Chairman and CEO Warren Buffett’s annual letter to Berkshire Hathaway’s shareholders for 2018 results was recently released.
Table of Contents
The letter is a treasure trove of personal finance lessons.
Business and investment savvy Buffett has long been an American folk hero whose optimism for the financial markets, American business, and America herself has been cause for celebration.
As a Professor teaching business students, I have used Buffett’s shareholder letter for lessons on Berkshire’s various businesses. These diverse businesses represent a tapestry for our economy, stock investment strategies, accounting standards, business ethics, management style, and his indelible wit and humor.
As a Wall Street analyst, I often read Buffett’s letter. But there was no comparison. Buffett writes his own letter every year, edited by his friend, and his contemporary, and journalist (former editor of Fortune) Carol Loomis.
At age 88, Buffett along with his older compadre Berkshire’s Vice Chairman Charlie Munger, age 95, is the oldest leadership team of Fortune 500 companies, providing superb insights with an energy level that could and does challenge far younger management teams.
15 Personal Finance Lessons:
1. Berkshire’s outstanding stock price performance is the best measure of the company’s business.
In its 54 years history (with Warren Buffett at the helm) Berkshire compound annual return of 20.5% exceeds the S& P’s not too shabby 9.7%. In 2018, Berkshire outperformed the S&P by 7.2 percentage points. Indeed, Berkshire stock beat the market 38 times out of 54 years, a great record for any company.
2. Diversification is a hallmark of Berkshire’s success.
Just like any stock portfolio, Berkshire’s holdings reflect diverse businesses while providing insights into the health of our overall economy. Buffett’s prowess in buying wonderful companies “at sensible prices” is well known in both insurance and non-insurance businesses, such as GEICO (in 1976) and Johns Manville (in 2001), the latter after having been troubled by asbestos lawsuits.
Typically, Buffett buys 80%-100% controlling interests of these businesses. In this letter, Buffett likened his businesses to economic trees, though imploring shareholders to “focus on the forest-forget the trees.” Berkshire’s businesses are in five groves, from twigs to redwoods.
The largest grove is the huge collection of insurance operations. However, the company’s most valuable groves are the largely acquired diverse non-insurance businesses, including from largest: BNSF railroad, BH Energy, Clayton Homes, International Metalworking, Lubrizol, Marmon, Precision Castparts, Forest River, Johns Manville, MiTek, Shaw, and TTI. They also own many smaller businesses.
3. Conservative accounting standards and disclosures are favored.
Buffett refers to earnings, as bottom line or net earnings. This means earnings after taking into account all income taxes, interest payments, management compensation, restructuring costs, depreciation and amortization, and home office overhead costs. This is, in contrast, to often practiced adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization). The latter results in a much higher number than the net earnings that Berkshire always uses and is more conservative.
The use of the EBITDA is typically deployed by high growth companies that do not focus on earnings. The practice has been endorsed by Wall Street bankers and analysts to sometimes drive investors to consider 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 earnings. Some management don’t want to include these items as an expense, but as Buffett quips: “What else could it be– a gift from shareholders?” Buffett’s use of the quintessential quote of Lincoln’s is fitting: “If you call a dog’s tail a leg, how many legs does it have? Four, because calling a tail a leg doesn’t make it one.”
4. Business ethics are strong.
Berkshire Hathaway’s “Code of Business Conduct and Ethics’ is not part of the company’s shareholder letter but worth inspection. It can be downloaded from the company’s website. The letter stressed the desire of corporate management to meet Wall Street expectations to be so great that it has led to ‘bad corporate behavior” as companies felt the pressure to hit quarterly expectations.
Long term perspective
Berkshire takes a longer term perspective than most companies. As Buffett writes: “What starts out as an “innocent” fudge in order to not disappoint ‘the Street’….can become the first step toward full-fledged fraud..” (As an equities analyst, I still cringe at the amount of fraudulent carnage I saw among the corporate management I trusted. I also was a casualty at Drexel Burnham at an early stage of my career..but that’s a story for another day).
