Value Investing

7 Enlightening Insights From Warren Buffett’s 2017 Letter to Shareholders

Warren Buffett is one of the best investors of our time.

As the Chairman and Chief Executive Officer of Berkshire Hathaway (BRK.A) (BRK.B), Warren Buffett oversees a common stock investment portfolio that is worth more than $100 billion.

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Over the years, Buffett has shared his investing and business wisdom through Berkshire Hathaway’s annual Letter to Shareholders, which are published in February or March of each year. These documents have helped to educate some of the world’s best investors.

This continues to be true in recent years. On February 24th, 2018, Buffett published Berkshire Hathaway’s 2017 Letter to Shareholders. It contains actionable investing insights as well as clues regarding the future of Berkshire Hathaway.

This article will analyze Warren Buffett’s 2017 Letter to Shareholders in detail, with a particular emphasis on how self-directed investors can apply the information contained in the document.

Table of Contents

You can jump to a particular section of this analysis using the table of contents below:

Insight #1: Valuations Are Posing A Problem For Berkshire’s Acquisition-Based Growth Strategy

It is no surprise to anyone active in the financial markets that the valuations of most assets are meaningfully higher than their long-term averages. This is true for stocks, bonds, and most other asset classes.

For Buffett, this has negatively impacted Berkshire’s ability to grow via acquisitions. Buffett touches on this with the following passage in his letter to shareholders:

“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.

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.”

From Buffett’s perspective, there are two major factors that are causing this broad overvaluation within the markets. The first is the desire of most CEOs to rule the largest kingdom possible:

“Why the purchasing frenzy? In part, it’s because the CEO job self-selects for “can-do” types. If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.

Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase. Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size. Investment bankers, smelling huge fees, will be applauding as well. (Don’t ask the barber whether you need a haircut.) If the historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint.”

Buffett also believes that low interest rates played a role.

Indeed, global interest rates have been near zero for several years and, although they are beginning to rise now, this has yet to meaningfully deflate the prices of real assets.

Buffett writes the following about the role of low interest rates on higher asset prices:

“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.

Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need. We held this view 50 years ago when we each ran an investment partnership, funded by a few friends and relatives who trusted us. We also hold it today after a million or so “partners” have joined us at Berkshire.

Despite our recent drought of acquisitions, Charlie and I believe that from time to time Berkshire will have opportunities to make very large purchases. In the meantime, we will stick with our simple guideline: The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.”

The last paragraph quoted above shows that Berkshire will remain active on the acquisition front. It will not, however, force acquisitions when corporate valuations are high enough to impair the returns that will be generated by these transactions.

Buffett’s distaste for the current valuations attributed to both private and public companies meant that Berkshire only completed one major acquisition in 2017: truck stop operator Pilot Flying J. This acquisition is discussed below.

Insight #2: Berkshire’s Pilot Flying J Acquisition Was Its Lone Major Acquisition in 2017

Buffett writes the following about Berkshire’s one major acquisition in 2017:

“We were able to make one sensible stand-alone purchase last year, a 38.6% partnership interest in Pilot Flying J (“PFJ”). With about $20 billion in annual volume, the company is far and away the nation’s leading travel-center operator.

PFJ has been run from the get-go by the remarkable Haslam family. “Big Jim” Haslam began with a dream and a gas station 60 years ago. Now his son, Jimmy, manages 27,000 associates at about 750 locations throughout North America. Berkshire has a contractual agreement to increase its partnership interest in PFJ to 80% in 2023; Haslam family members will then own the remaining 20%. Berkshire is delighted to be their partner.

When driving on the Interstate, drop in. PFJ sells gasoline as well as diesel fuel, and the food is good. If it’s been a long day, remember, too, that our properties have 5,200 showers.”

In many ways, the Pilot Flying J acquisition is a typical Berkshire Hathaway transaction. Berkshire was able to acquire a significant interest in this company while a family member (Jimmy Haslem) stays on to operate the company and send capital back to Berkshire’s head office. Moreover, if the U.S. economy continues to grow, then Pilot Flying J should be able to deliver satisfactory returns to Berkshire Hathaway.

Buffett also later writes that the management at Clayton Homes was a major reason why the Pilot Flying J acquisition was able to close. He says:

“Both Clayton Homes and PFJ are based in Knoxville, where the Clayton and Haslam families have long been friends. Kevin Clayton’s comments to the Haslams about the advantages of a Berkshire affiliation, and his admiring comments about the Haslam family to me, helped cement the PFJ deal.”

