Huge fan of Berkshire Hathaway. What investor would not appreciate a 50 year run with a 20% CAGR? The fact that the #3 richest man in the world is humble beyond comparison, eats McDonald’s, and drinks Coke only cements the allure. Full letter dated Feb 23, 2019 here. My takeaways:
Berkshire website = 1997 Geocities
Have you been to the Berkshire Hathaway website? It’s a treat. It looks like something from 1997 Geocities. At first, I thought this was the wrong site and it was a pfishing scam here.
Promotions: Ajit Jain & Greg Abel
Buffett and Munger – the two leaders of Berkshire are 88 and 95 years old. Buffet jokes that he is the younger of the two. That said, Ajit Jain was promoted and now runs insurance, while Greg Abel was promoted and now runs all other operations.
Focus on the forest – not the trees
Berkshire Hathaway invests in a diversity of assets – in size, industry, maturity, and future. Comparing them to trees, Buffet says, “A few of our trees are diseased and unlikely to be around a decade from now. Many others, though, are destined to grow in size and beauty.” As such, he urges investors to pay attention to the investments in aggregate, the forest, not the trees. He describes investments in 5 groves (of trees).
The largest ‘”grove” are non-insurance companies where they have 80-100% ownership. These generate $16B+ (of the total $24B+) of net profits. He mentions that these earnings are clean, not “adjusted” for restructuring expensive, or stock-based compensation. Basically, he mocks companies that report adjusted EBITDA, and uses a joke by Abraham Lincoln:
“Abraham Lincoln once posed the question: “If you call a dog’s tail a leg, how many legs does it have?” and then answered his own query: “Four, because calling a tail a leg doesn’t make it one.” Abe would have felt lonely on Wall Street. ”
The second “grove” of trees are publicly-traded companies. These companies provide great dividends, but just as importantly, have massive retained earnings which is not necessarily reflected immediately in the stock prices. As an example, Apple gave BRK-A dividends of $740M+, but had retained earnings of $2.5B+, which directly makes BRK-A’s holding more valuable. Also, Buffet notes that stock buy-backs are good when the timing is right; their holding in AMEX was unchanged over 8 years – and yet – their ownership increased from 12.6% to 17.9% because of repurchases.
The third “grove” of investments are partial investments – Kraft Heinz is a notable one example, which generate $1.3B+ of net profits. This was a big losing investment for BRK-A.
The fourth “grove” is $130B+ in US treasuries and liquid investments; basically, this is the cash that Buffet keeps as a safety cushion and dry powder to buy distressed assets. Buffet said, “I will never risk getting caught short of cash.”
Whole > sum of the parts?
In my strategy class, we just finished reading Michael Porter’s seminal 1987 article, “From Competitive Strategy to Corporate Strategy” where Porter outlines why diversification rarely adds value. Corporate strategy (where to compete) is difficult to do well. Synergies often do not add up. Investors can diversify for themselves. Unlocking value is not easy. Keeping winners and selling losers is hard. And yet, Buffet – the Oracle of Omaha – seems fairly adamant about this portfolio approach:
Berkshire’s value is maximized by our having assembled the five groves into a single entity. This arrangement allows us to seamlessly and objectively allocate major amounts of capital, eliminate enterprise risk, avoid insularity, fund assets at exceptionally low cost, occasionally take advantage of tax efficiencies, and minimize overhead. At Berkshire, the whole is greater – considerably greater – than the sum of the parts.
It’s really hard to argue with results. That said, it’s not difficult to prove that most M&A destroys value. Most companies are not BRK. Most CEOs are not Buffet / Munger. Integrating disparate companies is tough work. It takes discipline to restructure operations, cull the portfolio, transfer skills, and share activities. How do they do it?
Float, float, float
Buffet makes it clear – once again – to readers that the reason that BRK has a sizable insurance property / casualty business is because it creates a large float $$ (premiums are paid in advance and claims are paid later) which can be invested. BRK has a huge war chest to invest. . .
“Berkshire’s unrivaled financial strength allows us far more flexibility in investing our float than that generally available to P/C companies. The many alternatives available to us are always an advantage and occasionally offer major opportunities. When other insurers are constrained, our choices expand.”
To do this well – to have plenty of float – you need to be good at insurance underwriting. You can’t underestimate risk, and expect to survive in the insurance business. BRK has had an underwriting profit 15 of 16 years.
“Disciplined risk evaluation is the daily focus of our insurance managers, who know that the benefits of float can be drowned by poor underwriting results. All insurers give that message lip service. At Berkshire it is a religion, Old Testament style.”
Management focus = long-term
Clearly, Berkshire Hathaway is different from many reasons, but here are three things from this annual report.
1) BRK are long-term investors.
“For 54 years our managerial decisions at Berkshire have been made from the viewpoint of the shareholders who are staying, not those who are l leaving. Consequently, Charlie and I have never focused on current-quarter results.”
2) BRK does not prepare monthly consolidated financials.
“Berkshire, in fact, may be the only company in the Fortune 500 that does not prepare monthly earnings reports or balance sheets. I, of course, regularly view the monthly financial reports of most subsidiaries. But Charlie and I learn of Berkshire’s overall earnings and financial position only on a quarterly basis.”
3) BRK does not have a corporate budget.
“Berkshire has no company-wide budget (though many of our subsidiaries find one useful). Our lack of such an instrument means that the parent company has never had a quarterly “number” to hit. Shunning the use of this bogey sends an important message to our many managers, reinforcing the culture we prize.”
The US Government owns AA shares
Buffet explained that the corporate tax rate went down recently, and this created a windfall for shareholders who got to keep more of their earnings. Interestingly, and a bit ironically, he called the US Treasury a preferred dividend shareholder who gets paid first. So true.
Deferred taxes, a good thing
When discussing BRK’s capital structure, it’s a short few paragraphs. 1) They don’t use much debt because it’s dangerous. 2) They’ve built up a massive amount of equity 3) The float works 4) Deferred taxes (from unrealized capital gains and accelerated depreciation) is a good tool.
In essence, the ability to buy equity investments and reinvest those gains while deferring taxes is “an interest-free ‘loan’ that allows us to have more money working for us in equities than would otherwise be the case.” As a case in point, their cost basis in Coca Cola stock is $1.3B and the current market value is $18.9B. Why sell and pay taxes now? Keep it. Let it grow.
The American tail-wind
Buffet spends 960+ words (shorter than this blog post) recounting American history, starting with George Washington, and how America has persevered – through world wars, civil wars, Republican and Democratic administrations, 20%+ interest rates – and turned out fine.
He is pro-America and pro-future. It’s smarter (over the long-term) to be bullish on American entrepreneurs and ingenuity. Stocks have proved a better investment than bonds, than gold, than anything else. In the end, he argues for optimism and humility. Solid.
“It is beyond arrogance for American businesses or individuals to boast that they have “done it alone.” The tidy rows of simple white crosses at Normandy should shame those who make such claims.”
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Great read mate, the best can read the play and see the brutal reality for what it is…