A few weeks ago, Warren Buffett released his annual shareholder’s letter and again delivered some compelling insights for investors. Buffett’s timeless and simple investment principles are great lessons for all investors to revisit. Even if you don’t agree with Buffett on all of his political/personal views, his investing advice remains the gold standard for investors who want long-term, actionable wisdom. He honestly speaks his mind and backs up his words with action – often billions of dollars of action behind his investments. He has what most market pundits lack – skin in the game. When Buffett talks about investing when others are fearful, he backs that up by investing large amounts of money. This is a striking difference to most market advisors and strategists who recommend ideas, but rarely commit any of their own money. If there is real money, it’s the clients, and not theirs, at risk.

Buffett’s words are so powerful because he 1) has the track record to back up his claims and 2) he commits Berkshire capital when he says he will. Given these reasons, Buffett’s annual letter should be recommended reading for all investors. After digesting his latest annual letter, I’ve summarized 5 key principles investors should incorporate into their own process. Most of these are not new, but unfortunately investors have a bad habit of forgetting obvious lessons. It pays to revisit these and the annual Buffett letter is a great way to do it.

Note: I highly recommend reading the letter in its entirety. Here’s a direct link to the letter. All italicized passages in this article are directly from the 2017 letter.

Principle #1: Investment success depends on the price paid, not just the inherent fundamentals of the underlying asset.

Here’s Buffett from the 2017 Annual Letter:

In our search for new stand-alone businesses, the key qualities we seek are 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. [my emphasis added]

That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.

Buffett mentions many of the same things other investors emphasize – great companies, wide business moats, attractive reinvestment opportunities, superior management, etc. Hard to disagree with those. But when investors screw up, it’s often because they get the price wrong. Even though they find attractive companies, they pay too high of a multiple, leading to investment underperformance or negative returns, even though the underlying business is performing well.

Think about it – if price didn’t matter, Buffett wouldn’t be sitting on cash today. Surely he has identified great businesses he would like to own today. Why doesn’t he just buy these great businesses and watch them grow and grow and deliver great results for Berkshire shareholders? It’s simple - it wouldn’t work. As the price rises, returns on any investment migrate from great to good to mediocre to poor to disastrous. What you pay determines where on that scale you will fall.

 It’s tough work to figure out what you should pay. It’s a complex mix of discount rates, growth, return on investment, business/credit cycle, competition, and on and on. There’s never an easy answer and it will never be easy. That’s why investing is hard and there are so few Buffett’s. It’s not supposed to be easy.

Most investments across asset classes have simple and consistent valuation benchmarks to determine a reasonable price. It’s not an exact science. The point is to buy when there is a clear margin of safety. In today’s markets, most equities and fixed income assets are priced in the upper valuation ranges, some at extreme levels.

As Buffett mentions, investors need to exercise caution when allocating to risk assets. There is a growing sense of comfort and complacency in the market, given the recent tax cuts and continued economic growth. However, valuations already take this into account. It’s a fatal error to pick out arbitrary events (like the tax cuts) to justify higher and higher valuations. And there’s even debate on whether tax cuts will deliver any long term, net economic growth at all. Many investors who justify paying top decile valuations are doing so on a very shaky foundation. Historically (and mathematically), paying top valuations leads to subpar future returns.

It won’t turn out well for these investors. The sins of poor decision making today won’t be apparent until the future. It takes significant independent and long-term thinking to make wise investments in today’s markets. Buffett is clear about where he stands on valuations, and you as an investor should ensure you fully understand the price you are paying and the implications it will have on future returns. If you think valuations are reasonable today, prove to yourself you understand what has to go right to make sure the future turns out the way you need it to.

Principle #2: Beware of leverage as it often hides fatal flaws in many investments. Leverage takes a mediocre return and creates the illusion of an exceptional return. Unfortunately, investors don’t realize this into it's too late.

Here’s Buffett from the 2017 Annual Letter:

The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed. At Berkshire, in contrast, we evaluate acquisitions on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual business would generally be fallacious (leaving aside certain exceptions, such as debt dedicated to Clayton’s lending portfolio or to the fixed-asset commitments at our regulated utilities). We also never factor in, nor do we often find, synergies.

It’s obvious that a bad business, loaded up with debt, is a disaster waiting to happen. However, it’s less obvious that good businesses with too much debt often suffer the same fate. Leverage is seductive. Leverage enhances returns, growth, and EPS. For a while at least. Even the worst business can show earnings growth by either buying another company or investing internally, if it’s fueled with cheap debt. It works in the short-term and will continue as long as the current environment doesn’t change. But economies, markets, and businesses are subject to a shockingly high degree of unforeseen change and disruption, all of which will destroy leveraged investments and transactions.

Business executives and investors fall victim to this curse. It’s hard to resist borrowing cheap money when there appears to be arbitrage like opportunities to put that money to work in higher returning investments. The fatal flaw in this process is the simple: the future will not remain like the present. Investors often deal with an unknown future by extrapolating current trends and assuming the environment will stay the same.

Investors who have studied their history understand that the past is filled with unexpected shocks and regime changes in the markets. Growing economies go into deep recession. Great businesses face new competition that destroy their current business model. Free flowing credit markets seize up, causing solid businesses to face a liquidity squeeze when their debts mature. Accommodating markets can quickly become unaccommodating, so leverage will swiftly impair investments when the cycle turns.

It’s not an easy thing to do, but at some point investors need to decide whether they are on the offensive or defensive. As Howard Marks has stated, you can’t have both. You can’t get all the return you want and be super defensive. It’s one or the other.