It is clear that Buffett’s network of operating business helped to create the dealflow that led to the Pilot Flying J acquisition. Indeed, Berkshire has become known as a great company to sell your business to, which is a strong competitive advantage given the company’s acquisition-based growth strategy.

You may be wondering – how does the company generate the cash to fund these transactions?

There are two sources: internally-generated cash and insurance float. We discuss insurance float below.

Insight #3: Insurance Float Continues To Be Very Important For Berkshire Hathaway

Since Buffett’s first acquisition of an insurance company several decades ago, Berkshire has generated a tremendous amount of insurance float – money that has been collected as insurance premiums and is later expected to be paid out as insurance claims.

Berkshire has used this float to acquire wholly-owned operating subsidiaries outside of the insurance sector. While this may suggest that insurance float has become less important to Berkshire as time has passed, this is not the case.

Buffett wrote the following about the continued importance of insurance float in Berkshire Hathaway’s 2017 Letter to Shareholders:

“Before I discuss our 2017 insurance results, let me remind you of how and why we entered the field. We began by purchasing National Indemnity and a smaller sister company for $8.6 million in early 1967. With our purchase we received $6.7 million of tangible net worth that, by the nature of the insurance business, we were able to deploy in marketable securities. It was easy to rearrange the portfolio into securities we would otherwise have owned at Berkshire itself. In effect, we were “trading dollars” for the net worth portion of the cost.

The $1.9 million premium over net worth that Berkshire paid brought us an insurance business that usually delivered an underwriting profit. Even more important, the insurance operation carried with it $19.4 million of “float” – money that belonged to others but was held by our two insurers.

Ever since, float has been of great importance to Berkshire. When we invest these funds, all dividends, interest and gains from their deployment belong to Berkshire. (If we experience investment losses, those, of course, are on our tab as well.) Float materializes at p/c insurers in several ways: (1) Premiums are generally paid to the company upfront whereas losses occur over the life of the policy, usually a six-month or one-year period; (2) Though some losses, such as car repairs, are quickly paid, others – such as the harm caused by exposure to asbestos – may take many years to surface and even longer to evaluate and settle; (3) Loss payments are sometimes spread over decades in cases, say, of a person employed by one of our workers’ compensation policyholders being permanently injured and thereafter requiring expensive lifetime care.

Float generally grows as premium volume increases. Additionally, certain p/c insurers specialize in lines of business such as medical malpractice or product liability – business labeled “long-tail” in industry jargon – that generate far more float than, say, auto collision and homeowner policies, which require insurers to almost immediately make payments to claimants for needed repairs.

Berkshire has been a leader in long-tail business for many years. In particular, we have specialized in jumbo reinsurance policies that leave us assuming long-tail losses already incurred by other p/c insurers. As a result of our emphasizing that sort of business, Berkshire’s growth in float has been extraordinary. We are now the country’s second largest p/c company measured by premium volume and its leader, by far, in float.

Here’s the record:

Berkshire Hathaway Insurance Float

“Our 2017 volume was boosted by a huge deal in which we reinsured up to $20 billion of long-tail losses that AIG had incurred. Our premium for this policy was $10.2 billion, a world’s record and one we won’t come close to repeating. Premium volume will therefore fall somewhat in 2018.

Float will probably increase slowly for at least a few years. When we eventually experience a decline, it will be modest – at most 3% or so in any single year. Unlike bank deposits or life insurance policies containing surrender options, p/c float can’t be withdrawn. This means that p/c companies can’t experience massive “runs” in times of widespread financial stress, a characteristic of prime importance to Berkshire that we factor into our investment decisions.

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.”

Berkshire’s continued ability to generate rising levels of insurance float is a key competitive advantage for the company. Indeed, Berkshire held nearly $115 billion of float at the end of fiscal 2017.

We expect Berkshire’s float to continue to grow moving forward. With that said, Berkshire’s insurance operations are not completely immune to the occasional year of poor financial performance.

Last year was an example of this, as several natural disasters had a negative impact on Berkshire’s results. We discuss this in the next section of this article.

