Insights from Warren Buffett’s Letter to Shareholders

For the last few years, I’ve been enjoying reading Warren Buffett’s annual letter to Berkshire Hathaway’s shareholders. These letters are full of interesting nuggets and insights of all kinds, not just on money management, but on life.

Last week, the most recent letter to shareholders was released, and I spent an afternoon reading it, marking with a pen the little bits that I found interesting.

I thought I’d share with you many of those bits that I highlighted, along with some of my own comments on them.

Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of “great uncertainty.” But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.

Preparing for the future is always a good idea because the future is always uncertain. You don’t know what tomorrow will be like.

I’m very much in favor – much as Buffett is – of having a very large emergency fund so that you have the flexibility to handle whatever comes your way.

Don’t let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.

We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.

Of course, preparing for tomorrow does not necessarily mean just preparing for the negative. It also means preparing for the positive.

Tomorrow might hold something disastrous, but it might also hold some great opportunity. The more you can prepare for both, the better off you’re going to be.

Again, this is a great argument for having a lot of cash in the bank. The more cash you have, the more capable you are of handling the negative and taking advantage of the positive.

Today might be September 10, 2001, but it might also be the day before you meet the love of your life.

Other companies we hold are likely to increase their dividends as well. Coca-Cola paid us $88 million
in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In
2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I
would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of
Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful
business.

In other words, the stocks of Coca-Cola that Buffett bought in 1995 cost him somewhere on the order of $750 million. Got that?

He’s sat on those stocks for sixteen years now, collecting dividends each year. In 2011, Buffett anticipates collecting a dividend of $376 million, roughly half of what he paid for the stock.

In ten years, Buffett expects to collect a dividend of over $750 million. In other words, he’ll receive a dividend in one year that exceeds what he paid for the stock.

How is that possible? Patience. He sat on that stock regardless of whether the stock price went up or the stock price went down. He sat on that stock regardless of a booming economy or an economic apocalypse. He was patient, and now that patience is being rewarded.

With all the talk of stock trading and maximizing P/E and selling high and buying low, the simple act of buying a dividend-paying stock and just sitting on that stock is forgotten.

Unquestionably, some people have become very rich through the use of borrowed money. However,
that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re
clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very
few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in
2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a
single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart
people.

For individual people, the “leverage” that Buffett speaks of equates to consumer debt.

Sometimes, you can get into debt to swing a purchase that will amaze everyone around you. How did he afford that house?

The problem is that you have to pay the piper eventually, and the uncertainty of the future often causes people to fall short of the grandiose dreams they have when they first get into debt. They’re either stuck struggling to make ends meet every single month or, worse, they fall into foreclosure, losing the things they’ve dumped so much money and effort into.

The best solution is to avoid consumer debt if at all possible. The only types of debt that make any reasonable sense are student loan debts, mortgage debt on a reasonable small home, and car debt on your very first car. After that, you should do everything in your power to avoid further debt.

I didn’t meet Charlie [Munger, Buffett's partner in Berkshire Hathaway] until he was 35, though he grew up within 100 yards of where I have lived for 52 years and also attended the same inner-city public high school in Omaha from which my father, wife, children and two grandchildren graduated. Charlie and I did, however, both work as young boys at my grandfather’s grocery store, though our periods of employment were separated by about five years. My grandfather’s name was Ernest, and perhaps no man was more aptly named. No one worked for Ernest, even as a stock boy, without being shaped by the experience.

[...] Ernest never went to business school – he never in fact finished high school – but he understood the importance of liquidity as a condition for assured survival. At Berkshire, we have taken his $1,000 solution a bit further and have pledged that we will hold at least $10 billion of cash, excluding that held at our regulated utility and railroad businesses. Because of that commitment, we customarily keep at least $20 billion on hand so that we can both withstand unprecedented insurance losses (our largest to date having been about $3 billion from Katrina, the insurance industry’s most expensive catastrophe) and quickly seize acquisition or investment opportunities, even during times of financial turmoil.

Again, Buffett hammers the point home that being liquid – meaning having cash that’s easily accessible and available to handle whatever may come – is a great way to always be prepared for the future, whatever it may hold.

Berkshire Hathaway often holds far more in cash than comparable businesses. Of course, at the same time, Berkshire Hathaway is incredibly successful by any measure. They can handle any emergency and they can take advantage of any opportunity that comes along.

I tend to think there’s a big lesson to be learned from that with regards to how to manage your own finances.

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  1. Teal says:

    Once again the Oracle of Omaha has timeless words of wisdom to express upon all of us that are willing to turn our ears and take the time to learn. Great job on reporting this article on your site. Keep up the good work!

