Each year I read Chairman and CEO Warren Buffett’s annual letter to Berkshire Hathaway’s shareholders upon its release. For many reasons, I do so as a shareholder, an investor, a former equity analyst, and a professor. Teaching finance to college students the letters are a treasure trove and better than many textbooks.  They are enjoyable to read, and I learn a ton from them.

The 2020 letter provides insights into the company’s diverse businesses. These businesses represent a proxy for our economy. What makes the letter so special is that Buffett writes it himself, sharing money and investing lessons with his memorable wit and humor. Each year, Buffet aims his words at investors at every level.  He pretends he is writing to his two sisters, Doris and Bertie. They have a significant amount of shares.

This year’s letter had several new aspects, which contained some soul searching but no major surprises. Buffett and his partner in crime, Charlie Munger, are the oldest leadership team of Fortune 500 companies at ages 90 and 96, respectively. They recognize the need to be candid with shareholders about the company’s future without them.

13 Key Takeaways:

 

1. 2019 Was Not A Stellar Year For Berkshire’s Stock Performance

Berkshire’s stock underperformed the S& P 500 index, the market’s proxy, by 20.5 percentage points in a strong year for equities. This year’s performance was its biggest disappointment since 2009. Looking at its 55 years history, Berkshire compound annual return of 20.3% exceeded the S&P 500’s not too shabby 10%. While this is an excellent performance for any company, Wall Street’s “what have you done for me lately?” mentality raised many questions for Buffett. The company has been hurt by its lack of acquisitions, particularly in fast-growth areas like the technology sector.

The company’s operating earnings in 2019 were slightly down compared to a year ago. Berkshire Hathaway does not pay a dividend to shareholders who would have boosted returns to shareholders.

2. A Disciplined Acquisition Strategy

Acquisitions are a signature priority for the company. However, Buffett has had trouble finding an “elephant-sized” one. Buffett tried buying Tech Data, a technology distributor, but  Apollo Management bid higher and acquired the tech company.

Buffett uses three criteria for buying new businesses:

  • The business must earn good returns on the net tangible capital required for its operations.
  •  Berkshire’s unique acquisition strategy prefers to inherit strong and honest managers.
  • Buffett wants to pay a sensible price and will not enter into bidding wars.

Although they prefer to own 100% of the acquired company or at least a controlling interest, they have valuable non-controlling interests in many businesses. Those holdings are worth $248 billion based on the year-end 2019 market price. They represent long-term holdings of reliable companies include American Express, Apple, and Delta Airlines.

However, the accounting isn’t as favorable a contributor for their non-controlling stakes. Berkshire can only realize the dividends that Berkshire receives in operating earnings they report. However, they cannot include the proportionate retained earnings reported by these holdings. Dividend income from the ten largest holdings in 2019 amounted to $3.8 billion compared to its share of $8.3 billion for retained earnings.

 

3. Reinvestment In Diverse Productive Operational Assets Remains Top Priority

Berkshire Hathaway splits their controlling businesses into insurance and non-insurance operations. Together, they reflect diverse companies representing a tapestry of our economy. Buffett has acquired dozens of companies over the years. In the current letter, he analogizes acquisitions to marriages: “Joyful weddings — but then reality tends to diverge from prenuptial expectations. Sometimes, wonderfully, the new union delivers bliss beyond either party’s hopes. In other cases, disillusionment is swift.” Almost poetic!

Although Buffett does not explicitly cite the significant disappointments, his commentary pointed to the original one. That dates back to early 1965 when he acquired Berkshire’s textile business, which received most of the capital. Buffett began acquiring companies, which received more of the company’s money. The textile’s losses became a drag on growth and eventually lost financial support. Of course, without that business, there may not have been a Berkshire Hathaway today. Today, Berkshire designates most of its capital to their companies that achieve good-to-excellent returns and less for those that perform poorly.

Top businesses that get superstar status in Berkshire’s portfolio are insurance operations,  followed by BNSF railroad and BH Energy acquisitions. The rest are Clayton Homes, International Metalworking, Lubrizol, Marmon, Precision Castparts, Forest River, Johns Manville, MiTek, Shaw, and TTI. They also own many smaller businesses.

