the cents of money

In his latest annual letter to shareholders, Warren Buffett, CEO of Berkshire Hathaway, wants you, the investor, to understand Berkshire Hathaway, the company he has steered since 1965. As in past years, I anxiously await Warren’s annual letter (he writes his letter as if he is addressing you personally, so hence my liberal use of “Warren”)  to learn or refresh my knowledge with his numerous golden nuggets.

Here is Warren Buffett’s letter that is a review of 2019. 

My Thoughts At First Glance

There aren’t any huge surprises though Buffett admitted to an error in overpaying for Precision Castparts in 2016. One of the best sections was his tribute to the founders of companies he purchased that show “success stories abound throughout America” as entrepreneurs without capital but with a strong work ethic. Look for “Mrs. B”  as a highlight that I embraced.

The letter is disappointing for what Buffett omitted. He mentions COVID-19 only once, alluding to it when he commented on the furniture company’s temporary closing. Yet, the pandemic destroyed small businesses and caused significant unemployment.

Another topic Buffett should be upfront about was the lack of making any acquisitions and his poor timing of selling stakes in banks and airlines during 2020. Buffett did talk about repurchasing more Berkshire Hathaway shares which may contribute to higher earnings with lower outstanding share count.

Labor Of Love

I read the letters and search for Warren Buffett money lessons, a task I enjoy since graduate school for business. It is my labor of love. My goal is to share his wisdom with others, notably with my college students and, of course, my readers. It is an exercise of enjoyable reading for American history buffs and those who are in finance.  

Buffett letters to Berkshire Hathaway shareholders go back to 1965 and chronicle the growth and challenges of the company’s businesses. I always uncover Warren Buffett’s money lessons as I did in the current letter on investing, diversification, overspending, debt reduction, entrepreneurism, ethics, and more.

Many of Buffett’s iconic quotes come from these letters filled with honesty, integrity, sardonic humor, and corniness when it comes to America. He and Vice Chairman Charlie Munger share their intellect, and at ages 90 and 97, respectively, it is no small feat. Longevity may just be one of the benefits of being a longtime Berkshire shareholder, as Buffett shares in this letter. 

The Letter At A Glance

There aren’t any huge surprises though Buffett admitted to an error in overpaying for Precision Castparts in 2016. One of the best sections was his tribute to the founders of companies he purchased that show “success stories abound throughout America” as entrepreneurs without capital but with a strong work ethic. Look for “Mrs. B”  as a highlight that I embraced. 

The letter is disappointing for what Buffett omitted. He mentions COVID-19 only once, alluding to it when he commented on the furniture company’s temporary closing. Yet, the pandemic destroyed small businesses and caused significant unemployment which remains high.

Another topic Buffett should be upfront about his lack of making any acquisitions, even after the market downturn. He also divested his bank or airline holdings in 2020, presumably due to COVID-19, but he didn’t explain his actions in the letter. 

Buffett Remained On The Sidelines

Most importantly, why was he uncharacteristically quiet in 2020?

If investors were hoping the 2020 letter would fill in some of the gaps in understanding Buffett’s uncharacteristic silence much of last year, they are going to be disappointed. What was going on that Warren Buffett did not take advantage of the dramatic stock market downturn in March 2020 to buy bargain stocks? 

He often is a voice of calm and reason when markets are extremely volatile. Typically, Buffett uses this scenario as an opportunity to pick up some bargains, either by purchasing equity stakes or making acquisitions. He remains healthy, and the letter does not cause us to worry about him, at least as far as being a 90-year-old man.

Uncovering Money Lessons From Warren Buffett’s Letter To Shareholders

Misses And Mistakes

Warren Buffett addressed the company’s two primary goals: increasing earnings and acquiring large and favorably situated businesses. Management met neither goal. However, they repurchased 5% of Berkshire Hathaway’s shares, which reduces the share count, raising EPS potential. 

Admits To An Error On Overspending

The Precision Castparts acquisition made in 2016 has not lived up to its profit potential. Berkshire took an $11 billion write-down. Buffett’s mistake of overpaying for this asset took him only four years to acknowledge compared to his 20-year famed struggle with the textile business he inherited at Berkshire. That is a big step in the right direction to acknowledge a mistake, Warren!

Berkshire Is A Conglomerate

Buffett describes Berkshire as a conglomerate,” but only in part.”  It differs from the prototype of “aspiring conglomerateurs” who will buy up for mediocre businesses.  Many conglomerates overpay for companies with overvalued stock. Tools to foster overvaluation involve “promotional techniques and ‘imaginative’ accounting maneuvers that were, at best, deceptive and sometimes crossed the line into fraud.”

