March 3, 2008

	Buffett's sobering lesson By Scott Francis
	Warren Buffett's letter to shareholders

• 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.