4. Wind As A Major Energy Accomplishment

Berkshire Hathaway Energy has been very successful in charging lower energy rates. They realized efficiencies from converting wind into electricity. The company expects to be wind self-sufficient for its Iowa customers in 2021, far ahead of the other Iowa utility. Berkshire’s move to the wind is potentially well ahead of other utilities in the US. Positively, Berkshire’s energy business may take on more utility projects.

5. Valuable Insurance Businesses With Conservative Risk Approach

Berkshire’s property/casualty insurance businesses provide a lot of capital by “float” or “free money.” Float is an attractive aspect of the insurance business. The insurers receive premiums upfront from the sale of insurance policies. They make payment of claims which can stretch out over decades. In the meantime, the company invests the float money in conservative high-grade bonds. Given our low-interest-rate environment, the returns have been low for these financial instruments in recent years. Had the float been invested in lower-quality bonds or stocks with higher returns, Berkshire and its shareholders would have been bigger beneficiaries but at far greater risk.

Instead, Berkshire is sticking with a conservative investment policy for the float. Insurance can be a risky business. There have been significant catastrophes in the past, such as asbestos, Katrina, earthquakes, and tsunami in Japan. When they occur, it can be tragically devastating for human lives and significantly impact businesses unexpectedly.

6. The Compounding Power Of Retained Earnings

Buffett discussed an economist, Edgar Lawrence Smith, who had written Common Stocks As Long Term Investments in 1924 in his letter. Smith argued that stocks would perform better than bonds when prices rise, and bonds would deliver better returns when prices decline. However, the author himself admitted that the studies he was using did not prove his theory.

Giving support to Smith’s insights, John Maynard Keynes wrote in his review of Smith’s book: “I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point. Well-managed industrial companies do not, as a rule, distribute to 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 (Keynes italics) 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 dividends paid out to shareholders.”

Before Smith’s book, stocks were considered speculative compared to bonds. Reading The Beautiful And Damned classic by F. Scott Fitzgerald written in 1922, the protagonist Anthony Patch had lived off his bonds, selling them off as his emergency fund as he had no other income. Stocks were not what gentlemen buy.

Think of the company’s retained earnings as its savings account compounding growth. This growth can be invested in new opportunities, whether to buy new companies or expand their holdings.

7. “If”

Buffett is a big fan of Rudyard Kipling’s poem “If and uses “If” when asked about predictions. When making forecasts, Buffett Cannot predict future interest rates, tax rates, or economic growth. Changes in these rates can cause stocks to have significant drops in the market of 50% or greater. That said, he remains an unflappable optimist about our country and the future of stocks for the long term. Equities are the better choice over fixed-rate debt securities assuming interest rates and corporate rates remain as they are now. Hard to predict significant “ ifs.

That said, equities perform better over the long term benefiting from compound growth. However,  you can do things to reduce your risk by not using borrowed money (e.g. buying on margin) to buy stocks. Control your emotions when the markets get rocky so that you don’t sell good stocks recklessly. Volatility in the markets happen regularly but weather the dips for the long term rather than sell out of nervousness. An emergency fund helps you maintain liquidity when the unexpected happens, such as a job loss.

8. Use Of Conservative Accounting Standards

Buffett and Munger refer to earnings as bottom-line net earnings, meaning after considering all income taxes, interest payments, management compensation, restructuring costs, depreciation and amortization, and home office overhead costs. Net earnings contrast to the often practiced adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA is a much higher number than net earnings. However, Berkshire prefers net earnings, which is more conservative. Munger has often referred to the EBITDA profit metric as “BS earnings.”

High growth companies who are not year generating bottom-line earnings use EBITDA as a measurement. Wall Street bankers and analysts have endorsed EBITDA as alternative valuations for growth companies. Buffett is critical of companies that report earnings before “one-time events” such as restructuring and stock-based compensation costs. What he means is that these costs still need to be deducted from gross earnings. Some management doesn’t want to include these items as an expense, but as Buffett quips: “What else could it be–  a gift from shareholders?”

