In his annual letter to shareholders,  Berkshire Hathaway’s Warren Buffett makes the case for sticking with "big, 'easy' decisions" and reaffirms that Berkshire is ready and willing to take on a big deal--if the price is right.

Keep It Simple

In 2007, Buffett made a $1 million bet with Protégé Partners that an S&P 500 index fund would outperform a group of five fund-of-hedge funds. Buffett handily won the bet with the index fund gaining 8.5% a year and the hedge funds returning between 0.3% and 6.5% annually.

Buffett has written and spoken about the bet extensively but he shared three more takeaways in this year's letter. The first is to always keep an eye on costs. Even as the hedge funds posted middling returns, the managers earned "staggering sums" from their fixed fees. Buffett reminds us that, "Performance comes, performance goes. Fees never falter."

The second was that the market can sometimes present unusual opportunities, and that you don't have to be a genius or have an insider knowledge of Wall Street to seize them. He writes that, "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 example he uses was the valuation mismatch between stocks and bonds in 2012. The prize money for the bet was being held in Treasury bonds, which five years into the wager were trading at a yield/maturity of 0.88%. Given that paltry yield, Buffett and Protégé decided to sell the bonds and instead purchase Berkshire B shares. The result? Instead of a $1 million donation at the end of the bet, the beneficiary got $2.2 million.

Buffett is quick to point out that, "In any upcoming day, week or even year, stocks will be riskier--far riskier--than short-term U.S. bonds," but that over a long-term horizon, common stock investments are the safer choice. He says that "often, high-grade bonds in an investment portfolio increase its risk."

The final lesson is that investors should "stick with big, 'easy' decisions and eschew activity." Buffett contrasts his "kindergarten-like" analysis to the amount research and trading that the hedge fund managers did. Doing more doesn't mean getting more.

Cash Is Burning a Hole in Berkshire’s Pocket

There was notably less analysis of the firm’s operating businesses in this year’s letter, with Buffett pointing investors to the 10-K for more information.

There was some discussion on what they weren’t able to do: find large acquisitions. The barrier was cost. "Prices for decent, but far from spectacular, businesses hit an all-time high," so the firm wasn’t able to put its cash to work. What does Buffett think is driving prices higher? Cheap debt, incentives for CEOs to do deals, and optimistic forecasts for synergies.

With $116 billion in cash and Treasury Bills, Berkshire thinks it will get a chance to execute some large deals. But until prices come down, it "will stick with (the) simple guideline: The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own."

Don’t Confuse Price and Value

With the return of volatility to the stock market, Buffett also offered some timely advice about not allowing price randomness to “obscure long- term growth in value.” He points to four short periods where Berkshire shares fell by anywhere from 37% to 59%. 

It’s a good reminder that there "is simply no telling how far stocks can fall in a short period" and that "the light can at any time go from green to red without pausing at yellow." Buffett also says this is a strong argument against leverage, writing, "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."

Who's Next?

The letter ends with a brief mention that Ajit Jain and Greg Abel were both added to the board of directors early this year. Gregg Warren explained at the time that this move wasn’t a surprise and reaffirmed his view that both are the front-runners to take over the CEO position. Gregg thinks that Greg Abel, who has more operational experience and is a bit younger, is likely in the pole position. 

We'll be in Omaha for the annual meeting on May 5, where we expect to hear plenty more conversation about succession planning, the cash pile, and more.