“Financial history is replete with the names of famous conglomerateurs who were initially lionized as business geniuses by journalists, analysts, and investment bankers, but whose creations ended up as business junkyards.” I knew several candidates professionally he may have in mind.

Buffett is not a fan of Wall Street, particularly in this letter, as we discuss later.

Controlled and Non-Controlled Businesses 

Berkshire Hathaway is a holding company with controlled and non-controlled businesses. Their controlled businesses are typically those they own at least a 50% interest in and manage operations. Berkshire owns equity stakes or holdings of marketable stocks in non-controlled businesses they do not operate. 

 Buffett and Munger view Berkshire’s holdings of marketable stocks as a collection of businesses. These holdings had a year-end market value of over $281 billion in 16 company equity stakes, up from its $108.6 billion costs. For GAAP purposes, Berkshire can only book the dividend income from these companies, not their marketable (but unrealized) gains.

Four Family Jewels

#1 Property And Casualty Operations And Its Insurance “Float”

Berkshire’s insurance companies are its valuable businesses. They have unique characteristics that allow them to enjoy  $138 billion of insurance “float.” Like other insurers, premiums paid by customers can be invested in securities when customers pay premiums for policies and the time they make insurance claims that are liquidated.

The float is money that doesn’t belong to Berkshire and will go to intended parties in the future. It is free money in the meantime for investments.

Unlike its competitors, Berkshire follows an equity-heavy investment strategy not feasible for most of its insurer competitors with regulatory and credit-rating restrictions.

Instead, these competitors invest their premium proceeds in bonds that have to generate low-interest income from the likes of 10-year US Treasury bonds, yielding 0.93% at the end of 2020. Buffett worries that some insurers and bond investors may turn to increase their returns by buying more risky loans, which are “not the answer to inadequate interest rates.” It is hard to find income in a low-interest environment without adding risk as we discuss here.

However, the 10-year yields rose to 1.54% in late February 2021, above the year-end rate. 

Berkshire’s #2 And #3 Most Valuable Assets

Buffett’s points to the company’s second and third most valuable assets that appear to be a tie, and frankly, seems surprising.  The tie in Berkshire Hathaway’s most valuable assets is between Berkshire’s 100% ownership of BNSF, America’s largest railroad based on freight volume, and its 5.4% interest in Apple.

A 5.4% Interest In Apple, Helped By Share Buybacks

Roughly 42% of the marketable gain comes from its now 5.4% in Apple due to share buybacks.  Berkshire began investing in Apple in 2016 and mid-2018, representing an initial 5.2% stake, and realizing regular dividends of $775 million annually. They had an $11 billion gain from selling a small portion of their stake.

Through the math of Apple’s share buybacks and Berkshire’s repurchases, Buffett told investors that they “own a full 10% more of Apple’s assets and future earnings” than they did in July 2018. Q to Buffett Does he think that Wall Street analysts give proper credit to this non-controlled interest in their price targets in Berkshire.

 BSNF – Its Railroad Business

Tied with the Apple interest is its 100% ownership of BNSF, acquired in early 2010. It has been operating since 1850. It has required substantial investments since Berkshire’s purchase.  BNSF paid significant dividends of $41.8 billion in total to Berkshire after it fulfills its business commitments and maintains a $2 billion cash balance, reflecting a conservative policy.

Railroads are a fascinating industry for any Americana history buff. Their challenges are well documented from their early start and are in a more mature stage.

#4 Jewel – Berkshire Hathaway Energy

Berkshire’s fourth family jewel is Berkshire Hathaway Energy (BHE), owned for 21 years. Unlike BNSF and most electric utilities, it pays no dividends to Berkshire. BHE is amid a long-term $18 billion project to rework and expand a substantial portion of its outdated electricity grid throughout the West. The project began in 2006 with a  2030 competition date. This project is complex and essential to be able to deliver clean energy.

Berkshire Hathaway Ranked #1 As Largest Owner Fixed Assets

Berkshire is the largest owner of American-based property, plant, and equipment with fixed assets of $154 billion, followed by AT&T, at $127 billion. That Berkshire fact alone means it is an asset-heavy company that invests a lot of capital, not necessarily generating the best-earning results or even a good investment.

As most business college students learn in school, good returns can come from companies with minimal assets in high-margin businesses that have expanding topline growth. Simply being asset-heavy is not a reflection of a beauty contest.