Buffett and Munger have always communicated directly and worked for shareholder-partners, rather than analysts. Buffett used the letter to point to the company’s long term strategy designed for their longstanding shareholders, rather than temporary shareholders who buy and sell Berkshire shares for a quick trade. Berkshire Hathaway maintains a different culture throughout its subsidiaries and does not seek to hit analysts’ short term estimates for the company.
5. Berkshire Hathaway does not have a company-wide budget.
It does not prepare monthly earnings reports or monthly balance sheets. What? Unlike its Fortune 500 brethren, the holding company has few employees, and depends on its terrific companies to report results to their parent. However, Berkshire instills a culture that looks at long term, not short results. Buffett regularly views monthly reports of most subsidiaries but reviews earnings and financial position on a quarterly basis.
6. Tax reform benefits were released as the corporate tax rate was lowered to 21% from 35%.
Last year’s tax reform passage was beneficial for Berkshire Hathaway as for many companies. Buffett pointed to how the US government receives dividend payments from Berkshire in annual tax payments. In 2018, one of Berkshire’s larger companies (its utility business) passed that savings directly onto customers.
7. Buy-Hold investment strategy is a trademark of Warren Buffett and Berkshire Hathaway.
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 (though stakes like American Express are higher than 10%) in very large companies which deliver dividends and stock appreciation. There are fifteen positions thoughtfully bought and intended to be held long term.
At the end of year, Berkshire’s portfolio had a market value of $172.8 billion, well over its $102.9 billion cost. This portfolio does not include Berkshire’s bigger holding in Kraft Heinz because they are in a control group. Berkshire has taken a significant hit to its valuation given that Kraft Heinz’s stock price caused by Kraft’s fourth quarter results.
The Kraft Heinz Issue
Kraft Heinz also disclosed that the Securities and Exchange Commission sent a subpoena to Kraft relating to its accounting practices. This is not usually good news. This is one acquisition that Buffett likely believes the company overpaid. One of his few mistakes. Overall, Buffett often is praised for his buy-hold portfolio diversification. He is also known for his preference of low-cost index funds (see below), rather than the higher fees charged by many investment management firms.
8. Berkshire remained a significant repurchaser of its own shares.
Company management will repurchase shares at prices above their book value (cost) but below their estimate of intrinsic value. The management of their constituent companies will also repurchase shares, using their retained earnings. This boosts Berkshire’s ownership percentage from the lower outstanding share count.
The use of the company’s capital to buy back their shares has become something of a political football as some politicians and pundits have expressed that companies should use that capital for wage growth and other sources. As a capitalist who has been generous by dedicating the vast majority of his wealth for charitable causes, Buffett seems to be unfazed the day-to-day news.
9. Berkshire has an ample emergency fund.
Berkshire maintains a high level of cash-equivalent securities, including US Treasury bills of $112 billion at the end of 2018. Buffett admits to making expensive mistakes and has missed opportunities. Berkshire could also take an equity hit if investors flee the market and it also has some risky businesses. To guard against any potential calamities, the company will always maintain a minimum of $20 billion. Berkshire will never want to sell any of the businesses which are core to Berkshire itself.
10. Berkshire uses a disciplined approach to risk, using debt sparingly.
Berkshire’s property/casualty insurance businesses provide a lot of capital by virtue of “float” or “free money’ as they receive premiums upfront from the sale of insurance policies for payment of claims later on. Assessing insurance risks carefully doesn’t mean there couldn’t be mistakes. Events like Hurricane Katrina are risks. There is intense competition in this business and over time its float is expected to decline but in the meantime, it gives the company financial flexibility.
For funding, Buffett prefers equity, and Berkshire stock has been an able means of capital. Buffett has used little debt personally and does not favor using debt for acquisitions. The unpredictable nature of times when credit disappears and holding debt can be painful. Buffett says, ” Rational people don’t risk what they have and need for what they don’t have and don’t need.” A personal finance gem!
