2011/04/07

Letters from Buffett

In the financial world, everyone is advised to read the letters Warren Buffett writes to the shareholders of Berkshire Hathaway as if they are the epistles of St Paul. I recently read the latest of these letters, finally giving in to the common consensus.

The letter was certainly interesting (though I am told it is not his best). However, rather than point out all its wisdom (there are enough people calling Buffett the messiah of value investing already), I would like to point out what I believe to be flaws.

America, the land of opportunity

This year’s letter (and possibly others- I do not know) is laced with American favouritism. Buffett goes to great lengths to reassure his investors that he will invest primarily in America. Would an objective investor truly ignore the rest of the world, when this potentially limits his investment universe? Consider that in the same letter he mentions how his success with Berkshire began when he moved away from textile industries and considered a much larger pool of possible investments.

After the earthquake in Japan, Buffett seems to think Japanese stocks may be cheap. Looking abroad is what one would expect from a man who looks for value wherever it can be found. It is not, however, clear whether he has actually bought any Japanese stocks.

Lucky GEICO

Berkshire Hathaway’s performance over the past 40 years has indeed been far above average. But does this automatically mean Buffett is a genius?

Buffett relates how he was introduced to GEICO because his hero Ben Graham was its chairman. Buffett (personally) bought stocks in the company and recommended it to others. Its subsequent success worked in his favour. Later, when GEICO was struggling, Berkshire bought stocks in the company. This was the start of Buffett’s success with insurance. Now, how much of this was luck, luck that started with GEICOs association with Ben Graham?

“Free” money

Considering Buffett’s famed success with insurance, I was surprised to find the following statement in relation to the capital held on this business

We will benefit just as we would if some party deposited $66 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit.” (pg 10)

Buffett is referring to the fact an insurer receives premiums upfront and pays out claims later. In the meantime it can invest the money and if its claims are not too unfavourable (if it makes an underwriting profit) it makes a profit from these returns.

I do not think Buffett actually believes that statement to be true. He only thinks he does, perhaps. It would be very silly to act as if you were just being paid to make investment profits off of other people’s money. Insurance companies are being paid to take on risk. Just because less of this risk materialised now, this does not negate the fact that the price you pay for taking on all that money is risk. That risk could bankrupt even GEICO tomorrow.

Buffett tries to justify why HIS insurers should continue to make underwriting profits. And yes, good management helps, but the fundamental situation is unchanged. A little less of a risk (if it’s not all just luck anyway) is still a risk.

Another point to note is that property and casualty insurers are hardly ‘investors’. Given the (usually) short-term nature of the risks and possible large payouts most of the investments should be in liquid guaranteed instruments and with a relatively low level of return. Such a restriction is hardly to be found with “free” capital.

One man show

Throughout the letter Buffett heaps praise on the various CEOs that run his businesses, and some dollops to others as well. I am sure this helps to motivate them and make them feel appreciated, but a business does not consist of its CEO. I cannot help but wonder how much of a business’s success really depends on that one man. The jury is still out, I reckon.

The bigger picture

I have, I realised, managed to point out just some small flaws in a letter that otherwise contains some very important wisdom. I would be happy to hear what you think, though. That is why this blog has a comment function.

Some references

The famous letter
  • Buffett, W. (2010). Letter to the shareholders of Berkshire Hathaway Inc. October. Retrieved from http://www.berkshirehathaway.com/letters/2010ltr.pdf.
An article on Buffet’s view of Japan
  • Jin, H. (2010). Warren Buffett: Japan Disaster Presents A “Buying Opportunity.” Huffpost Business. Retrieved April 7, 2011, from http://www.huffingtonpost.com/2011/03/21/warren-buffett-japan-pres_n_838281.html.

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