An Investor's Buffet: Eat Your Own Cooking

Last week saw Warren Buffett mail out Berkshire Hathaway’s annual letter to shareholders. As always, the letter is filled with gems. Below are nine such gems that stood out to me in terms of the way sensible investment thinking is fashioned and great businesses are run.

1. Big Does Not Equal Good, Especially In Investment Management

Buffett makes the point about the relationship between size and performance clearly: “The big minus is that our performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain to continue.” This is an important recognition. Whilst Buffett is making the argument in relation to a few hundred billion dollars, the point is valid throughout the investment management industry. Size counts, because investment performance and size are inversely correlated. The bigger you are, the fewer the opportunities.

2. Why Pay For Passive Investment That Poses As Active Investment?

A characteristic of many so-called “active” investment managers is that they tend towards being closet trackers. Their portfolios are heavily weighted to holding index positions and to holding what others in the industry hold. Consequently, a sadly large proportion of active managers deliver market-like performance yet charge active management fees, thereby delivering worse than market results.

In considering Berkshire Hathaway’s relative performance, Buffett notes: “Selecting the S&P 500 as our bogey was an easy choice because our shareholders, at virtually no cost, can match its performance by holding an index fund. Why should they pay us for merely duplicating that result?”

3. Investing Is As Much About What You Do As What You Don't Do

Successful investment management is as much about what you don’t own as it is about what you own. In this regard, Charlie Munger quips: “All I want to know is where I’m going to die, so I’ll never go there.”

4. Hype Kills

Hype is an investment killer. Equally, hype sets the foundation for unhappy clients as expectations become sentiment charged and unrealistic: “We make no attempt to woo Wall Street. Investors who buy and sell based upon media or analyst commentary are not for us. Instead we want partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand and because it’s one that follows policies with which they concur.”

5. Forecasting Is Inherently Flawed And Wasted Effort

Despite our industry’s slavish obsession, forecasting is futile. Buffett notes with regard to his and Charlie Munger’s expectations: “We are certain, for example, that the economy will be in shambles throughout 2009 – and probably well beyond – but that conclusion does not tell us whether the market will rise or fall.”

6. Success Will Flow From Finding Your Element And Living It

Great businesses involve the contribution of people who love what they do, and consider their work to be a passion and a privilege. Buffett notes: “We both feel lucky to work at a business we love.”

7. Buffett's Buffet: Eat Your Own Cooking

A true test of a person’s conviction is whether they are willing to eat their own cooking. Buffett notes with regard to Berkshire Hathaway’s investment in the aviation business, NetJets: “... we eat our own cooking ... no other testimonial means more.”

8. On Leadership

On the subject of leadership, Buffett is unequivocal: “Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries ... If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.” This stance differs sharply from the common business practice of “the buck stops there”.

9. A Rare Example Of The Much-Loved Business School Principle Called "Synergy"

Finally, great businesses can feed great businesses. This makes a rare example of the business school principle of “synergy”. Thus, Buffett signs off his letter imploring the shareholders to come to the annual meeting in Omaha by rail: “P.S. Come by rail”, he writes. Berkshire Hathaway recently made a substantial investment in the rail industry in buying Burlington Northern Sante Fe.

The library of Buffett's shareholder letter can be found at www.berkshirehathaway.com/letters/letters.html. Enjoy the read.