Underperformance In Berkshire Shares

Indeed, Berkshire’s stock performance in 2020 was poor, up 2.4% compared to the 18.4% terrific climb for the S&P 500. Relative stock performance in 2019 was also weak, with 21% underperformance.

Investors would have done better with a passively managed Vanguard S&P 500 index fund paying an expense ratio of 0.14%. That means an investor would be paying about $14 fee annually for a $10,000 investment in the fund. Actively managed funds have higher expense ratios of 1% or higher, costing a $100 management fee for a $10,000 investment.

American Prosperity Fuels Business Creation And Entrepreneurship

Despite his age, Buffett is still playing for the long term with high confidence in Berkshire’s businesses, management, and employees. He is proud of his extensive property and casualty business and his smaller companies. They remain treasures within the Berkshire family, and he shared their beginnings as business creations by individuals that are American success stories.

One reason Warren Buffett may have less of need for Wall Street bankers is that he does his research, making purchases for Berkshire, even on a handshake after getting to know the founders and its business potential.

Berkshire’s Gems:

• See’s Candy, a West Coast company acquired in 1972. Mary See began the business a century ago, reinventing age-old candy with new recipes such as Buffett’s favorite peanut brittle.
• GEICO (Washington D.C.) began as an auto insurance company by the Goodwins in 1936. It became Buffett’s first love when he bought shares in 1951 as a Columbia Business student, purchasing GEICO for Berkshire in 1996.
• National Indemnity (Omaha) began in 1940 by the Ringwalts to compete against well-funded giant insurers. It was purchased in 1967 and is Berkshire’s largest business.
• Tennessee-based Clayton Homes and Pilot Travel Centers (38% interest but 80% in 2023) were each begun by young men, continued by their sons under Berkshire’s umbrella.

A Young Immigrant’s Story Seems Familiar

“One question I always ask myself in appraising a business is how I would like, assuming I had ample cash and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings.”

Warren Buffett, from Wikipedia

Buffett continued to buy Omaha businesses. Among those was the Nebraska Furniture Mart (NFM), with an enchanting story told in Buffett’s letter. The founder of NFM was Rose Blumkin (Mrs. B), who arrived in Seattle in 1915 as a Russian emigrant, unable to speak or read English. She settled in Omaha and used her $ 2,500 savings to start a furniture store in 1936.

By 1946, her business stalled, and she was down to $50. Louie, her only son, rejoined the store after four years in the Army. He earned a Purple Heart, having fought at Normandy on Omaha Beach on D-Day and sustained injuries in the Battle of the Bulge. He joined his mom, renewing the business, and by 1983, their business worth $60 million.

Buffett purchased the furniture business, leaving the Blumkins to manage the place. Mrs. Blumkin worked every day until she was 103, and Buffett wrote, “…a ridiculously premature retirement age as judged by Charlie and me.” The business still run by the third and fourth generation of the Blumkin’s and now has the three largest home furnishings stores in the US today.

 Immigrant Stories Are America

Their story reminds me of my own mother’s immigrant story. She became a thriving retail owner after coming to America as a Holocaust survivor with $5 in her pocket. My husband’s account tells me of his two great grandmothers’ export-import and furrier businesses. Each story is unique but has parallels of strong immigrant women, who came to the US with little money, didn’t speak English, were primary breadwinners in their families, and loved America.

Buffett’s post-script to the Blumkin story could be my family’s or the many immigrants that landed in this country. When Mrs. Blumkin’s large family gathered for holiday meals, she always asked that they sing before eating. That song was Irving Berlin’s “God Bless America.” I promised you corniness!

Buffett And Munger’s  “Special Kinship” With Individual Investors

In business ethics, stakeholders of a company have interests in the outcome of the decisions made. Typical stakeholders are the board of directors, management, employees, customers, lenders, and stockholders.

The BH directors want the company to delight the customers, develop and reward the company’s 360,000 employees, called associates of the company. It is up to the board to determine dividends, strategic direction, CEO selection, acquisitions, or divestitures to act in the corporation’s best interests and its owners.

The owners are the stakeholders that most matter in the letter written by Warren Buffett and to whom he most directs his comments. 

