On my must-read list is Warren Buffett’s annual letter to Berkshire Hathaway (BRK.B) shareholders. Even if you are not a Berkshire shareholder (like I am), the observations on the financial markets and investing are often priceless. This is year was no different. Though Buffett’s comments about acquisitions received the most attention after the latest letter was released last weekend, there were several observations about investing that are worth paying attention to (and even saving).

Possibly the best parts of the letter came from Buffett’s discussion about a 10-year bet. Buffett predicted that the returns of a plain-vanilla S&P 500 index fund would beat those of hedge funds. He won the bet handedly. So I’ll start with the lessons he shared in discussing the bet before moving on to other noteworthy parts of the letter.

The Secret to Dealing With Market Volatility: In putting market fluctuations into perspective, Buffett wrote, “Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period—or even to look foolish—is also essential.”

The Difference Between Risk and Investing: Echoing a point our founder James Cloonan made several times over the years, Buffett told shareholders, “Investing is an activity in which consumption today is forgone in an attempt to allow greater consumption at a later date. ‘Risk’ is the possibility that this objective won’t be attained … As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.”

Costs Matter: In discussing his 10-year bet that a plain-vanilla index fund could beat an active manager over the long term, Buffett credited his victory, in part, to very high fees charged by the fund-of-funds structure. He quipped, “Performance comes, performance goes. Fees never falter.”

Think Like an Owner, Not a Speculator: Buffett and his partner Charlie Munger view Berkshire’s investments in various companies “as interests in businesses, not as ticker symbols to be bought or sold based on their ‘chart’ patterns, the ‘target’ prices of analysts or the opinions of media pundits.” A few paragraphs later, he added, “Stocks surge and swoon, seemingly untethered to any year-to-year buildup in their underlying value. Over time, however, Ben Graham’s oft-quoted maxim proves true: ‘In the short run, the market is a voting machine; in the long run, however, it becomes a weighing machine.’”

Many Corporate Acquisitions Aren’t Smart: Among the key traits Berkshire looks for in an acquisition is “a sensible purchase price.” (Buffett used italics.) He lamented that this requirement was a big hurdle in Berkshire Hathaway’s attempt to find acquisitions last year because “price seemed almost irrelevant to an army of optimistic purchasers.” While I’ll side-step his racier comments, Buffett criticized CEOs for being “can-do” types, never lacking for forecasts that justify their purchases, being aided by cheap debt and relying on spreadsheets that “never disappoint.” He added that he and Munger “never factor in, nor do we often find, synergies.” (This is not the first time Buffett has criticized so-called synergies forecast by other CEOs to justify mergers and acquisitions.)

As far as what Buffett and Munger look for in a potential acquisition, Buffett explained: “Durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.” He also shared a simple guideline followed by Berkshire: “The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.”

Avoid Relying on Debt (Including Margin): Buffett discussed the use of debt a couple of times. First, in describing Berkshire’s desire not to have to rely on “the kindness of strangers.” Then later in his letter, he warned against investing on margin by writing, “There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”

Be Skeptical of Loss Reserves Reported by Insurers: Buffett estimates the total industry loss from insured claims related to last year’s three hurricanes to be approximately $100 billion. This estimate could be “far off the mark” as initial estimates following mega-catastrophes are often low. The actual losses could also be far in excess of what insurance companies have allocated for. Buffett warned, “Ignorance, wishful thinking or, occasionally, downright fraud can deliver inaccurate figures about an insurer’s financial condition for a very long time.”

The New Tax Law Is Altering Financial Statements: Buffett said $29 billion of Berkshire's $65 billion increase in shareholder equity was due to a one-time, noncash reduction of net-deferred income tax. Berkshire is among many companies to report significant fourth-quarter adjustments related to the Tax Cuts and Jobs Act.

Firms With Unrealized Gains and Losses Could Have More Volatile Earnings Going Forward: A change in accounting (GAAP) rules now requires companies to include the net change in the value of their investments in reported net income. For companies impacted by this rule, their underlying earnings could swing for reasons completely unrelated to their business operations. Buffett believes the rule will create “considerable confusion among shareholders for whom accounting is a foreign language.”

• Insights on Warren Buffett From His Friend and Editor – Carol Loomis, who edits Buffett’s annual letter, spoke about his investing and management process.
• Reflections on the Past and Future for the Individual Investor – AAII founder Jim Cloonan shared his views on what risk really is this past November.

• Tax Guide Update: The Tax Cuts and Job Act and 2018 Taxes – We discuss the changes (and parts of the tax code that haven’t changed) affecting most individual investors, including the new tax rates, deductions and exemptions.
• March 2018 Editor’s Note – My observations on the new tax law and some suggestions on what do with your savings from it.

Fourth-quarter earnings season will start to wind down. Still, nine S&P 500 member companies are scheduled to report: Autodesk Inc. (ADSK), H&R Block Inc. (HRB), Ross Stores Inc. (ROST) and Target Corp. (TGT) on Tuesday; Brown-Forman Corp. (BF.B), Costco Wholesale Corp. (COST) and Dollar Tree Inc. (DLTR) on Wednesday; and Cooper Companies Inc. (COO) and Kroger Co. (KR) on Thursday.

The week’s first economic report will be the ISM’s February non-manufacturing index, released on Monday. January factory orders will be released on Tuesday. Wednesday will feature the February ADP employment report, January international trade data, the first revision to fourth-quarter productivity and the periodic Beige Book. February jobs data, including the change in unemployment and nonfarm payrolls, will be released on Friday.

