light of strong year over year growth in corporate profits yet labor market slack appears to be the main culprit. The current overcapacity of workers has meant that there is little need for hiring. With automation permeating modern businesses there has been a broad decline in both high and low paying jobs. This has lead to further overcapacity and has reduced the incentives for employers to raise wages reinforcing the cycle of weak consumption and slow growth.

6) US Q4 corporate earnings reports point to a slowdown in 2015

Around 80% of reporting S&P 500 companies have beaten estimates on earnings and 58% on sales which marks the 8th consecutive quarter of year-over-year earnings growth for the index after a year over year decline in Q3 2012 (-1.0%). Nevertheless, this earnings growth is not projected to continue into 2015 as Wall Street has revised estimates down from a 4% increase to an overall earnings growth of around -2%.

7) The price of oil has taken a bone chilling dive

The price of oil has dropped to 6 year lows in only 6 months sparking a fierce debate over whether lower prices are on balance a positive for global growth. Is this drop in oil prices simply an oversupply issue or is it a symptom of something more sinister such as a slowdown in demand caused by a sputtering global economy?

8) Bond markets have been rallying

Around the world investors have been opting to buy bonds with negative yields which on paper imply a guaranteed loss. Why would investors buy such bonds of various maturities in as many as ten countries?

There could be several reasons but fear is the most significant. By accepting a negative yield investors are signaling their uncertainty about global growth and their appetite for safety.

The apparent question is whether the direction of the market in January will determine the coming year’s trajectory. There is no doubt that the dark clouds explained above have made investors nervous about committing new money to the market yet, as I write, a 7% surge in the price of oil is pushing all major US Indexes higher with key commentators calling a bottom. Can January already be safely forgotten? In my view, slight pullbacks like the one experienced in January are symptoms of a healthy bull market and not yet indicative of an impending prolonged downturn.

Nevertheless, we can worry and debate all we want about whether oil has found a bottom or whether the S&P 500 will end positive for the year but the bottom line is that we shouldn’t lose our focus on the long term. The themes above are important yet what the market does from day to day or year to year shouldn’t be your primary concern. Instead, the wise investor should focus on investing in quality businesses and stay calm in order to take advantage of healthy pullbacks like the one that began 2015.

Originally posted on: Seeking Alpha

Five Market Predictions for 2015

In the sixth-century BC, poet and philosopher Lao Tzu observed the following: “Those who have knowledge don’t predict. Those who predict don’t have knowledge.”

I agree with Mr. Tzu and don’t presume to be a seer, yet despite his wise words, I will be providing my top 5 “predictions” for the global markets in 2015. Why? because the notion that the financial future is not in any way predictable is just too unpleasant a thought for the romantic (all true investors are romantics are they not?).

Here are some predictions for the public markets in 2015:

1) Non-energy related South-East Asia and Latin America will help boost global growth estimates

Latin America is going through a very unique demographic environment. On the one hand, Latin America is seeing an increase in its aging population. In 2000, the number of seniors (60 and up) in Latin America was approximately 43 million and by 2020 it is expected to be roughly 83 million. However, there is also incredible growth in young middle class workers. In 1990, there were 170 million workers aged 15-35 and in 2010 that number grew to 280 million. By the year 2020, that number is expected to reach nearly 300 million. Moreover, the largest portion of that growth is expected to be amongst women, who currently comprise over 100 million in the workforce.

In 2014, many Latin American economies had a very good year. The Argentinian stock market rose nearly 54% and Colombia was near full productive capacity. In fact, growth in countries like Peru and Colombia have made it difficult for these nations to curb inflation. Colombia has grown the fastest in 2 years with its GDP growing at 6.4% from a year earlier and Peru has seen an increase in its GDP of 4.9% from a year earlier. A lot of this growth is due to infrastructure as public works spending in Colombia grew 24.8% from a year earlier.

Nations like Vietnam are also seeing incredible growth. Vietnam grew 6.96% in the latest quarter beating all estimates. Exports are surging and retail sales are rising drastically with 10.6% growth from a year earlier, which could rise more due to lower energy costs. Moreover, Thailand is seeing record consumer spending (albeit from increased household debt and the Bank of Thailand’s commitment to low rates) but this has allowed the economy to grow faster than normal. In fact, the entire Southeast Asian region is seeing record levels of consumer debt which I believe will continue to accelerate as interest rates and inflation remain low (inflation in Thailand decreased to 1.26% last quarter), creating more growth than previously estimated.

Overall, expect to see rising consumption in Latin America especially on big purchase items like automobiles. The Latin American consumer is shifting towards more ‘convenience’ so consumer staples with strong brands will play an essential role in the region. Global growth according to the IMF is expected to be 3.8% in 2015 but expect to see growth slightly above 4% due to these region specific catalysts.