  2. Chris Jones says:

    I agree with Warren Buffets approach to finances. He is always prepared to take advantage of any opportunities that arise. He is the king of his craft. My wife and I have this same thought in mind for our own personal finances. We have almost 8 months worth of income in our emergency fund so far. We also pay one and a half times our monthly mortgage payment every month, with plans to pay even more on occasion. It is always good to have enough money easily available for emergencies. However, we dislike the uncertainty of the stock market so we tend to put an extra money towards our mortgage to pay be debt free.

  3. Tim says:

    I bought three investment foreclosure properties last year with (variable rate) home equity line.

    The first home for $29,000. I rent it for $625 per month. Annual taxes on it are just shy of $1400.

    The second home for $32,000. I rent it for $550 per month. Annual taxes on it are the same as the previous mentioned.

    The third home for $21,000. When I complete it this month, I expect to be able to rent it for $600 per month. Annual taxes on it are the same as the previous mentioned.

    Where is the flaw in my logic that borrowing money to buy rental properties that are yielding this high of a return is okay? I don’t like that it’s variable rate.. but right now the interest rates are under 5% and I didn’t have to pay closing costs.

    My first $29k line of credit has allowed me to earn $7500 in rental income. Yes, I’m simplifying matters here.. but that’s almost 26% interest. Of course I have capital gains and other taxes, insurance costs, and a mortgage interest.. but at the absolute least, I’m making a killing where most CDs are paying less than 1%.

    This foreclosure crisis will not last forever and homes this cheap are getting harder to find.. you have to strike while the iron is hot as they say.

    Why does this debt not make ‘any reasonable sense’ (other than the variable rate)?

  4. AC says:

    Trent,

    Long time reader, first time poster… Great Article! Just wanted to point out that you may have misunderstood Buffett’s words a bit. When he said “I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment”. He wasn’t suggesting that annual dividends would equal what he paid for the stock. He was saying that Coke’s TOTAL earnings per share would equal what he paid for the stock. It would also have been impossible for Buffett to have paid $750MM for the stock when he purchased Coke in 1995. If they received $88MM in dividends in 1995 and the stock cost him $750MM that would mean that when he purchased Coke it was paying an almost 12% dividend in 1995 which was not the case.

  5. Matt says:

    Warren Buffet is a genius, and there’s a reason he’s where he’s at today. Anyone can try to dismiss him as just an outlier, but its his philosphy that got him where he was. The liquidity point you made was a good one, Trent. It works at any income level. Even something as simple as buying a 12-pack of soda for $3 instead of single cans for $.75 — save for a few days to buy the 12-pack, and you’ll have saved $6 over the course of those 12 cans. Starting small and keeping at it will net huge gains in the long run!

  6. Andrew says:

    I greatly respect Warren Buffett for what he has done. You obviously don’t become one of the world’s richest men by accident, and his annual reports are indeed great reads.

    I may not be a proponent of his style of investing right now (buying and holding a stock for dividends is great when you have a $750 million dollar position and billions more in reserve, but I need to be more aggressive to grow my funds right now), but one can definitely gain wisdom by reading his writings. Warren Buffett did use “leverage” when starting out, but he did it the right way. Instead of taking out a loan and investing it, he formed a partnership and used other people’s money to invest, minimizing his own risk but ensuring he had ample funds. Smart move.

  7. levi says:

    Thanks for posing this, Trent. After reading it, I got curious and went to the Berkshire Hathaway website and read the entire piece.

  8. Becky says:

    “Ernest never went to business school – he never in fact finished high school – but he understood the importance of liquidity as a condition for assured survival.”

    I like that! I think it supports the value of the Emergency Fund, but also affords a person the ability to seize an opportunity when it presents itself.

  9. lanjha says:

    Trent

    By leverage, I dont think Warren Buffett was implying consumer debt as you said. I think he was talking about Margin trading, Options trading and other complex trading options, which are all desinged not with the client in mind.

  10. A says:

    Hi,

    It would be helpful to put the symbol of the stock being referred to in the article.

    There are so many possibilities for “Coke”.

    Do you think he’s referring to:
    Coca-Cola Bottling Co Consolidated
    NASDAQ:COKE
    currently paying a yield of 1.4% right now?

    Can someone offer an opinion as to why investing in a stable company with a higher dividend yield would not be better?

  11. Jessica says:

    @ #3A: It says Coca-Cola and then Coke later on. I never even see the word “COKE” in the whole quotation.

    Also, I found this article’s message (and Buffet’s for that matter) to be very inspiring! We should not only prepare for the future’s emergency but also maintain some leverage for opportunities as well.

  12. Georgia says:

    When I worked at an S&L in the 70′s and 80′s, I often had people tell me that it was foolish to save because money would not be worth anything is 20-30 years or more. I informed them that if they had $50 in savings and bread was $50 a loaf, they could live a few days longer. Savings are never invalid.

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