Three Federal Reserve officials will make public appearances: New York president William Dudley on Tuesday and Wednesday, Atlanta president Raphael Bostic on Wednesday; and Chicago president Charles Evans on Friday.

The proportion of individual investors describing their short-term outlook as neutral is at a seven-month high. The latest AAII Sentiment Survey also shows a drop in optimism and a slight rise in pessimism.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 7.4 percentage points to 37.3%. The drop puts optimism below its historical average of 38.5% for the second time in four weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, jumped 6.7 percentage points to 39.3%. Neutral sentiment was last higher on July 27, 2017 (41.2%). The historical average is 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 0.6 percentage points to 23.4%. Pessimism is below its historical average of 30.5% for the 11th time in 12 weeks.

Neutral sentiment is now close to the upper end of its typical range. Readings above 40% are unusually high. Bullish and bearish sentiment are also currently within their typical ranges.

The current financial and economic backdrop is having a varied effect on individual investors’ six-month outlook. Higher interest rates are having an influence on some, but not all. The rebound from February’s correction has made valuations less attractive to would-be bargain shoppers relative to a few weeks ago. Also playing a role are tax cuts, earnings and concerns about whether a steeper drop in stock prices is forthcoming.

This week’s special question asked AAII members how, if at all, this year’s increase in interest rates is influencing their sentiment toward stocks. Nearly three out of five respondents (58%) said the rising rates are not having any impact. Some of these respondents said that the increases are already priced in or haven’t been large enough or that they are keeping their focus on the long term. Others said they are not influenced now, but if rates increase faster than expected their opinion may change. Nearly 28% of respondents said the increase in interest rates has prompted them to become more cautious or they expect rising rates to be a drag on further stock price gains. About 10% view rising rates as a positive, describing them as being reflective of economic growth, boosting rates on savings or making financial stocks more attractive.

Here is a sampling of the responses:

• “Not changing my sentiment at all; however, I am hoping rates will not increase too quickly.”
• “Does not seem to have an effect. I think the tax cuts will overcome interest rate jitters.”
• “I think at least three interest rate increases are priced into the market. If there end up being four or five, it would be a different story and a new ball game.”
• “Increases in interest rates will be accelerated by rising inflation, which will combine to slow the stock market.”
• “It will slow down the rate at which stocks increase.”
• “The increases have raised market volatility, so I’m using the resulting dips to finally buy more stocks.”

Bullish: 37.3%, down 7.4 points
Neutral: 39.3%, up 6.7 points
Bearish: 23.4%, up 0.6 points


Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%

Cash allocations among individual investors rose to a four-month high last month. The February AAII Asset Allocation Survey also shows declines in equity and bond allocations.

Stock and stock fund allocations declined for a second consecutive month, falling 1.1 percentage points to 70.1%. January was the 59th consecutive month that equity allocations were above their historical average of 60.5%.

Bond and bond fund allocations pulled back by 0.5 percentage points, declining to 15.0%. The drop reversed January’s increase. This is the fourth time in six months that fixed-income allocations are below their historical average of 16.0%.

Cash allocations rose 1.7 percentage points to 15.0%. Cash allocations were last higher in October 2017 (15.1%). Even with the increase, cash allocations remained below their historical average of 23.5% for the 75th consecutive month.

Last month was just the 40th month with equity allocations at or above 70% out of the more than 30-year history of our asset allocation survey. Some individual investors took advantage of last month’s correction to buy stocks while prices are down. Others have expressed concerns about the possibility of an even larger decline in stock prices.

In regard to interest rates, many individual investors likely welcome the higher yields on their savings accounts. Some, however, have concerns about the impact that higher rates could have on stocks, especially if there are more hikes than anticipated.

Last month’s special question asked AAII members how the stock market’s record highs influenced their portfolio allocations. We posted the question just before February’s correction started and did not change it after the correction occurred. More than half of all respondents (56%) said the record highs and last month’s volatility have not influenced their allocations. Many of these respondents said they either adhere to a long-term strategy and/or rebalance. Nearly 18% said they increased their cash positions, while approximately 14% said they reduced their stock exposure or otherwise switched to a more conservative allocation. (Several of these respondents said they both reduced their equity exposure and raised their cash allocations.) About 4% raised their fixed-income allocations, while a similar percentage bought more stocks and equity funds.

Here is a sampling of the responses:

• “I keep it as simple as a I can. I don’t overthink the market.”
• “I have increased my cash holdings by refraining from investing new money in the market.”
• “Over the past 18 months, I have used the highs in the stock market to take profits and establish a bond and cash allocation.”
• “Rebalanced to maintain my proper asset allocation.”
• “No change, even after the recent correction.”
• “I sold some stocks that ran up in price and bought stocks when the market sold off.”

• Stocks and stock funds: 70.1%, down 1.1 percentage points
• Bonds and bond funds: 15.0%, down 0.5 percentage points
• Cash: 15.0%, up 1.7 percentage points

• Stocks: 30.5%, down 2.8 percentage points
• Stock Funds: 39.6%, up 1.6 percentage points
• Bonds: 2.6%, down 0.6 percentage points
• Bond Funds: 12.4%, up 0.1 percentage points

Take the Asset Allocation Survey.

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