11. Like traditional IRAs, Berkshire defers tax liabilities.
Berkshire has significant amount (close to $15 billion) that arises from unrealized gains in their equity holdings. These liabilities are accrued at the now 21% corporate rate and will eventually be paid at the prevailing rate when the investments are sold. So it works as an interest-free loan that allows the company to make its money work. When you save money in your traditional IRA account, you are saving money tax-free, deferring taxes until you begin to withdraw at age 59.5 years.
12. The magic of compounding interest.
Berkshire’s strategy of long term holding of businesses and equity holdings that has resulted in compounding interest has been a huge benefit. Retaining all earnings that can be used to buy more companies has allowed Berkshire to grow into the financial behemoth it is now.
Using the example of $114.75 that Warren Buffett infamously used at age 11 in 1942 (77 years ago) to make his first investment, had he put that amount into a no-fee S&P index fund, with all of the dividends reinvested, it would have grown to $606,811 on a pretax basis on January 31, 2019, a gain of 5,288 for 1.
Buffett used a different example, using a $1 million investment made by a tax-free institution such as a college endowment fund, which would have grown to $5.3 billion. However, if that institution paid a 1% to investment managers (a frequent peeve of Buffett’s) its gain would be halved. Powerful lessons here.
13. The American Tailwind
. Warren Buffett has never hidden his enormous optimism and respect for America. He referred to three periods of 77 years since George Washington’s installation as President and founding of our country. The first two periods (up to 1942) saw America grow into the most powerful nation on earth but faced tough challenges amid the losses in World War II and continues to be challenged today.
To prove America’s endurance and the reason to continue to invest, he used the apt example of government budget deficits. Our national debt has increased 400-fold since 1942, or 40,000%. Buffett pondered: “Suppose you had foreseen this increase and panicked at the prospect of runaway deficits and a worthless currency.
To “protect” yourself, you might have eschewed stocks and opted instead for 3.25 ounces of gold with your $114.75.” The punchline: your gold would be worth $4,200, less than 1% of what would have been realized from the unmanaged investment in American business. Buffett’s message: have faith in America and long term buy-hold stock investing.
As a result of savings and investments, US household wealth is estimated to be $108 trillion according to the latest Federal Reserve. Buffett and Munger acknowledge their success has been a product of the American Tailwind. In a humorous quip, Buffett wondered whether he and Munger in “their old age” would become consumers rather than investors. My guess would be “no, of course.”
15. Older age doesn’t mean you stop being productive.
Berkshire Hathaway has the oldest senior management team among the top Fortune 500 companies. Warren Buffett is among the wealthiest and generous CEOs in the US and globally. He doesn’t have to continue to work, read 500 pages daily, and contribute to shareholders and to society. Buffett and Munger are refreshing in sharing their long term views. They are American icons who still have a lot to do.
Berkshire Hathaway’s Annual Shareholder meeting is on Saturday, May 4, 2019. You can attend if you are a shareholder or you can obtain a pass ahead of time. The event begins the evening It takes place in downtown Omaha where both Warren Buffett and Charlie Munger will field questions and answer them fully, not partly as is often the case. Yahoo will webcast the Saturday meeting, going live at 8:45 AM.
Beside being a mecca for investors, it is a tremendous shopping day filled with company-backed products. One question that will likely be raised and addressed perhaps by a twinkle, is when will Warren Buffett and Charlie Munger step down and announce their successors? There are two important prospects and internal management—Ajit Jain and Greg Abel–touted increasingly in this year’s letter. My guess? Buffett and Munger seem to be having too much fun at the moment to step aside at the pre-announced date.
There are so many enjoyable stories about Warren Buffett. Has Buffett influenced you or your investing in any way? Do you have one any you might want to share? We would love to hear from you!
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.