2) Sectors to watch: Global Healthcare

This leads me to my next prediction, which is the continued growth in global healthcare. Mexico is seeing a drastic increase in demand for healthcare with a rapidly ageing population but is having difficulty keeping drug administration costs low. This dynamic creates a ripe environment for large generic manufacturers to enter the region. Moreover, companies like Pfizer and AstraZeneca are making sizeable investments into Latin America via acquisitions as they are betting on continued growth in the demand for pharmaceuticals given shifting demographics. Companies like Stericycle and ResMed will also be increasing their exposure in Latin America, particularly in Brazil. Asia is also a significant growth catalyst for pharmaceutical companies as incomes are rising among an expanding middle class. India is also of note as it is experiencing a rise in the demand for healthcare which is evidenced by the recent surge in Indian market focused, Mumbai headquartered Sun Pharma’s earnings. Finally, the USA looks promising as there will be reliable growth in demand for healthcare caused by the ageing baby boomers and the requirements of the Affordable Care Act (think ETFs like VHT and CURE).

3) Europe will see better than expected stock market performance

A bit of a contrarian prediction perhaps, but I remain “carefully” optimistic about Europe’s economic prospects and expect some surprise upside in 2015. Although 2014 was supposed to be the year Europe made it safely out of the fire of the debt crisis, several factors held it back. The first was a slowdown in China and emerging markets, the second was the impact of the Russia-Ukrainian fiasco (think of the big impact on the German economy) and the third and most significant was the inability of Euro governments to remove the structural barriers which make the rebalancing of Euro economies difficult.

These “structural deficiencies” include poor institutions to streamline the restructuring of private sector debt, high corporate and personal taxes, entrenched special interests such as unions and political patronage networks, corruption and stifling bureaucracy. These factors make investors and businesses uncomfortable and thus without their removal the creation of any new cycle of growth will be improbable.

How difficult is it for Euro Governments to address these problems? Reform is proving to be very difficult as such deficiencies cut to the core of European culture itself. Thus, as we are seeing in Greece, European nations will have to ask themselves what kind of vision they have of their societies moving forward and deciding may take more time and more pain.

Nevertheless, I believe these negative catalysts are outweighed by the positive catalysts which are ECB stimulatory measures, lower interest rates for a prolonged period of time, a weaker Euro, a banking sector more flexible with its loan policies and lower commodity prices.

In addition, there is an “elephant in the room” that no one seems to be talking about. After seeing record stock market returns in the S&P 500, many feel that US markets are overvalued and ripe for a major correction. There is no doubt that companies today are more expensive than they were in 2009-2010, but consider the fact that the MSCI Emerging Market Index ETF is currently trading at a paltry 11.2 projected trailing 12 month PE and the MSCI All-World Index (excluding the US) is down 6.2% for the year. Thus, investors will be looking for value outside the US in favour of the developing world and Europe which may cause a surprise rise in European markets (think quality European companies like BUD).

4) Oil will remain weak

With the recent drop in energy over the past few months, and with Saudi Arabia warning that they “may never see $100 barrel oil” again, it seems that there are too many catalysts in play which will prevent oil from getting back to triple digit territory. To be clear, I don’t bet on the price direction of a fixed dollar investment like oil (or gold or silver or any commodity for that matter) since that is a dangerous game, but with current output levels relative to demand, commitment to OPEC market share, technological innovation, a slowing China, Japan in recession-mode and new pipelines in areas like Kazakhstan, I don’t expect oil to be above $100 at year end; for a short position think ETFs like ERY and DWTI. Many funds and traders are betting on the rise of the Canadian energy sector which took a massive beating at the end of the year, and if oil were to rise to $65-$70 that may be a good ‘trade’. However, with oil still in sharp decline and with these new fundamentals intact, I don’t expect to see oil back at what it was at in the beginning of 2014 and thus “playing” the Canadian oil sands could be a particularly painful gamble. Instead, I view oil lower for longer which may amount to a considerable tailwind for many companies with significant operating costs (think airlines, tire manufacturers, chemical companies).

5) Volatility is back

As of the date of this writing the VIX, the most popular measure of volatility which focuses on the stock market (it measures the cost of options which can be conceptualized as the price investors are willing to pay to insure against sudden market moves) is up around 10% for the year. If we consider a chart of the VIX at its peak around 2008 until today there are only two slight spikes (2010, 2011) and from 2011 on it has been relatively smooth as the S&P 500 has marched forward with broad gains for most stocks. This relative calm can largely be attributed to supportive monetary policy (QE and low interest rates) as equities slowly marched back to pre-recession levels. Yet in 2015 the narrative has changed. Equities are widely believed to be fully valued with investors looking at any slip in earnings to justify a selloff and the Federal Reserve has ended QE and is prepared to begin normalizing interest rates. Add to the mix concerns about global growth, an oil shock and a potential geo-political confrontation or two and 2015 looks to be more bumpy indeed.

Originally posted on: Seeking Alpha