Every year, the Oracle of Omaha, Warren Buffett, releases the annual report of his conglomerate, Berkshire Hathaway. In it, readers can find a treasure trove of information. This year was no exception. So, let’s look at six essential lessons I gleaned from the latest 2017 annual report that was published at the end of last month (for the first three lessons, head here).
“Free money” from the insurance business
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One of the main reasons why Berkshire has been able to do exceptionally well thus far is the float that it has. Float is essentially the difference between the premiums collected by an insurer and the claims paid out to insured parties. Insurers like Berkshire use the float it has to invest in financial instruments or other companies. All dividends, interest, and capital gains from the invested-float belongs to the insurer.
Some claims such as car repairs have to be immediately paid out but others, such as harm caused by asbestos exposure, can take years to surface, and even longer to investigate and settle. Also, loss payments may at times spread over decades, like a worker being permanently injured and requiring lifetime care. Such time lags are an advantage for Berkshire.
The float that Berkshire collects grows as its premium volume climbs. In 1970, it had US$39 million in float on the back of US$39 million in premium volume. This has increased to US$114.5 billion in float with US$60.6 billion in premium volume in 2017.
Buffett added that the float will probably increase slowly for at least a few years, and if there is a decline, it will be small. Berkshire’s float from property and casualty insurance is also “protected” as it cannot be withdrawn, unlike bank deposits or life insurance policies with surrender value. Such characteristics is paramount for Berkshire when it is planning its investments.
Embrace stock market volatility (without using leverage)
Even though Berkshire has created tremendous shareholder value over the years (its book value per share has increased by nearly 11,000 times from 1965 to 2017), it has not been spared from Mr Market’s tantrums as its stock price has “suffered four truly major dips,” as seen below:Source: Berkshire Hathaway 2017 annual report
In the most recent 2008-09 financial crisis, Berkshire’s shares tumbled by 50.7% from peak-to-trough. The biggest decline it saw was in 1973 to 1975, when its stock price fell by over 59%. In the short-term, stocks can bobble up and down, but in the long-term, strong companies which have been building up their underlying value will do well. From 1965 to 2017, Berkshire’s book value per share has increased by nearly 11,000 times (10,880 times to be exact!) as mentioned earlier; its stock price has jumped by 24,047 times in value over the same period.
Buffett warned that in the next few decades, the stock market will experience declines of magnitudes seen above, and that no one can predict when these will happen. But when such turmoil occurs, “they offer extraordinary opportunities to those who are not handicapped by debt.”
Invest in low-cost index funds
Warren Buffett entered a bet in 2007 with fund manager, Protégé Partners. In that wager, Buffett claimed that a low-cost S&P 500 index fund would beat a basket of hedge funds chosen by Protégé Partners over the next decade. With 10 years having passed since the bet started, the funds in question had generated an average annualised return of just slightly less than 3%. Meanwhile, Buffett’s S&P 500 index fund had an annual return of 8.5%.
The main reason for the poor performance of the funds is the high fees charged by them. Buffett thus recommends that investors put their money in a low-cost index fund instead of giving them to professionals as the high fees charged by such professionals would easily eat into the gains made. He summed it up nicely by saying, “Performance comes, performance goes. Fees never falter”.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.