This is the thirty-seventh in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2016. For all of the prior shareholder letters, see here.
The 2013 letter weighs in at 12,890 words, a 5% decrease from 13,580 words the prior year. Berkshire's $32 billion increase in net worth during the year was 18.2% of beginning 2013 net worth.
ALL BUFFETT ASKS FOR IS A 10% UNLEVERAGED RETURN
Most of the 2013 letter is a relatively mundane recitation of Berkshire's 2013 operating results (at least, as mundane as a $32,000,000,000 net gain can be made to sound), however Buffett includes an interesting digression on investing towards the end of the letter. In this digression he includes a tale of two smallish investments that he made in the mid-1980s and early 1990s with his personal funds. What is particularly interesting about his discussion is how modest his investment goals are--he simply seeks an unleveraged (i.e., safe) return of 10% per year. Here is Buffett's description of these investments:
Some Thoughts About Investing
Investment is most intelligent when it is most businesslike. — The Intelligent Investor by Benjamin Graham
It is fitting to have a Ben Graham quote open this discussion because I owe so much of what I know about investing to him. I will talk more about Ben a bit later, and I will even sooner talk about common stocks. But let me first tell you about two small non-stock investments that I made long ago. Though neither changed my net worth by much, they are instructive.
This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble’s aftermath than in our recent Great Recession.
In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.
I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property. Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm.
In 1993, I made another small investment. Larry Silverstein, Salomon’s landlord when I was the company’s CEO, told me about a New York retail property adjacent to NYU that the Resolution Trust Corp. was selling. Again, a bubble had popped – this one involving commercial real estate – and the RTC had been created to dispose of the assets of failed savings institutions whose optimistic lending practices had fueled the folly.
Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant – who occupied around 20% of the project’s space – was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property’s location was also superb: NYU wasn’t going anywhere.
I joined a small group, including Larry and my friend Fred Rose, that purchased the parcel. Fred was an experienced, high-grade real estate investor who, with his family, would manage the property. And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our original equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I’ve yet to view the property.
Income from both the farm and the NYU real estate will probably increase in the decades to come. Though the gains won’t be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and, subsequently, for my children and grandchildren.
Buffett wasn't greedy. All he wanted was a safe 10%. (Incidentally, Buffett's biographer Alice Schroeder told a similar tale with respect to Buffett's early years, except back then he looked for a safe 15% return in underwriting investments--see here). If the investments turned out better than that, great, but either way he would sleep well at night. Most investors, of course, take the opposite approach, also known as "get rich quick". They focus almost exclusively on the return and forget about the risk (naturally leading them to overestimate the former and underestimate the latter). Even corporations are prone to this disease. For example, take an oil & gas driller like as Pioneer Natural Resources (ticker PXD). They claim to underwrite their wells to achieve returns on capital of 40% to 75% per year(!) (source here):
We one sees such claims, the phrase "If it sounds too good to be true, it probably is" should spring to mind. People who claim to consistently achieve these kind of returns on invested capital are likely either delusional or dishonest, or possibly both. Interestingly, although PXD's stock has quadrupled since it IPO'd in August 1997, this works out to just a 7% increase per year (note that the company has only paid out a measly $1.88/share in dividends in aggregate over its entire 20-year history as a public company). So much for those mythical 40-75% IRRs on wells (if they exist, they certainly haven't filtered down to shareholders very well):
Buffett draws some common sense lessons from his dual investments to share with his readers, which in essence define the boundary between investment and speculation:
You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”
Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.
If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)
My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.
Buffett concludes his mini-sermon on investing with a few warnings about succumbing to the pitfalls of the frenzied atmosphere surrounding the stock market, which often causes investors to make emotional, rather than logical, decisions:
There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.
It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.
Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.
Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there, do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.
A “flash crash” or some other extreme market fluctuation can’t hurt an investor any more than an erratic and mouthy neighbor can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.
During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And, if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well. Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?
For the record, in 2013 Berkshire's stock appreciated 33%, beating the S&P 500 by 0.3%, the Red Sox beat the Cardinals 4-2 in the World Series and the Seahawks destroyed the Broncos 43-8 in Super Bowl XLVIII. Next up, 2014, the year Russian said to the Ukraine "Excuse us, but we'll take back Crimea now".