Learning investment strategies from Warren Buffett’s shareholder letters

One of the best ways to learn more about the way share markets work and how to make money by investing in them is by reading Warren Buffett’s annual letter to shareholders in his investment company Berkshire Hathaway.

There is a wealth of wisdom in these letters written in a folksy and easy to understand way and with a refreshing admission of mistakes made as well as modest recognition of trades that really paid off.

In this year’s letter I think one of the great lessons is contained within Buffet’s touching tribute to his longtime friend and Berkshire vice-chairman, Charlie Munger, who died aged 99.

Munger the architect of Berkshire’s success

In acknowledging that Charlie Munger was the true architect of Berkshire’s stellar growth rate to become a $US905 billion ($1.38 trillion) company – Buffett, 93, said he was merely the guy who was in charge of the “construction crew” – the chief executives of the various companies within the sprawling empire.

The really interesting part – other than the charming acknowledgement that their relationship was that of “part older brother, part loving father” – was the important role Charlie Munger played in transforming Buffett’s investment philosophy.

While Warren Buffett has always been seen as a value investor – and that was his background from his initial mentor and the father of value investing, Benjamin Graham – the reality is that many of Berkshire’s best results have come from buying big stakes in solid, growing companies and simply hanging on for the long term.

The company’s early stake in Coca Cola is a great and enduring example but there are hundreds of others.

Buffett weaned off the cigar butts

Buffett admits that his value training often led him to the sorts of investments that are best described as “cigar butt’’ companies – those that might have just one good puff left from which to extract some value.

That is still the case today, with true value investors often identifying companies that are trading at a big discount to their assets, for the obvious reason that they are not being well run and often don’t have a strong future in their current form.

Buffett revealed that it was Munger who was instrumental in shifting him away from that approach of identifying undervalued dogs and instead to begin investing in fairly priced but well-run businesses.

“Charlie became my partner in running Berkshire and repeatedly jerked me back to sanity when my old habits surfaced,” Buffett said in his letter.

Great combination of growth and value

It is this combination of a strong value focus but with a bias towards buying strong businesses that are well run and have a good future that has created Berkshire Hathaway today – and was behind the astonishing performance of a 4.4 million % return since 1964 – a vastly better return than the still impressive 31,233% made by the benchmark S&P 500 over the same period.

One great current example of the combined Buffett / Munger approach is Berkshire’s investment in five Japanese trading houses, which are known as sogo shosha.

Buffett bought large stakes of around 9% in the five large conglomerates – Mitsubishi, Mitsui, Itochu, Marubeni and Sumitomo – at a time when Japanese shares were sluggish and depressed and the trading house approach was out of fashion.

Since then, of course, there has been a startling rise in Japan’s Topix index, with the last year alone seeing it rise 33% to fresh record highs.

The diversified trading houses have performed even better than that with Berkshire’s initial $25 billion Japanese investment up 81% at the end of the year and potentially around 11% higher since then.

Even better, the deal allowed Buffett to borrow lots of long-term money at rates of around 1% and pocket a dividend yield of closer to 5% from the trading houses.

Critics might point to the depreciation of the yen as a negative on that performance but that really points to another factor in the genius of the Buffett / Munger move, which simultaneously involved selling an almost matching amount of Japanese bonds to remove a lot of the currency risk from the transaction.

Those bonds have softened but not eradicated the currency risk, with last year’s gain coming down to a still sensational 61% or $12.2 billion.

Buffett insists he won’t be shooting the lights out

Another refreshing thing about Buffett’s letter is that he refuses to gild the lily or show any hint of ego or hubris.

Given Berkshire’s stellar investment record and even the evidence of his foresight with the monster Japanese trading house investments, Buffett is honest enough to predict that Berkshire will struggle to produce massive returns from now on.

Instead, he claims that Berkshire should continue to “do a bit better” than the average US company “and, more important, should also operate with materially less risk of permanent loss of capital”.

“Anything beyond ‘slightly better’, though, is wishful thinking,” Buffett said.

The reason is one that has been around for many years now but has become more apparent in the last decade as Berkshire started to rely more on share buybacks to grow shareholder value than mega-deals.

Deals not big enough for Berkshire

There are simply very few deals that could make the same sort of transformative impact as previous ones given Berkshire’s size now, which represents around half of the entire Australian share market.

“There remain only a handful of companies in this country capable of truly moving the needle at Berkshire, and they have been endlessly picked over by us and by others,” Buffet said.

“Outside the US, there are essentially no candidates that are meaningful options for capital deployment at Berkshire.”

Cash pile still rising

Another measure of the problems facing Berkshire is the growth of the company’s cash pile, which has gone from large to absolutely enormous and is often criticised by fund managers as a brake on growth.

Despite plenty of large purchases, that cash pile hit a record $256.3 billion at the end of 2023, up $59.6 billion over the year.

As Buffett wistfully puts it: “Size did us in, though increased competition for purchases was also a factor.”

“For a while, we had an abundance of candidates to evaluate. If I missed one – and I missed plenty – another always came along. Those days are long behind us.”

It is a startling admission but one that won’t stop the army of devoted Berkshire shareholders, for whom a “slightly better” performance with greater safety is still an opportunity to be savoured.