WWII 115: Warren Buffett Berkshire Hathaway Shareholder Letter Part 2

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Main Topic: Warren Buffett Berkshire Hathaway Shareholder Letter Part 2

This episode is a continuation of last week's episode which was Part 1 of my analysis of Warren Buffett's Berkshire Hathaway annual shareholder letter for 2017.

Buffett Wins the Big Bet

In last year's shareholder letter, Buffett did a detailed report on the progress of his $1,000,000 bet that a low cost index fund would beat five "fund-of-funds" picked by Protege Partners.

Protege then picked five investment experts (the people who each ran a "fund-of-funds" who then choose several hundred other investment experts who each ran their own hedge fund.

Buffett''s point in making this bet was two-fold:

1. To turn his initially outlay of $318,250 into $1 million for his favorite charity

2. To show to the world that an unmanaged index fund would outperform most investment professionals.

During the course of the ten years of the bet, the fund-of-fund managers could re-arrange which funds they were invested in as much as they wanted. But it really didn't matter who they went with. This was a bit like re-arranging the deck chairs on the Titanic.

So after ten years, Buffett tabulated the final results. After fees, the best of the five fund-of-funds provided an annual gain of 6.5% versus the S&P 500 index fund's 8.5%. The rest of the five fund-of-funds provided an annual gain of 3.6% or less, which is less than half of the index.

It's important to note that one of the five fund-of-funds was shut down and liquidated during the ten years from lack of good performance.

Buffett wins again.

It's interesting to look at the mechanics of the bet. Ten years ago, Protege and Buffett each funded their portion of the ultimate $1 million prize by buying $500,000 face amount of zero coupon U.S. Treasury bonds. The bonds cost each party $318,250, a bit less than .64 on the dollar, with the $500,000 payable in ten years. The yield to maturity was a 4.65% annual return until it matured in 2017.

And then, something weird happened in the bond market. The price of the zero coupon bond, which should have risen at  predictable intervals until its maturity ten years letter, rose at faster pace until by November 2012, with more than half its duration to go, was selling at 97.5% of face value, which meant a yield of maturity of less than 1% over the next five years.

So the decision that Buffett and Protege had to make, was accept a less than 1% annual return over the next five years, or sell the bonds and buy something else. In 2012, as the parties where mulling over the decision, the S&P 500 was yielding 2.5%, or more almost three times the yield of the bonds.

Being practical and rational, the parties agreed to sell the bonds and buy Berkshire B shares.

As a result of that decision, Buffett will be giving $2.2 million, or twice the original bet amount, to charity.

This analysis is followed by another amazing quote from Buffett:

"Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. "Risk" is the possibility that this objective won't be attained." - Warren Buffett

What this should mean to you is that old rules may not apply to current times. The advice advisors used to give was that the older you get, the more money you should have in bonds. This would have been terrible advice in 2012. The buyer of bonds in 2012 would have received a paltry yield to maturity, and would have missed out on a major part of the bull market move.

Buffett says:

"It is a terrible mistake for investors with long-term horizons...to measure their investment "risk" by their portfolio's ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk."

New Additions to Berkshire's Board of Directors

Buffett announced that Ajit Jain and Greg Abel were added as directors of Berkshire and were also designated as Vice Chairman.

If you are a follow of all things Berkshire, this move is an big one. Ajit Jain ran the super-cat insurance business for Berkshire and is the one manager that Buffett would talk to almost every day.

Greg Abel ran Berkshires energy group and was widely considered to be the next Berkshire CEO.

The fact that they were made vice chairmen as well means, let me do the math on this one, that there are now three vice chairman, including Charlie Munger.

Ajit will run the insurance operations and Greg will oversee the rest of the portfolio businesses, leaving Warren and Charlie to focus on investments and capital allocation.

This move was obviously part of the succession plan for Warren and Charlie, and was widely anticipated. Personally, I wish them both luck and godspeed.

Although the annual letter can be somewhat repetitive at times, it's always worth a read and I highly recommend it to all willing to sit quietly and learn much.

Ask JB: Is Buying Stock in Your Parents Company Insider Trading?

Can you invest in a company that your parents are executives of? (self.investing_discussion)

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I'm looking to sign up with a brokerage account specifically to invest in a company my dad is the president of. When signing up, they always ask if an immediate family member is a exec or whatever at a publicly traded company. After answering yes and providing the company, am I going to be prohibited from investing in that company? If so, I don't want to bother creating the account.

UPDATE: I went ahead and called the brokerage firm and they said absolutely I could still purchase the stock where my dad is the president even after disclosing that. By disclosing that trades I make of that stock may be a higher priority for scrutiny from the SEC, but if I don't do anything shady (like dump all my stock 3 days before the CEO announces they are stepping down), then I'll be fine.

JB Says: I'm not a regulatory attorney, but usually to be an insider trade, you will have to have an intent to profit on non-public information. This usually means some kind of short-term trade around a release of information to the public that you know in advance.

You can certainly buy stock in a company a parent works for. You will certainly have more scrutiny from the regulators, but feel free to buy. Consider not trading it, but adding it to your pile of assets for the long term.

JB Says: If you want to hear my answer to this great question, listen to the episode!

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About the Author

Jeremy Scott Bailey is an investor, author, entrepreneur and host of the "What Works In Investing?" podcast now available on iTunes. He is founder and Chief Investment Officer of Burgeón Group, Inc. an investment advisory firm that provides portfolio management services to families and individuals.

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