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 Buffett's Sobering Lessons - Eureka Report Article 

March 3, 2008
Buffett's sobering lesson
By Scott Francis
Web page Warren Buffett's letter to shareholders

PORTFOLIO POINT: In his latest letter to shareholders, Warren Buffett dispels the notion that house prices and sharemarkets can rise forever.


Every year investors around the world wait for Warren Buffett's annual letter to shareholders in his role as chairman of Berkshire Hathaway. Buffett is generally regarded as the world's greatest living investor and the letter is a rare insight into how great investors deal with the market. You can read the whole 21-page letter by clicking here.

The letter starts with some thoughts on the "credit crunch". Buffett refers to a Silicon Valley bumper sticker that requested, 'Please God, Just One More Bubble' (Silicon Valley being the home of the dotcom bubble). He argues that this wish was granted as Americans believed that house prices would rise forever, with the pain now coming as prices fall.

The conviction that house prices would rise forever meant that "lenders, who shovelled out money" relied on house price appreciation to "cure all problems". This is probably a good reminder to us on the other side of the Pacific, that house prices do rise and fall.

Buffet reserves some of his most lucid observation into the notion of neverending stronger returns from the sharemarket. To all investors who have a built in presumption that markets must keep rising and returning 10% annually, Buffett pulls no punches.

He explains that the Dow Jones index advanced from 66 to 11,497 over the course of the 20th century: a 5.3% compound annual growth rate. To repeat this performance in the 21st century, the Dow would need to reach almost two million by the end of 2099.

After sobering investors with this forecast, Buffett then lobs the powerful question: Does anyone really believe this is the most likely outcome?

What Berkshire looks for as an investor

Buffett's letter reiterates the basic attributes of a good business:
  • A business that is understood (Berkshire Hathaway famously avoided the dotcom bubble because it did not understand technology stocks).
  • Favourable long-term economics.
  • Able and trustworthy management.
  • A sensible price tag.

The letter talks about the "moat" that great businesses must have to protect the returns for the capital invested. Moats mentioned in the letter include being a low-cost provider or having a powerful brand.

The worse businesses around - those described in Buffett's letter as "gruesome", include those businesses that grow quickly, require a lot of money to grow quickly, and then earn little or no actual money. His classic example is airlines. He goes as far as to say that, "if a farsighted capitalist had been present at [the Wright brothers' first flight at] Kitty Hawk, he would have done his successors a huge favour by shooting Orville down". Anyone who doubts the wisdom of avoiding airlines should look at the underperformance of Qantas and Virgin over the past five years - even with the bounce in share price that came with Qantas being a takeover target.

Since March 2003, shares in Qantas Airways (QAN) have gone from $3.12 to only $4.17; Virgin Blue's shares have dropped from their IPO price of $2.40 on December 8, 2003, to $1.31 on March 3, 2008.

The financial services industry and "beating average returns"

This year's letter also has Buffett making some trenchant comments about the promise of "better than average returns" so often promoted by fund managers and advisers.

His comments are that the returns for those people who pay more in fees to try and beat the market average "must be below average". He puts forward his reason in three steps:

  • Investors as a group will earn the average market return minus their costs.
  • Passive and index investors will receive that average market return minus costs that are very low.
  • Given that passive and index investors receive the average market return less costs, so must the remaining group - the active investors. But he points out that this group "will incur higher transaction, management and advisory costs. Therefore, the active investor will have their returns diminished by a far greater extent percentage than their inactive brethren."
  • The passive group of investors - what Buffett calls the "know-nothing" group - must win.

Conclusion

Buffett's annual letter is always a useful pointer to investors; he has the ability to cut right to the heart of many investment debates. A quick look back to last year's letter shows his concerns over "weakened lending practices", something that has proved prophetic 12 months on. Letters in the late 1990s and early 2000s also make comments regarding his concern as to whether internet companies had a sustainable competitive advantage, again an astute forecast. As well as having interesting commentary, these annual letters are written in plain language and with enough humour to make them enjoyable as well.

Scott Francis' articles in the Eureka Report 

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