Insight #4: 2017 Was a Difficult Year For Berkshire’s Insurance Business, But It Remains Best-of-Breed

Buffett wrote the following about the performance of Berkshire Hathaway’s insurance operations in fiscal 2017:

“The downside of float is that it comes with risk, sometimes oceans of risk. What looks predictable in insurance can be anything but. Take the famous Lloyds insurance market, which produced decent results for three centuries. In the 1980’s, though, huge latent problems from a few long-tail lines of insurance surfaced at Lloyds and, for a time, threatened to destroy its storied operation. (It has, I should add, fully recovered.)

Berkshire’s insurance managers are conservative and careful underwriters, who operate in a culture that has long prioritized those qualities. That disciplined behavior has produced underwriting profits in most years, and in such instances, our cost of float was less than zero. In effect, we got paid then for holding the huge sums tallied in the earlier table.

I have warned you, however, that we have been fortunate in recent years and that the catastrophe-light period the industry was experiencing was not a new norm. Last September drove home that point, as three significant hurricanes hit Texas, Florida and Puerto Rico. 

My guess at this time is that the insured losses arising from the hurricanes are $100 billion or so. That figure, however, could be far off the mark. The pattern with most mega-catastrophes has been that initial loss estimates ran low. As well-known analyst V.J. Dowling has pointed out, the loss reserves of an insurer are similar to a self-graded exam. Ignorance, wishful thinking or, occasionally, downright fraud can deliver inaccurate figures about an insurer’s financial condition for a very long time.

We currently estimate Berkshire’s losses from the three hurricanes to be $3 billion (or about $2 billion after tax). If both that estimate and my industry estimate of $100 billion are close to accurate, our share of the industry loss was about 3%. I believe that percentage is also what we may reasonably expect to be our share of losses in future American mega-cats.

It’s worth noting that the $2 billion net cost from the three hurricanes reduced Berkshire’s GAAP net worth by less than 1%. Elsewhere in the reinsurance industry there were many companies that suffered losses in net worth ranging from 7% to more than 15%. The damage to them could have been far worse: Had Hurricane Irma followed a path through Florida only a bit to the east, insured losses might well have been an additional $100 billion.

We believe that the annual probability of a U.S. mega-catastrophe causing $400 billion or more of insured losses is about 2%. No one, of course, knows the correct probability. We do know, however, that the risk increases over time because of growth in both the number and value of structures located in catastrophe-vulnerable areas.

No company comes close to Berkshire in being financially prepared for a $400 billion mega-cat. Our share of such a loss might be $12 billion or so, an amount far below the annual earnings we expect from our non-insurance activities. Concurrently, much – indeed, perhaps most – of the p/c world would be out of business. Our unparalleled financial strength explains why other p/c insurers come to Berkshire – and only Berkshire – when they, themselves, need to purchase huge reinsurance coverages for large payments they may have to make in the far future.

Prior to 2017, Berkshire had recorded 14 consecutive years of underwriting profits, which totaled $28.3 billion pre-tax. I have regularly told you that I expect Berkshire to attain an underwriting profit in a majority of years, but also to experience losses from time to time. My warning became fact in 2017, as we lost $3.2 billion pre-tax from underwriting.

A large amount of additional information about our various insurance operations is included in the 10-K at the back of this report. The only point I will add here is that you have some extraordinary managers working for you at our various p/c operations. This is a business in which there are no trade secrets, patents, or locational advantages. What counts are brains and capital. The managers of our various insurance companies supply the brains and Berkshire provides the capital.”

As you can see, 2017 introduced numerous challenges for Berkshire’s insurance subsidiaries. With that said, the company remains one of the most financially sound businesses in the insurance industry. We believe that Berkshire will continue to outperform its peers in the insurance industry moving forward.

This section discussed one component of the insurance business – underwriting. The other component is an insurance company’s investment operation.

In Buffett’s Letter to Shareholders, he touched on a new accounting rule that will have a large impact on Berkshire’s investment operation. We discuss this new accounting rule below.

Insight #5: New Accounting Rules Will Meaningfully Impact Berkshire Hathaway’s Financial Results

Buffett writes the following about a new accounting rule that will affect how Berkshire pays tax on its investments in marketable securities:

“The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line. Berkshire owns $170 billion of marketable stocks (not including our shares of Kraft Heinz), and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire’s “bottom-line” will be useless.

The new rule compounds the communication problems we have long had in dealing with the realized gains (or losses) that accounting rules compel us to include in our net income. In past quarterly and annual press releases, we have regularly warned you not to pay attention to these realized gains, because they – just like our unrealized gains – fluctuate randomly.

