Two investors I admire have recommended that to learn about investing, investors should read Berkshire Hathaway Inc.'s (BRK.A, Financial) (BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, I cover the 2007 letter.
Fanciful figures: How public companies juice earnings
In the 2007 letter, Buffett has a long essay on Corporate America’s approach to accounting. He first reviews how in the 1990s, the Financial Accounting Standards Board allowed companies the choice between expensing the value of awarded stock options or to ignore the expense as long as their options were issued at market value. The vast majority of companies took the “low road,” thereby ignoring a large and obvious expense in order to report higher “earnings.”
Fast forward to 2007 and Buffett noted, “decades of option-accounting nonsense have now been put to rest, but other accounting choices remain.” Important among these is the investment-return assumption a company uses in calculating pension expense.
Buffett looked at the assumption that averaged for the 353 S&P 500 companies that have pension plans 8% in 2006. He did the math.
"The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss. This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been."
Reality check on investment expectations
Buffett then asked how realistic this expectation was, given during the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually.
He wrote, "An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century."
Dow 2,000,000
Buffett calculates that in the 21st century, for investors to merely match that 5.3% market value gain, the Dow – which in 2007 had been below 13,000 – would need to close at about 2,000,000 on Dec. 31, 2099. Eight years into the 21st century, Buffett notes the Dow had racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel over the course of the 21st century to equal the 5.3% of the last. He continued:
"It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?"
Understanding pension plan assets
With dividends continuing to run about 2%, Buffett noted that even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of pension plan assets – allowing for expenses of 0.5% – would produce no more than 7% or so. Buffett also warned that 0.5% may well understate costs, given the presence of layers of consultants and high-priced managers.
Why pensions as a group will underperform
Buffett highlighted the logic. Because of costs, pensions as a group will have to underperform the market (which bears no costs). He said:
"The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the 'know-nothings' – must win."
Investment expectations and reality
Buffett stated that investors expecting to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100.
Down the rabbit hole
Buffett then says of the advisors, with characteristic wit:
"Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: 'Why, sometimes I’ve believed as many as six impossible things before breakfast.' Beware the glib helper who fills your head with fantasies while he fills his pockets with fees."
The auditors and actuaries who are charged with vetting the return assumptions, Buffett said, seem to have no problem with them.
But the reason all this happens, Buffett said, is no puzzle. Companies opt for high investment assumptions so that they can report higher earnings. If their assumptions turn out to be wrong, this will not be apparent for years to come, by which time it will be somebody else’s problem. Buffett noted he thought the 8% average assumption would turn out to be wrong.
Course correction and lessons
Buffett said Corporate America had been pushing the envelop for decades in order to report the highest number possible for current earnings. He called for a course correction, quoting Charlie Munger (Trades, Portfolio): “If you’ve hit three balls out of bounds to the left, aim a little to the right on the next swing.”
For companies with pension liabilities, and for insurance companies too, it is important to check the return assumptions on the assets set aside to meet future liabilities, because if they are too aggressive, a shortfall will occur which will then require the company or insurance firm to make a top-up payment, hitting cash flows. It also shows management is being short-sighted and is a red flag for aggressive accounting policies. Good companies that are worthy of investment make strong earnings through competitive operations. Companies which cannot do that may resort to accounting shenanigans to make up the difference. With a little bit of digging, we can find out which companies are which.
