Buffett criticizes high-fee managers in annual letter

In his annual letter to shareholders, Warren Buffett comes down hard on high investment fees. One of his goals for 2017, he says, is to highlight “strong opinions I have about investing.”

Here’s a look at some of Buffett’s investment tips.

Avoid unnecessary investment fees. Buffett reiterated his position on passive strategies. “In Berkshire Hathaway’s 2005 annual letter, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still.”

His reasoning was “the massive fees levied by a variety of ‘helpers’ would leave their clients – again, in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund.”

Buffett concedes, “There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified […] only 10 or so professionals that I expected would accomplish this feat.”

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He notes Berkshire has paid “outrageous fees” to investment bankers, as well as “paid substantial sums for over-performance to our two in-house investment managers […].” He hopes to continue this next year.

However, when it comes to regular investors, Buffett says too many “listen to the siren song of a high-fee manager,” when passive investment options such as low-fee funds following broad markets are a better bet.

Buffett seems critical of the investment industry, but is mainly targeting players like hedge funds, says Jeff Hull, senior financial advisor at Manulife Securities Inc. in Mississauga, Ont., and a Berkshire investor for more than 20 years. Also, Buffett says the average investor can be emotional, Hull notes, “meaning they get easily worried or nervous, and leave the market.”

As such, these investors are better served when “they buy it, park it and don’t try to trade around it, and this is where good advisors can add value, by helping clients do this,” says Hull (for his part, Buffett will sell companies when they become way overvalued or when the business case has changed or decayed, so he’s not 100% buy and hold).

The bottom line, says Buffett in his letter, is “when trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”

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Understand share repurchases. There are two situations where share buybacks shouldn’t occur, says Buffett. First, when a business needs all available funds to expand, and, second, “when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser.”

Also, while such repurchases are “always a plus” for existing shareholders, he says, they only make sense for continuing shareholders “if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value.”

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The debate about share repurchases has “become heated,” says Buffett, who adds, “It is puzzling […] that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed,” given that wouldn’t be the case if a management team was buying externally.

Compare adjusted versus GAAP earnings. In his letter, Buffett points out that “too many management [teams] – and the number seems to grow every year – are looking for any means to report, and indeed feature, ‘adjusted earnings’ that are higher than their company’s GAAP [generally accepted accounting principles] earnings.”

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To properly assess businesses and investments, he argues, it’s important that company management teams report on unusual items that affect GAAP earnings in their commentaries, such as restructuring costs and executive compensation.

Buffett says, “After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting ‘adjusted per-share earnings’ makes us nervous.”

If Berkshire Hathaway were to have “major expenses in a single year,” says Buffett, he would mention those in his commentary. He says, “Indeed, when there is a total rebasing of a business, such as occurred when Kraft and Heinz merged, it is imperative that, for several years, the huge one-time costs of rationalizing the combined operations be explained clearly to owners.”

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Overall, Buffett offers few surprises in his letter. He notes Berkshire will continue to acquire businesses and achieve “decent results,” but that muted future returns are likely due to the company’s size and strong past performance.

Still, Buffett’s confident about the future, says Hull, who spoke with Berkshire contacts today. In a nod to the U.S. election, Buffett’s message is that “America is still great” and that the economy will continue to grow.

In his message, Buffett also highlighted two 2016 acquisitions in the manufacturing, service and retail space: the buys of Duracell and Precision Castparts Corp. For Duracell, there were costs of $109 million* for restructuring. In 2017, these businesses “will for the first time contribute a full year’s earnings.”

Going forward, Buffett sees further investments in the purchase of real estate brokerages, and he remains optimistic about airlines, says Hull. Currently, Berkshire’s float from its insurance businesses is $100 billion—compared to $92 billion at the end of 2016, and the highest it’s ever been—and this money can be used to invest, Hull adds.

Hull points out that Berkshire would benefit from any U.S. corporate tax reforms. “Last year, Berkshire was [one of the] largest taxpayers in the U.S.,” he adds, which means lower corporate taxes would be “a major tailwind.” The company is domiciled in the U.S. and doesn’t use off-shore havens, and “many of their businesses tend to operate mainly within the U.S.”

Berkshire’s Class A shares have gained in the past year by nearly 30%, seeing a 52-week low of $202,600 and a high of $256,384. As of 3pm on Feb 27, the shares were up 0.37% from market open, at US$255,980.

What about succession?

Buffett, who’s 86, failed to touch on his retirement and succession plans. But investors are confident the company still plans to split Buffett’s job into three parts: chief executive officer, chairman and investment manager.

Hull says Buffett and Berkshire vice chairman Charlie Munger, 93, have reassured shareholders that they’re both healthy. Buffett is still confident in Ajit Jain, 65, who is likely to take over as chief executive officer. Meanwhile, Todd Combs, 46, and Ted Weschler, who’s in his mid-50s, are expected to become co-CIOs. Updated, February 28: Jain runs most of the company’s insurance operations, and Combs and Weschler manage about $10 billion each of the company’s investments–together, they manage $21 billion, though they manage their own portfolios.

Sixty-two-year-old Howard Graham Buffett (Warren’s son) will be tasked with protecting the company’s culture, says Hull.

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Berkshire’s Q4 and full-year profits

Q4 profit improved 15%, but that most of the gains came from the paper value of Berkshire Hathaway Inc.’s investments and derivatives contracts.

The Omaha, Nebraska-based conglomerate released its latest results Saturday along with Buffett’s annual letter to shareholders. Read Berkshire’s 2016 annual report.

Berkshire says it earned $6.29 billion, or $2.55 per Class B share—that’s up from $5.48 billion, or $3.65 per Class B share. Berkshire generated $58.3 billion revenue in the fourth quarter, up from $51.7 billion a year earlier, and its investments and derivatives were worth roughly $1.2 billion at the end of the quarter, up from $399 million. That overshadowed the 6% profit decline at Berkshire’s operating businesses.

For the full year, Berkshire’s earnings were nearly flat at $24.07 billion, or $16.05 per Class B share.

Berkshire’s largest investments

Berkshire Hathaway Inc. owns more than 90 companies, including railroad, clothing, furniture and jewelry firms. At year-end, Berkshire Hathaway’s top five investments by market value were:

• Wells Fargo and Company ($27,555 million; 10% of company owned)
• Coca-Cola ($16,584 million; 9.3% of company owned)
• IBM Corp. ($13,484 million; 8.5% of company owned)
• American Express Company ($11,231 million; 16.8% of company owned)
• Apple Inc. ($7,093; 1.1% of company owned). Jeff Hull, senior financial advisor at Manulife Securities in Mississauga, says Berkshire now owns 2.5%** of Apple after the company more than doubled its investment in January.

*A previous version of this story stated that the costs were $100 billion. Return to the corrected sentence. **A previous version of this story stated that Berkshire owns 4% of Apple.