Owner Constituents:

1. Warren Buffett’s Berkshire shares ownership will eventually be annually distributed to various philanthropies as part of his estate plan
2. Passive investing is a fund strategy that tracks a weighted index such as S&P 500 index funds.
3. Actively investing refers to a portfolio management strategy where portfolio managers make investments. Both active and passive investing are institutional investors who may either have a long-term focus or use computers employing algorithms to trade with a short-term mentality.
4. Individual investors are investors whose purchases are of smaller volume than institutional investors. They may buy Berkshire shares for long-term investment or use Berkshire shares as a source of funds. 
5. Warren Buffett’s special kinship for the individual investor comes from his early roots as a money manager through partnerships. He and his family invested in the partnership with these individual investors of million-plus investors who line up with Berkshire’s philosophy favored by him and Charlie Munger. They are more likely to have long-term perspectives. 

Original partners were longstanding holders of Berkshire shares, many of whom are descendants of the original partners. They share a commonality with Buffett by being old-fashioned long-term investors who trust the management to do the right thing.

Stepping Down To Retire? Nope

“Could it be that Berkshire ownership fosters longevity?”

Warren Buffett

Would it surprise you that there were no announcements of Warren Buffett or Charlie Munger stepping down and moving over for Vice Chairmen Ajit Jain and Greg Abel? Me neither. In their 90’s, they remain energetic and love their jobs.

Instead, Buffett spoke of Pilot Travel Center founder “Big Jim” Haslam, who recently authored a book at age 90.

Buffett pointed to the earliest investors–a group of Omaha doctors who formed a partnership. One of those veterans just turned  100 years old, and he and all the doctors kept their original Berkshire shares they received from the partnership.

Wall Street And Speculators

Throughout the years of writing letters, Buffett and Munger together have shown there is no love lost for Wall Street, notably the investment bankers, analysts, and those of that ilk. As a former analyst, I take no offense, recognizing the culture of working on “The Street”  is often difficult to maneuver.

This letter was no exception. I thought there was more than the usual Buffett bite in this read. We use his quotes when he refers to Wall Street.

On conglomerates, Buffett refers to the overvaluation of an overvalued conglomerates’ stock to make acquisitions, he says, “Wall Street loves the fees that deal-making generates, and the press loves the stories that colorful promoters provide. At a point, also, the soaring price of a promoted stock can itself become the “proof” that an illusion is reality.”

After his tribute to individual investors, Buffett refers to the tens of millions of other investors and speculators who have “a wide variety of equity choice to fit their tastes.” (His emphasis). According to Buffett, these investors will find CEOs, market gurus, price targets, managed earnings,  “stories,”  and “technicians” who will “instruct them as to what some wiggles on a chart portend for a stock’s move.”

The Monkey And Its Dartboard

Buffett believes many of these investors will do well, saying:

“Indeed, a patient and level-headed monkey, who constructs a portfolio by throwing 50 darts at a board listing of all the S&P 500, will–over time–enjoy dividends and capital gains, just as long as it never gets tempted to make changes in its original selections.”

His italicizing of “over time” reminds investors of the need for having a long-term perspective, something that may be lost in the world of computer algorithms and day trading.

Buffett’s Book Recommendation

Warren Buffett is well known to be an avid reader and shares many recommendations. In his letter, he recommends “Common Stocks And Uncommon Profits” written by Philip A. Fisher in 1958.

In the book, Fisher analogizes running a public company to managing a restaurant. He said, “If you are seeking diners, you can attract clientele featuring either hamburger served with a Coke or a French cuisine accompanied with exotic wines. But you must not capriciously switch from one to another.” You and your business’s message to potential customers must be consistent with what they find when going to your premises

Inflation Wasn’t Addressed In This Letter

Not surprisingly, Buffett did not comment on inflation as our economy is not yet near full employment. However, Buffett did comment in his 1980 letter when the inflation rate was 13.5%, giving us a glimpse into his thoughts on high inflation in the late 1970s and early 1980s:

“High rates of inflation create a tax on capital that makes much corporate investment unwise – at least if measured by the criterion of a positive real investment return to owners.

“This ‘hurdle rate’ the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners – has increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.”

Our recent post on Inflation And How To Protect Yourself From Its Effects

Final Thoughts

I learn from Warren Buffett’s letters to Berkshire Hathaway’s shareholders. The letters contain golden nuggets of money and life lessons. That doesn’t mean Buffett is beyond criticism, especially in his account of  2020 where omissions did not address many questions I would have for him. Becky Quick of CNBC in her standard interviews of Warren Buffett will ask the questions I raised in this article.

May 1st in the Berkshire shareholder meeting, and for the first time will be held in Los Angeles instead of Omaha. Buffett and Munger will be answering questions.

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