Every year since 1977, Warren Buffett has released a shareholder letter. In recent years, it’s been a highlight of the financial calendar with investors eagerly poring over his words to glean his thoughts on everything from bond valuations to the dangers of debt. I’m a big fan of Warren Buffett – I like his sensible, easy-to-digest insights into business and investing, and like many retail investors think there’s plenty of learn from his words.
With this in mind, I’m going to start a series of articles on Warren Buffett’s Shareholder Letters. One a quarter, I’m going to read his letters (all available for free on Berkshire Hathaway’s website) and provide an overview of the content and my thoughts on it.
Berkshire Hathaway: 2019
Warren’s latest shareholder letter begins with the eye opening statement that “Berkshire earned $81.4 billion in 2019”. Warren provides some clarification on this point however, stating that over $50bn of that sum come from unrealised capital gains which the company is required to declare due to an accounting change in 2018.
Before the change in accounting rules, companies were never to include unrealised gains or losses in their earnings unless their sole business was in trading securities. To me, this makes perfect sense – after all, if I own a house and my estate agent tells me it’s worth £100k more this year than last year, I’m not actually any richer than I was last year but under the new regulations, I would have to declare the £100k as ‘earnings’, making it a totally fictional representation of the cash I received that year.
Reflecting that in the case of Berkshire Hathaway, this fiction is much greater, Warren encourages shareholder to concentrate on operating earnings which more accurately reflect the cash generation of the underlying companies held by Berkshire.
Common Stocks as Long Investments
Warren goes on to write about a book written in 1924 by an author called Edgar Lawrence Smith. He refers to an argument within the book that during periods of inflation, stocks would perform better than bonds, but that the reverse would likely be true during periods of deflation. Although this seems obvious, apparently Smith was incorrect.
John Maynard Keynes wrote of this theory that “Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”
The power of retained earnings
Warren then refers to his long predilection towards reinvesting earnings and for seeking out companies which present attractive opportunities for doing so. It is here that he refers to three criteria against which he assesses companies.
- Find companies which earn ‘good returns on net tangible capital’.
- Ensure such companies are run by honest and able managers.
- Only invest in companies available at a sensible price.
Warren goes on in some detail to talk about the value of retained earnings; how paying money out in dividends is essentially an admission by management that they cannot deploy the capital usefully (or at least should be) but that profits not paid out are in fact compounded within the businesses held by Berkshire Hathaway. These retained earnings are a huge driver of value for Berkshire’s shareholders – a fact which is often overlooked by investors pursuing dividends.
Acquisitions are like marriage
A lesser observed fact of Berkshire Hathaway involves the significant investments in non-listed companies; that is those which are privately acquired and wholly owned by Berkshire Hathaway such as Sees Candies and Geico Insurance. In typical Warren style, the method of acquisition is given a colourful simile; marriage.
“In reviewing my uneven record, I’ve concluded that acquisitions are similar to marriage: They start, of course, with a joyful wedding – but then reality tends to diverge from pre-nuptial expectations. Sometimes, wonderfully, the new union delivers bliss beyond either party’s hopes. In other cases, disillusionment is swift. Applying those images to corporate acquisitions, I’d have to say it is usually the buyer who encounters unpleasant surprises. It’s easy to get dreamy-eyed during corporate courtships.”
Warren continues to review his direct holdings, giving a rather dry update on their performance which I won’t cover in detail. After this, however, he provides two final points of interest – one regarding his succession and another regarding stock buybacks.
Those that have followed Berkshire Hathaway may well have been doing so in no small part due to Warren Buffett and Charlie Munger’s tremendous success over the last 50 years. Sadly, all good things come to an end and both Warren and Charlie are now significantly aged (Charlie is the fantastic age of 96 and Warren isn’t too far behind him at 89). Anyone with elderly relatives will be well aware of the mental and physical declines that come with such advanced age and investors have long been wary of what will happen to Berkshire after these two giants move on.
Warren is no fool and as with many sticky topics addresses this head on. He reminds shareholders that Berkshire has traditionally had an extremely ‘hands off’ approach to managing its holdings as well as investing in a hugely diversified range of companies; everything from candies to railroads. The company has a vast, vast heap of cash (over $120bn) which provide it with significant security.
Berkshire Hathaway has also been long celebrated as a company with a truly unique, nurturing and value-focused culture. It has no expensive head office, no multi-million dollar expenses pots, and no multi-million dollar boards of directors with aides and offices to suit. These factors all combine, in the eyes of Warren, to ensure that the company will be well placed to continue to deliver value for shareholders for many, many decades to come.
Finally, Warren makes a few short statements on share buybacks “only when we perceive our price to be at a significant discount to intrinsic value” and that “over time, we want Berkshire’s share count to go down”. He also proudly states that Berkshire paid $3.6bn in US taxes over the year (which he calculates to be approximately 1.5% of federal taxes paid by all corporate America). This point is a significant one; both Warren and Charlie are huge advocates of paying fair taxes and have repeatedly gone on record as saying that top earners should shoulder the biggest tax burdens as the price for a civilised society.
My thoughts
Having waded through all 14 pages of the letter, I can honestly say that this is the first year where I’ve really wanted to use the word ‘waded’. In contrast to previous shareholder letters, this year’s felt dry and tired. Not so much insightful as indulgent. It’s a shame, as many of the previous letters have held truly insightful comments, but this year I came away with the distinct feeling that this was much harder work than in previous years. Much less enjoyable.
I think Warren and Charlie – through their vehicle at Berkshire – have delivered a truly stunning 50 years tale of capitalism at its finest. Wonderful treatment of staff, truly admirable corporate values, and decades of fantastic shareholder returns. I absolutely cannot name a single other company which I could compare to Berkshire Hathaway.
Having said that, the bigger the company has become, the slower those returns have become. Where Berkshire used to regularly make increases upwards of 50% in per-share value, the last 15 years they’ve slowly down hugely, averaging closer to 20% and largely tracking the SNP500. They’ve become more prone to mistakes (losing billions on Kraft Heinz, Tesco, ConocoPhillips, and Delta Airlines, to name just a few).
Respect for the man may well be clouding investor’s judgement over Berkshire’s future prospects. The company is vastly larger, the ‘star players’ much older, and the economy wildly changed from when Warren and Charlie started out in the 60s. Berkshire has an enormous play on financials – despite Warren’s repeated statements that most bank balance sheets are unintelligible due to derivative’s exposure. Likewise, it has huge exposure to US airlines, despite Warren saying that these companies have terrible returns on equity and generally destroy value for shareholders. The company also has an enormous ‘drag’ on its balance sheet from all that cash – Warren may tout financial conservatism as prudence today, but let’s not forget that when he was making stellar returns he was investing every cent he could lay his hands on into companies like Coca Cola and Sees Candies.
In short, I think the skills that got Warren where he is today are fading; that the opportunities that were once prevalent in his world are now too small for his capital and that ultimately this unwieldy conglomerate is probably likely to follow in the footsteps of companies such as General Electric.
BUT don’t let that put you off. Despite this rather gloomy outlook, Warren and Charlie are two brilliant investors whose shareholder letters and media interviews have given me an enormous insight into investing and developed a fundamental appreciation of the importance of buying high quality companies at reasonable valuations.
I have no doubt that many of you will be wondering why after reading this article but all will be revealed as we continue with this series of Berkshire Hathaway Shareholder Letters.