9. Buy-Hold Investment Strategy is A Longstanding Trademark

Berkshire has a significant collection of equity holdings. This portfolio is separate from the companies Berkshire controls. Here, Berkshire has ownership typically about 5%-10%+ stakes in substantial companies that deliver dividends and stock appreciation. Berkshire holds about fifteen positions thoughtfully bought and intended for long term. At the end of the year, Berkshire’s portfolio of $248.0 billion market value, well over its $110.3 billion costs.

This portfolio does not include Berkshire’s more significant holding in Kraft Heinz because it is in a control group. Kraft Heinz is one of his acquisitions that Buffett believes the company overpaid. One of his few mistakes. Overall, Buffett often is praised for his buy-hold portfolio diversification.

10. Berkshire Share Repurchases

Buffett and Munger will buy back shares if they sell at prices below their intrinsic value estimate and have sufficient cash. Berkshire bought back $5 billion in shares for about 1% of the company. They are reluctant to buy back shares solely for the appearance of propping up the stock. They have been critical of other companies doing that.

The management of their constituent companies has also repurchased shares, using their retained earnings. Repurchased shares boost Berkshire’s ownership percentage from the lower outstanding share count.

11. Has An Ample Emergency Fund

Berkshire maintains a high level of cash-equivalent securities, invested in US Treasury bills of $125 billion at yearend. They use debt sparingly with $19.9 billion.  Buffett admits to making expensive mistakes along with missed opportunities. The company always maintains a minimum of $20 billion to guard against any potential calamities. Holding this money is like an emergency fund for the company so they can have liquidity readily accessible. Berkshire would never want to sell any of their businesses to raise capital.

12. Planned Exits For Buffett And Munger

Neither management is going anywhere in the immediate future. They remain energetic and optimistic about the company’s future. The company is well known for its strong corporate culture throughout its many companies. That said, in preparation for Buffett’s eventual exit, he discussed the details of his will’s directives. According to Buffett’s directions, fiduciaries–executors and trustees–cannot sell any Berkshire shares right away. Both the Mungers and Buffett have most of their wealth concentrated in Berkshire shares.

Over time, the trustees will convert A shares into B shares annually and distribute them to various foundations. The higher-priced B shares are the original Berkshire Hathaway stock and have never gone through a stock split. A recent stock price for Berkshire A (BRK.A) was $343,449.00, while the B shares (BRK.B) are $229.33, a more accessible price for the average investor.  It will likely take 12-15 years to distribute after Buffett’s passing.

Buffett feels confident in his strategy despite the concentration of that much wealth in one stock. His faith in the company outweighs his need for diversification. That is not good advice for the regular investor, but hey, he is Warren Buffett. Buffett is aware that Investment banks may approach the Berkshire Board of Directors to change Buffett’s strategy. However, Buffett has a strong belief in his board. He has been critical of overpaid directors at other companies who do not buy shares with their savings except through grants. The need for board independence for Buffett has been a constant topic well before Sarbanes-Oxley law’s requirements.

13. “We Are All Duds At One Thing Or Another”

In a jab at directors he met through the years, Buffett said he would not have chosen them to handle his money or business matters. Adding, “They, in turn would never have asked me for help in removing a tooth or improving their golf swing. Moreover, if I were ever scheduled to appear on Dancing With The Stars, I would immediately seek refuge in the Witness Protection Program. We are all duds at one thing or another.”

Ajit Jain And Greg Abel Will Have More Exposure At This Year’s Shareholders Meeting

Jain and Abel –two prominent operating managers–have been touted by Buffett in recent years. Jain heads the insurance business, while Abel is part of the Berkshire Hathaway energy business. Buffett and Munger have not named Abel and Jain as successors. Buffett turned 90 on his last birthday (August 30), so it is only reasonable that investors encourage the company to make their decision official soon.

Final Thoughts

Warren Buffett has long been an investment icon, teacher, and generous philanthropist. His folksy letters to shareholders provide personal finance lessons in a manner of common sense. They are informative about the company’s businesses.  Buffett’s refreshing optimism about the future can be contagious. He owns up to mistakes and is self-deprecating with his wonderful sense of humor.

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