Buffett chooses defense. As he mentions in the letter, he evaluates deals on an all equity basis, even though adding leverage would enhance the return. He doesn’t count on synergies, even though they would make the acquisition more attractive. Investments based on leverage and synergies rarely deliver the promised returns to investors. Investors would be wise to remember this lesson as they evaluate new investments. Separate the speculation (leverage, synergies, high growth forecasts) for the likely reality (little synergies and modest growth).

Principle #3: While holding “safe” investments remains unpopular with many investors, it provides the necessary dry powder to withstand market shocks and take advantage of market opportunities.

Here’s Buffett from the 2017 Annual Letter:

Charlie and I never will operate Berkshire in a manner that depends on the kindness of strangers – or even that of friends who may be facing liquidity problems of their own. During the 2008-2009 crisis, we liked having Treasury Bills – loads of Treasury Bills – that protected us from having to rely on funding sources such as bank lines or commercial paper. We have intentionally constructed Berkshire in a manner that will allow it to comfortably withstand economic discontinuities, including such extremes as extended market closures.

Buffett is content sitting with billions of short-term Treasury Bills, a rare thought for most investors. Why does he do it? It goes back to the first principle – he can’t find attractive investments at today’s valuations. He’s patiently waiting for the next opportunity.

Should investors copy Buffett and sit in cash as well? It’s a tougher call for most investors. Obviously, most investors can’t match Buffett’s investment capability, temperament, and business analysis ability. It pays for investors to remain towards a fully invested portfolio. While investors don’t have to make a drastic move to safer assets, they should move enough to remain comfortable during the next downturn. A higher allocation to “safe” assets makes sense when valuations and expected returns are subpar or even negative.

Unfortunately, many investors neglect this and it’s not because they necessarily disagree with the logic. They don’t deny you should buy more assets when prices are low and sell assets when prices are high. Buy low, sell high. The problem sits with their emotions – as risk assets like stocks continue to run up, investors can’t handle the thought of missing out on future gains if the markets continue to rise. In short, they become momentum traders and hope the market continues to rise. But all economic, business, and credit cycles come to an end. If investors are top heavy in risk assets at the peak, they will suffer excessive losses on the way down. The solution is not to dump all the risk assets and sit in cash. It doesn’t have to be an extreme move. But investors should tilt away and rebalance to safer assets when valuations call for it. That’s why its imperative to have a fundamental gauge to judge the attractiveness of asset classes. It doesn’t have to be complicated – a moving average P/E for stocks, a long-term average spread level for bonds, etc.

The biggest problem comes back to investor’s emotional biases – they can’t stand re-allocating away from assets that have recently done well. The “buy low, sell high” logic is thrown out as they are seduced by the easy money being made today. But it will end, as it always does. Remember, the lesson is not to completely dump stocks and go to cash. The idea is to remember that all good markets come to and end, and investors need to consider their ability to handle a down market, and structure their portfolio accordingly.

Principle #4: In the short-term, prices disengage from fundamentals, often in a violent and unpredictable manner. Investors who are prepared for them will succeed, those who are unprepared will fail.

Here’s Buffett from the 2017 Annual Letter:

Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long-term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips. Here are the gory details:

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This table offers the strongest argument I can muster against ever using borrowed money to own stocks. 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.

Buffett emphasizes the lesson on the inherent dangers of adding leverage to an equity portfolio. As Buffett states, even a portfolio with high quality Berkshire shares would have been decimated if leverage had been added.

There is a bigger lesson here than just the dangers of leverage. It’s the idea that in the short-term prices can drop to wildly unexpected levels. Many investors aren’t ready when this happens, resulting in knee-jerk reactions and emotionally charged investment blunders. If quality investments like Berkshire fall over 50% in these time periods, imagine what happens to lower quality companies! There are two lessons here. First, these events, while unexpected, happen regularly in the markets. Second, the goal is not to predict these events, but the prepare for these events. Investors who are mentally ready and have dry powder to deploy will use these opportunities to make exceptional investments at absolute bargain prices. Investors who are not ready will often panic, sell out at the bottom, and lock in huge losses and forego any participation when the market recovers. Same market event, but two completely different outcomes, all based on the preparation of investors before these events occur.

Principle #5: Many active managers have failed to deliver their promise to investors. Hedge funds, fund of funds, and other active managers continue to lag their respective benchmarks, often by a large amount. Investors need to challenge their own conviction when allocating to active managers, making sure they really understand the unique capabilities of their managers.

In 2007, Warren Buffett made a simple bet with Protégé Partners. Buffett bet that the S&P 500 would outperform a group of five fund of funds over a ten-year period. Protégé, an advisory firm, selected a group of fund of funds and bet they as a group would outperform the S&P 500, after all fees and expenses. Buffett was making a bet based on something he has believed for a long time – the performance of most Wall Street products and strategies, after including the layers of fees and expenses, end up delivering staggeringly low returns to investors while enriching the managers. Buffett and Protégé each put up money that would be donated to the winner’s charity of choice at the end of the 10 years. Below is Buffett’s recap of the bet that just ended this year.

Here’s Buffett from the 2017 Annual Letter:

 “The Bet” is Over and Has Delivered an Unforeseen Investment Lesson

I made the bet for two reasons: (1) to leverage my outlay of $318,250 into a disproportionately larger sum that – if things turned out as I expected – would be distributed in early 2018 to Girls Inc. of Omaha; and (2) to publicize my conviction that m