The Most Undervalued Page In Buffett's Annual LetterSubmitted by Silverlight Asset Management, LLC on March 2nd, 2018
Every year, Warren Buffett releases a letter to the world that begins with a simple, yet extraordinary table. The 2018 letter, released a few days ago, continues the tradition.
On page 2, there’s a table showing the annual percentage change in Berkshire’s Book Value Per-Share and Market Value Per-Share, alongside the S&P 500’s total return. Here is a sample of the information that appears, showing just recent years and the long-term average.
It’s tempting to overlook the table. After all, it reappears every year, and the numbers only change slightly.
Aware of Buffett’s long-term track record, there are years where I’ve skipped it.
Now, I view the table differently. For me, it’s an annual reminder of several important lessons.
Price does not equal value
Buffett shops for stocks like normal people shop for everyday items—he looks for bargains.
To identify a bargain requires (i) a sense of what something is worth and (ii) a reference price.
Investing is no different.
Ben Graham taught Buffett to separate price from value. That’s why the table on page 2 of every Berkshire letter shows the annual change in book value per share as well as market value.
Buffett calls book value “a crude but useful tracking device for the number that really counts: intrinsic business value.”
Even though one can only estimate intrinsic value, there are advantages to focusing attention there. Value tends to be less erratic than price fluctuations, which helps if you’re trying to focus on the long-term. The standard deviation of Berkshire’s annual book value-per-share from 1965 – 2017 is 14.1%. Berkshire’s market price is more than twice as volatile, with an annual standard deviation of 34.3%.
Separating price from value also helps navigate volatility better. In bear markets, depressed investor sentiment usually results in price stretching below true intrinsic value, while in the euphoric stage of a bull market the opposite effect tends to occur. Having a value compass helps an investor resist the urge to believe whatever the crowd believes at a given point in time.
The table in Buffett’s letter also reminds us quality assets outperform.
From 1965 – 2017, Berkshire’s book value per-share increased at an annual rate of 19.1%, while market value increased 20.9%. In single years, these numbers can diverge by a lot. Yet over time, fundamentals and market prices tend to converge toward a similar pace.
Fundamentals always win out. It’s no coincidence Berkshire’s long-term return profile closely approximates its book value growth.
Firms which generate high returns on equity (ROE) and reinvest will always compound book value at a higher rate than low ROE firms lacking such opportunities.
So, if you’re a long-term investor, why even bother with low ROE firms?
Unless you’re a specialist at analyzing turnaround situations, which few people truly are, low return businesses are a waste of time.
"At Berkshire what counts most are increases in our normalized per-share earning power. That metric is what Charlie Munger, my long-time partner, and I focus on – and we hope that you do, too." - Warren Buffett
Finally, page 2 of the Berkshire letter illustrates the magic of long-term compounding.
The S&P 500 cumulative return from 1964 – 2017, shown at the bottom of the table, was up a staggering 15,508%.
But that’s nothing compared to Berkshire. By doing 11% better per year, Berkshire shares have appreciated 2,404,748%.
It’s also interesting to look at the marginal difference between Berkshire’s market return vs. book value. That spread is a mere 1.8% per annum (20.9% market vs. 19.1% book). Yet compounding the spread over 53 years more than doubles the cumulative return. From just a 1.8% difference!
In this year’s letter, Buffett describes a ten-year bet he won. He correctly bet the S&P 500 index would outperform a higher fee allocation to hedge funds.
A percent or two per year really can compound to a meaningful difference over the typical investor’s time horizon. So, he’s right—watch the fees you pay.
And next time you read one of those letters, don’t skip over the second page quite so fast.
Originally published by Forbes. Reprinted with permission.
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