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John Emerson
John Emerson
Articles (106) 

Warren Buffett's Annual Letter - On Risk And Investment Choices

February 26, 2012 | About:

When Warren Buffett departs from this world he will leave two extraordinarily important legacies. The first will be the philanthropic disbursement of almost all of his immense material wealth. The second legacy will be the philanthropic disbursement of almost all of his immense intellectual wealth. The former will be distributed mainly through the Gate's Foundation; the latter will be distributed through his annual letters. For value investors and money managers, the latter contribution is consummate to hitting the lottery so long as they take the sufficient time to absorb the lessons and follow Mr. Buffett's advice.

In this year's annual letter, on pages 17-19, Mr. Buffett succinctly categorizes the three investment options which exist for investors while discussing the risk associated with each scenario.

The three asset groups are:

1) Non-producing assets such as gold

2) Currency-based producing assets such as treasury bonds

3) Producing assets with inflation protection such as farmland, real estate and stocks with low capital requirements to growth earnings.

The prodigious wisdom expressed in that brief dissertation is the subject of today's discussion.

The Choices for Investors

I have a good friend who was born into a farm family in rural Nebraska. My friend and his wife owned and operated a small restaurant in a small college town for a number of years, until they moved to the "metropolis" of Lincoln where he became a teacher. They sold their restaurant for a tidy profit; however they did not sell the property, instead they leased the property to the current owner in order to secure a steady earnings yield.

Additionally, the couple owns some apartments which they rent for income and several years ago they purchased some farmland in western Nebraska. The land is suitable for growing corn as well as wheat and millet; although it possesses no irrigation potential.

My friend has little interest in the stock market other than holding a significant investment in Berkshire (NYSE:BRK.A) stock. I get the idea that he feels slightly uncomfortable about his position in Berkshire because unlike his other ventures, he does not receive an earnings yield since the company pays no dividend.

Think my friend is a country rube who merely got lucky? Think again, this man is following the suggestions which Mr. Buffett provided at the bottom of page 19 of this year's annual letter to a tee. Furthermore, he did so without consulting the Oracle of Omaha; instead his financial pursuits were merely a matter of his own common sense.

In his newly released annual letter, Mr Buffett suggested that the lowest risk assets and the ones most likely to increase one's buying power for the foreseeable future are: farmland, real estate and select businesses. Further, Buffett recommends businesses which rely upon minimal capital requirements to grow their earnings. He cited Coke (KO), IBM, and See's Candy as examples.

My friend took care of the real estate and farmland but left the selection of businesses to Mr. Buffett. King Solomon would have certainly approved of his thought process.

You see my friend has invested his net worth in producing assets which are unrelated to currency. According to Buffett, the riskiest assets for investors at this point in history are the ones which produce an earnings yield but provide nothing in the way of inflation protection. Such “conservative” investments as savings bonds and money market accounts hold an almost certain risk of losing long-term buying power when adjusted for inflation. The most risky are long-term treasury bonds which offer minuscule interest rates which are accepted under the guise of safety.

Buffett makes it perfectly clear to his readers that the guarantee of one’s return of principle accompanied by a meager interest rate offered by long term US Treasuries is a much riskier proposition than owning equities or even gold. That statement runs counter-intuitive to most conservative investors who similar to the academic proponents of CAPM theory equate market volatility with risk. In reality, risk should be equated with the probability that one will lose significant long-term buying power in the form of inflation should an investor foolishly opt to preserve the nominal value of their nest egg by purchasing low-yield treasury bonds.

In Mr. Buffett's opinion; real estate, farmland and businesses with low capital requirements for growth, particularly ones which possess an economic moat, will maintain their exchange rate in proportion to inflation. In other words, a worker will still be willing to exchange an equivalent amount of his labor for a bottle of Coke or a piece of See's candy. Likewise, the price of rent or the price of corn will rise in a manner that is largely commensurate to the increase in inflation. Of course in the case of grains, real estate or select businesses there will be down years and earnings yield fluctuations; however in the long run such entities will almost certainly maintain their inflation-adjusted gains.

Mr Buffett further states that businesses with high capital requirements will be much more affected by inflation; however such businesses will still outperform nonproductive assets such as gold and currency-based producing assets.

Buffett reflected upon the importance of selecting businesses with low capital requirements during inflationary periods in his 1983 Annual Letter. The following passage from the appendix of the letter which discusses the relationship between investment returns and inflation in detail:

"That probability exists because true economic Goodwill tends to rise in nominal value proportionally with inflation. To illustrate how this works, let’s contrast a See’s kind of business with a more mundane business. When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.

A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have been more, as our purchase price implied? The answer is "yes" – even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.

To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.

But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.

Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.

After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)

See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.

Remember, even so, that the owners of the See’s kind of business were forced by inflation to ante up $8 million in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least."

Clearly the best type of investments to own during periods of extended inflation are businesses which hold limited capital requirements thus reducing the ravages of inflation or other assets which are nearly guaranteed to rise proportionally in value as inflation increases. Of course pricing power is everything during inflationary runs.


Buffett has clearly spelled out to investors that he believes the meager interest rates currently offered by US Treasuries are entirely inadequate to offset the long term inflationary risk for investors. Thus the virtually guaranteed return of principle plus interest offers only the illusion of a risk-free investment. In reality, the greatest risk which all investors face is the substantial loss of long-term buying power.

Certainly most of us are not equipped to purchase a farm nor are many of us suited to enter the world of real estate investment. Additionally, such options are rarely available in one's 401K account. However, almost every one of us has the ability to invest our savings in the stock market in one form or another.

It has been obvious to many market mavens that the Fed has been intent upon eliminating the option of Treasury bond investment in favor of stimulating the economy and ensuring that deflation does not become a long-term problem. Holding interest rates at low levels for an extended period and engaging in quantitative easing practices has accorded astute investors few options other than to overweight equities.

At some time in the future, Treasury bond yields will rise to a point where they offer a legitimate alternative to equities as they have in decades past but that time frame lies well out on the horizon. In the meantime, astute investors have no choice but to hold stocks in their IRAs, 401Ks and savings accounts in hopes of preserving the buying power of their hard-earned nest eggs.

Just bear in mind one additional thought which Buffett pointed out in his letter; liquidity is everything. In the case of the individual investor, liquidity means holding enough cash to meet one’s intermediate needs and never I repeat never, employing margin in an attempt to magnify returns.

It is also important to note the importance of maintaining an earnings stream in the form of employment. The practice is immensely important in providing financial security as well as enhancing one's piece of mind. If Mr. Buffett can work productively into his 80s I imagine that most of us can make it until at least 65 years of age.

Disclosure: No position in any stock mentioned

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 3.5/5 (19 votes)


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