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What’s wrong, Warren?

That headline, above, isn’t actually mine.

At least, not originally.

Nor is it new.

But we’ll get to that.

Let’s start where we are now, in 2020.

On Sunday morning, Australian time, Warren Buffett released his Chairman’s letter to shareholders of his company, Berkshire Hathaway. (I own shares, for the record.)

In it, he opines freely about the company, accounting standards, corporate governance and a few other things. We’ll get to that, too.

But the glaring issue isn’t the letter. It’s his — more accurately, the company’s — recent performance.

See, Berkshire shareholders have had a tough decade. For the longest duration in his tenure at the top of the investment conglomerate, Buffett is being beaten by the market.

Yes, $1 invested in the boring old S&P 500 would have earned you more than $1 invested with the world’s greatest ever investor.

And that’s got tongues wagging.

Buffett is 89. His business partner, Berkshire’s vice-chairman, Charlie Munger is 96.

Have these men, after half a century of market-beating performance, finally passed their investing use-by date?

After all, the world has changed — a lot — since Buffett took control of a US textile manufacturing business called Berkshire Hathaway.

His heyday — the investments still talked about today — were made in the 60s, 70s and early 80s. His purchases of Coca-Cola shares, American Express shares, and the purchase of US insurance juggernaut GEICO and west-coast candy business See’s are fabled… but they’re history, these days.

Having seen Buffett in person a few years ago, and online in interviews (and the podcast of the company’s annual meeting) more recently, I can say that Buffett remains sharper, mentally, than 99% of us.

But Coke, AmEx and GEICO are industrial-era companies, and we’re in the age of tech, notably something Buffett himself says is outside his circle of competence.

He has US$128b of cash hanging around on the company’s balance sheet… but can’t find a single thing to buy. 

Which suggests one of two things:

Either Buffett is right, and prices are too high (he has a very, very small universe of investment options, given there’s no value in buying tiny companies that just can’t move the dial), or Buffett’s framework — at least the way he applies it — just isn’t as relevant any more.

We’ll get back to that.

Let’s touch, first, on his letter.

Even if you take the view that Buffett is no longer the investor he was, in practice, he has done more than anyone to educate three or four generations of investors, and no investor worth their salt should ignore the Oracle of Omaha, even if they don’t take everything he says as gospel.

Here’s a few of the things — new, or just reconfirmed — I thought were important.

The letter characteristically starts off with Buffett doing his best to explain the underlying profit to shareholders. He could have run with ‘Profits up 1,009%!’, which was true, but instead he wants shareholders to see, and understand, that the year-on-year change has more to do with accounting rules he disagrees with, rather than the actual underlying performance of the company.

That gives us Lesson 1: Focus on underlying earnings power, not ‘headline’ results

He wants you (and me) to remember to be prepared for volatility — something that’s a recurring theme in my articles, too. So, with his imprimatur, I’ll dip into that particular bucket again and share Buffett’s words:

Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater. But the combination of The American Tailwind, about which I wrote last year, and the compounding wonders described by Mr. Smith, will make equities the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions. Others? Beware!”

So:

Lesson 2: Be prepared for volatility, but don’t fear it, and don’t try to avoid it by not investing

And:

Lesson 3: Buffett expects shares to beat other asset classes over the long term

plus:

Lesson 4: Do NOT use borrowed money to invest

As well as:

Lesson 5: You must control your emotions (or at least control the actions you might otherwise take when you’re emotionally-charged)!

(That’s a pretty good bounty from a 71-word quote from the great man, don’t you reckon?)

I also got a chuckle from this:

“Three decades ago, my Midwestern friend, Joe Rosenfield, then in his 80s, received an irritating letter from his local newspaper. In blunt words, the paper asked for biographical data it planned to use in Joe’s obituary. Joe didn’t respond. So? A month later, he got a second letter from the paper, this one labeled “URGENT.”

“Charlie and I long ago entered the urgent zone. That’s not exactly great news for us. But Berkshire shareholders need not worry: Your company is 100% prepared for our departure.”

Buffett then goes on to list 5 reasons the company is set up to outlive both he and Munger. I won’t list them here, but:

Lesson 6: If you find a company whose leadership is planning for the time after their departure (mortal, or otherwise), you should feel extra-comfortable

Buffett also notes that CEOs are driven by what I’ve described as the ‘institutional imperative’, and encouraged by short-term-focused fund managers who want to see short term share price rises to please their bosses and investors. He says:

“Audit committees now work much harder than they once did and almost always view the job with appropriate seriousness. Nevertheless, these committees remain no match for managers who wish to game numbers, an offense that has been encouraged by the scourge of earnings “guidance” and the desire of CEOs to “hit the number.” 

