This is no joke.
If I simply copied and pasted pages 17 through 19 here of the Berkshire Hathaway 2011 Annual Report and did nothing more it would be immensely valuable. It’s simply that amazing.
I believe I can add some additional value so I’ll sprinkle my thoughts among those of the masters of investing: Warren Buffett and Charlie Munger. After reading this post do yourself a huge favor by clicking the link to the report, going to the section labeled “The Basic Choices for Investors and the One We Strongly Prefer” and reading for two plus pages.
Send your thanks to Warren and Charlie though, not me.
It’s impossible to highlight the key sections of two pages since every word has purpose and impact. I’m going to give it a shot anyway to make your life easier.
Note: all quotes come from the annual report unless otherwise called out.
Your behaviors and feelings about investing are about to never be the same.
The Definition of Investing
“Investing is forgoing consumption now in order to have the ability to consume more at a later date.”
Deep down you know the reason you save. It’s so that new money can be used later for something you don’t need now.
Rare is the person who doesn’t invest new money and hides it under the mattress instead. For the rest of us, we invest new money so we can consume (in the broadest sense of the word) later. Motivations for why and what to consume later are as numerous as the stars but it’s for a universal human purpose.
If we consume everything we have now we risk not being able to consume in the future.
Investing Risk is Not What You Think
“The riskiness of an investment…is measured by the probability of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.”
Let me first say…wow! I could write 5,000 words without being able to communicate what they just did in 63.
The key here is the contemplated holding period. A suitable investment for money you need in a month will look very different than the right investment for money you tap in a decade.
Their statement is that volatility in the value of your investment is not the same as the risk of the investment. If the value of an investment swung fifty percent every day it still wouldn’t be risky if you’re confident it will increase your purchasing power over the holding period.
And the kicker? Stability in the value of an investment can be majorly risky over time. Kind of makes you want to reassess your beliefs about fixed income investments, huh?
That leads nicely to the next pearl of wisdom from Warren.
The Sound of Your Purchasing Power Being Eaten
“During a 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income.”
For the full context Warren continues by saying that this investor’s taxes ate up 1.4% of the stated yield and inflation devoured the other 4.3%.
For this reason Warren evaluates his investment’s performance on an after tax and after inflation basis. If you lived in post World War II Hungary the astounding returns Berkshire Hathaway has generated would mean nothing. That’s what happens when hyperinflation is 41,900,000,000,000,000% (or 41.9 quadrillion percent) in one month and prices double every 15.3 hours.
Along the same line, you’d assess your investment returns differently paying a 62% tax rate in Denmark than a 35% tax rate in the U.S.
A quote from someone other than Warren sums up what fixed income investments have to offer these days.
“Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.” – Shelby Cullom Davis
Bottom line: Ignore any impressive investment return numbers that don’t account for inflation and taxes.
Gold, Tulips, Oxygen…It’s All the Same
“What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct… This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons)…gold will be unchanged in size and still incapable of producing anything.
Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”
Joel’s note: No add-on commentary here. I thought it would be fun to copy and paste a section of the report on gold (or tulips or anything without inherent value generation) and let Warren’s words stand on their own.
The Preferred Path
“My own preference (for) investment…(is) in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.”
“I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined (including fixed income and assets like gold). More important, it will be by far the safest.”
Is it just me or has Warren boiled down decades of investment amazingness into a math formula? He’s throwing this at us in just about the most basic terms possible! My interpretation of his formula is this:
Money Invested x Purchasing Power Increased – Taxes Paid – Inflation Rate = Total Return
Everything outside the formula is subjective.
Risk. Volatility. What constitutes a “long” holding period.
Bottom Line: Total return on investment over the holding period is based purely on objective components.
Speaking of risk, I’m running the risk of oversimplifying investing. After all, it is one of the most complex and irrational topics in the history of humankind.
But Warren has brought simplicity to a new level.
I have no doubt that behind-the-scenes there is an impossibly complex set of rules, equations, policies and beliefs that drive what Berkshire Hathaway has done. But Warren has taught us in two pages just about everything we need to know about investing.
Personally, I’m not going to spend decades learning the nuances and trying to come up with something better. When you come across someone giving away their best knowledge and resources for free – and they have an impeccable reputation and track record – you don’t ask questions.
You smile gracefully, say “thank you” and become happy that there are people out there like Warren.
So thank you Warren! I reflect back on your two pages with a new found awareness, a smile, and being a happier investor.
I can’t resist offering the world one last pearl of wisdom before the comments start to stream through.
“Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle.”
Please leave a comment about what these quotes mean to you or how you’re going to change your investing behavior and action as a result of reading this.