I do not own shares in Berkshire Hathaway (BRK.A), but I do eagerly read its letter from the Chairman religiously every year. After all, you don’t read too many frank and candid letters where the Chairman confesses that record earnings in the past year “benefited from a large dose of luck”. The bulk of the report deals with the myriad businesses of Berkshire’s subsidiaries ranging from insurance (GEICO) to underwear (Fruit of the Loom). The parts I am most interested in are Mr. Buffett’s opinions on Berkshire’s investment portfolio and his advice to investors.
Berkshire’s investment portfolio is a topic for discussion in a future post but it appears that Mr. Buffett is still expecting future earnings growth in the 6%-8% range. It would mean that future returns from equities are likely to be far more modest than in the past.
Mr. Buffett warns investors against chasing alpha while forking out ever-higher fees and advises against hedge funds:
In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive this bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee.
The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these “hyper-helpers.” Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.
Readers wanting to read the report for themselves can find it on the Berkshire website. The interesting parts are pages 15 to 17 (BRK’s investment portfolio), pages 19 and 20 (CEO compensation), pages 21 and 22 (warning against hedge funds and debunking the efficient-market hypothesis).
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