Again, while immodest to do so, I’ll note that it’s something we’ve been banging on about for a while here at The Motley Fool. No CEO should be giving guidance unless their revenue is contracted, or so certain that it would be a disservice to investors not to provide it. Every other CEO (and board) should, frankly, shut up about guidance.

Lesson 7: Company CEOs should stop giving guidance, and shareholders should stop asking for — and listening to — it.

Buffett takes a decent (and oft-justified) swipe at corporate governance in general this year, but this, about directors, stood out.

“Here, a pause is due: I’d like you to know that almost all of the directors I have met over the years have been decent, likable and intelligent. They dressed well, made good neighbors and were fine citizens. I’ve enjoyed their company. Among the group are some men and women that I would not have met except for our mutual board service and who have become close friends.

“Nevertheless, many of these good souls are people whom I would never have chosen to handle money or business matters. It simply was not their game.”

Which is worth remembering, any time you hear what a director says, and observe what they do. So frequently we hear of ‘director selling’ or ‘director buying’ as some sort of signal for investors to take action.

Maybe it is.

But as Buffett reminds us, many aren’t people he’d ask to manage his money. Which has to make you wonder: how good are their capital allocation decisions for the company… or for themselves

Lesson 8: Directors aren’t, necessarily, some elevated group, with divinely-granted abilities

There’s lots more, of course. Every single investor, no matter your approach or philosophical view of Berkshire or Buffett, should consider the annual letters to be required reading. You can find this year’s letter, here.

Okay, now back to our headline.

Buffett might be smart, folksy and worth listening to.

But has he lost it, when it comes to market-beating investments.

The short answer is: We don’t know.

It’s absolutely accurate to say the market has beaten him over the past decade.

What we don’t know — at least in totality — is why.

See, that headline, “What’s Wrong Warren” originally sat atop an article from revered US business magazine Barron’s.

And it was published on December 27, 1999.

At the time, Buffett was being killed by the ‘new breed’ of dot.com heroes. And some people thought he was past it. That the times no longer suited him. That it was a game for younger people (or just more modern minds).

And then?

Well, we know what came next — the dot.com collapse.

After lagging the market for a few years, Buffett roared back ahead, where he stayed for another decade and a half.

In 2019, the market beat Berkshire: 31.5% versus only (“only”) 11% for Berkshire.

Buffett won in 2016, 2017 and 2018, but lagged in 2015.

Net-net, though, the market has gained more than Uncle Warren, thanks to the effect of compounding and — most importantly — the impact of that ‘last’ year in any series. The 20% underperformance in 2019 hurt Berkshire’s relative performance… a lot.

That’s in the past. If we’d known that a decade ago, we could have invested differently.

The only thing that matters now, though, is the future.

And one specific question: Having amassed US$128 billion in cash, thanks to profitable business operations, but a lack of investment opportunities, will the dam break?

At present, Buffett is struggling to find businesses that are both large enough to be worth buying, and cheap enough to buy.

‘Cheap’ might be the problem. If Buffett ends up being ‘wrong’ here, it’ll be because he failed to pay up for companies that aren’t traditionally ‘cheap’, but which might actually be attractive investments if Buffett reset his expectations in line with newly lower interest rates.

Or, if rates go back up (and/or a market crash gives him an opportunity) Buffett’s final big masterstroke might be in exercising the patience of Job while others around him were telling him he was wrong, then being able to put all or most of that money to work on a very attractive acquisition.

My kingdom for a crystal ball!

As I said earlier, I’m a Berkshire shareholder.

I’m not thrilled that my investment has lagged the market in recent years.

But I’m not going anywhere.

Buffett might be wrong. He might be unlucky. Or, in the end, he might be right.

I’m not planning to bet against the world’s best investor, any time soon.

(By the way, the same writer who penned Barron’s (in)famous December 1999 story wrote another one in December 2019, titled “What’s Wrong With Warren Buffett’s Berkshire Hathaway?”. I’m not one for omens, but…)

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Scott Phillips owns shares of Berkshire Hathaway (B shares). The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and recommends Berkshire Hathaway (B shares) and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short March 2020 $225 calls on Berkshire Hathaway (B shares). The Motley Fool Australia has recommended Berkshire Hathaway (B shares). We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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