That’s largely because we sell securities when that seems the intelligent thing to do, not because we are trying to influence earnings in any way. As a result, we sometimes have reported substantial realized gains for a period when our portfolio, overall, performed poorly (or the converse).

With the new rule about unrealized gains exacerbating the distortion caused by the existing rules applying to realized gains, we will take pains every quarter to explain the adjustments you need in order to make sense of our numbers. But televised commentary on earnings releases is often instantaneous with their receipt, and newspaper headlines almost always focus on the year-over-year change in GAAP net income. Consequently, media reports sometimes highlight figures that unnecessarily frighten or encourage many readers or viewers.

We will attempt to alleviate this problem by continuing our practice of publishing financial reports late on Friday, well after the markets close, or early on Saturday morning. That will allow you maximum time for analysis and give investment professionals the opportunity to deliver informed commentary before markets open on Monday. Nevertheless, I expect considerable confusion among shareholders for whom accounting is a foreign language.

At Berkshire what counts most are increases in our normalized per-share earning power. That metric is what Charlie Munger, my long-time partner, and I focus on – and we hope that you do, too.”

While Buffett is concerned about the impact that this new accounting rule will have on Berkshire’s quarter-to-quarter earnings, he acknowledges that these sequential differences are not meaningful. Berkshire will continue to publish financial reports late on Friday to help subdue any volatility that might arise from quarterly fluctuations in GAAP earnings.

Insight #6: Berkshire Is Not Immune To Price Drawdowns

Berkshire Hathaway is often viewed as a “widows-and-orphans” stock – a low-risk security that still has a reasonable chance of delivering solid returns without any additional input from the investor.

With that said, Buffett devoted a section of this year’s Letter to Shareholders to reminding readers that Berkshire is not immune to price drawdowns. He wrote the following passage on this topic:

“Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure longterm 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:

Berkshire Hathaway Price Drawdowns

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.

In the next 53 years our shares (and others) will experience declines resembling those in the table. No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow.”

Does this passage imply that Buffett believes a stock market correction is on the way?

It is impossible to say. What we recommend is that investors continue to rationally allocate capital with no regard for what the market averages are doing. Additionally, this is a healthy reminder to understand the potential consequences associated with using borrowed money to purchase marketable securities.

Insight #7: When Future Returns of an Existing Investment Drop to Unattractive Levels, Sell and Reinvest The Proceeds Elsewhere

Many readers are familiar with Warren Buffett’s bet against hedge funds. In this bet, Buffett bet $1 million that an S&P 500 Index ETF would outperform a selection of hedge funds over a ten-year period.

Buffett was right – the S&P 500 trounced the performance of the funds selected by Buffett’s counterparty Protégé Partners. Buffett revisited this bet in the 2017 Letter to Shareholders to illustrate an interestingly unrelated point – that when the expected returns of one of your existing investments falls to unattractive levels, you should sell the investment and reinvest the proceeds in more appealing investment opportunities.

Here’s what Buffett writes on the subject:

“The bet illuminated another important investment lesson: 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.

Originally, Protégé and I each funded our portion of the ultimate $1 million prize by purchasing $500,000 face amount of zero-coupon U.S. Treasury bonds (sometimes called “strips”). These bonds cost each of us $318,250 – a bit less than 64¢ on the dollar – with the $500,000 payable in ten years.

As the name implies, the bonds we acquired paid no interest, but (because of the discount at which they were purchased) delivered a 4.56% annual return if held to maturity. Protégé and I originally intended to do no more than tally the annual returns and distribute $1 million to the winning charity when the bonds matured late in 2017.

After our purchase, however, some very strange things took place in the bond market. By November 2012, our bonds – now with about five years to go before they matured – were selling for 95.7% of their face value. At that price, their annual yield to maturity was less than 1%. Or, to be precise, .88%.

Given that pathetic return, our bonds had become a dumb – a really dumb – investment compared to American equities. Over time, the S&P 500 – which mirrors a huge cross-section of American business, appropriately weighted by market value – has earned far more than 10% annually on shareholders’ equity (net worth).

In November 2012, as we were considering all this, the cash return from dividends on the S&P 500 was 2.5% annually, about triple the yield on our U.S. Treasury bond. These dividend payments were almost certain to grow. Beyond that, huge sums were being retained by the companies comprising the 500. These businesses would use their retained earnings to expand their operations and, frequently, to repurchase their shares as well. Either course would, over time, substantially increase earnings-per-share. And – as has been the case since 1776 – whatever its problems of the minute, the American economy was going to move forward.

Presented late in 2012 with the extraordinary valuation mismatch between bonds and equities, Protégé and I agreed to sell the bonds we had bought five years earlier and use the proceeds to buy 11,200 Berkshire “B” shares. The result: Girls Inc. of Omaha found itself receiving $2,222,279 last month rather than the $1 million it had originally hoped for.

Berkshire, it should be emphasized, has not performed brilliantly since the 2012 substitution. But brilliance wasn’t needed: After all, Berkshire’s gain only had to beat that annual .88% bond bogey – hardly a Herculean achievement.

The only risk in the bonds-to-Berkshire switch was that yearend 2017 would coincide with an exceptionally weak stock market. Protégé and I felt this possibility (which always exists) was very low. Two factors dictated this conclusion: The reasonable price of Berkshire in late 2012, and the large asset build-up that was almost certain to occur at Berkshire during the five years that remained before the bet would be settled. Even so, to eliminate all risk to the charities from the switch, I agreed to make up any shortfall if sales of the 11,200 Berkshire shares at yearend 2017 didn’t produce at least $1 million.

Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that this objective won’t be attained.

By that standard, purportedly “risk-free” long-term bonds in 2012 were a far riskier investment than a longterm investment in common stocks. At that time, even a 1% annual rate of inflation between 2012 and 2017 would have decreased the purchasing-power of the government bond that Protégé and I sold.

I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. 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.

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.

A final lesson from our bet: Stick with big, “easy” decisions and eschew activity. During the ten-year bet, the 200-plus hedge-fund managers that were involved almost certainly made tens of thousands of buy and sell decisions. Most of those managers undoubtedly thought hard about their decisions, each of which they believed would prove advantageous. In the process of investing, they studied 10-Ks, interviewed managements, read trade journals and conferred with Wall Street analysts.

Protégé and I, meanwhile, leaning neither on research, insights nor brilliance, made only one investment decision during the ten years. We simply decided to sell our bond investment at a price of more than 100 times earnings (95.7 sale price/.88 yield), those being “earnings” that could not increase during the ensuing five years.

We made the sale in order to move our money into a single security – Berkshire – that, in turn, owned a diversified group of solid businesses. Fueled by retained earnings, Berkshire’s growth in value was unlikely to be less than 8% annually, even if we were to experience a so-so economy.

After that kindergarten-like analysis, Protégé and I made the switch and relaxed, confident that, over time, 8% was certain to beat .88%. By a lot.”

The most obvious takeaway from this passage is that when the potential returns of an investment drop, you should be willing to sell the security and reinvest the proceeds elsewhere.

There are a number of other lessons embedded in this passage, including:

  • Understand that real risk is not measured by volatility or beta; instead, it is the probability that you do not achieve your predetermined investment goals
  • Favor inactivity when debating whether to make trades in your investment portfolio
  • Recognize that equities are the best investment for building wealth over the long run 

Final Thoughts

Warren Buffett’s 2017 Letter to Shareholders continued the long-term trend of delivering profound advice about investing, business, and life in an easy-to-digest form.

We recommend that investors who are interested in learning more about Warren Buffett’s investment approach read the following analysis from Sure Dividend:

Warren Buffett’s investment portfolio is an excellent place to look for high-quality investment ideas.

With that said, it is not the only place where potential investments can be found.

If you are looking for investment opportunities with strong probabilities of increasing their dividends over time, we recommend searching through the following databases of stocks:

Alternatively, you may prefer to look at lists of stocks categorized by their dividend characteristics. If that is the case, the following Sure Dividend databases will be useful:

Stocks sorted by sector are also beneficial for investors looking to appropriately diversify their investment portfolios.

A last place to look for investment opportunities is within the major market indices. Sure Dividend provides free downloadable Excel documents containing each stock in the following indices:

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Article by Nick McCullum, Sure Dividend

ValueWalk readers can click here to instantly access an exclusive $100 discount on Sure Dividend’s premium online course Invest Like The Best, which contains a case-study-based investigation of how 6 of the world’s best investors beat the market over time.