Warren Buffett's letter to shareholders

Few case studies and concepts by Buffett given through the newsletters are compiled topic wise. It combines Buffett’s magic and mind, simplicity and subtleness which results into extraordinary results overtime past 60 years has been provided in these newsletters year after year. The idea of ”praise specifically criticize generally” can be seen over the years in these letters over the years.

Buffett’s letter each year packs a lot of wisdom, motivation, inspiration which serves as a key of treasure hunt mission which most of the aspiring managers, investors need to get through. I highly recommended to read all of those letters in chronological order.

Structure of Berkshire- Ownership of Berkshire now resides in five large “buckets,” one occupied by Buffett as a “founder” of sorts. That bucket is certain to empty as the shares he owns are annually distributed to various philanthropies.

Two of the remaining four buckets are filled by institutional investors, each handling other people’s money. That, however, is where the similarity between those buckets ends: Their investing procedures could not be more different. In one institutional bucket are index funds, a large and mushrooming segment of the investment world. In the other institutional bucket are professionals who manage their clients’ money, whether those funds belong to wealthy individuals, universities, pensioners or whomever. Fourth bucket consists of individual shareholders who operate in a manner similar to the active institutional managers. Fifth bucket: the million-plus individual investors who  joined with no intent to leave.

Good Great Gruesome

 2007 Letter to shareholders from Warren is one of the sacrosanct documents which condenses key his learnings in less than 21 pages. Some of them include:

1.Trust on management at all times –“Our competitive position in these businesses remains strong, and we have firstclass CEOs who run them right, in good times or bad.”

2.House prices bubble -  People believe that house prices would forever rise. That conviction made a borrower’s income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA – house price appreciation – would cure all problems.

3.Yardsticks of value for Berkshire – Investments and earnings from non insurance business.

4.Buffett explains with analogies and case studies of Nebraska Furniture, GEICO and insurance business and growth prediction over time in such businesses

5.Great Good and Gruesome :

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. A formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Case Study of See’s Candy

Bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. The company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

WHAT WORKED – In 2006, See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.

See’s sales were $383 million, and pre-tax profits were $82 million in 2006. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion.

WHAT MAKES IT GREAT? A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements.

GOOD Business - put-up-more-to-earn-more kind of businesses. E.g. Flight Safety

Gruesome Business –The one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. E.g. Airlines business

 Buffettt’s analogy and classification sits quite well as in the era of rapid technological advancement and changing of consumption patterns such classification stencil can help in reducing a lot of noise.

To human is to err

Precision Castparts (“PCC”)  was purchased at hefty cost  $11 billion and was written-down. In purchasing PCC, Berkshire bought a fine company – the best in its business. Mark Donegan, PCC’s CEO, was a passionate manager who consistently pours the same energy into the business but Buffett was wrong in judging the average amount of future earnings and, consequently, wrong in calculation of the proper price to pay for the business and overpaid.

Price vs. value

“Investing illusions can continue for a surprisingly long time. 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.”

Warren’s long term holdings as he calls them “family jewels” comprise major holdings of Berkshire.

Insurance business – What makes them different ?

1.Capital Advantage-Insurance fleet operates with far more capital than is deployed by any of its competitors worldwide. $138 billion of insurance “float” – funds that do not belong to company, but are nevertheless theirs to deploy, whether in bonds, stocks or cash equivalents

2.Capital allocation -That financial strength, coupled with the huge flow of cash Berkshire annually receives from its non-insurance businesses allows insurance companies to safely follow an equity-heavy investment strategy not feasible for the overwhelming majority of insurers. Those competitors, for both regulatory and credit-rating reasons, must focus on bonds.

Others include BNSF, BHE and Apple

Apple Story - Began buying Apple stock late in 2016 and by early July 2018, owned slightly more than one billion Apple shares (split-adjusted). Cost for that stake was $36 billion and since then, Berkshire have both enjoyed regular dividends, averaging about $775 million annually.(till 2020). Regular repurchasing of shares both by Apple and Hathaway reducing the number of shares outstanding. The math of repurchases grinds away slowly, but can be powerful over time. The process offers a simple way for investors to own an ever-expanding portion of exceptional businesses.

Nebraska Furniture Mart (“NFM”) - At year end 1946, the company’s net worth had grown to only $72,264. Cash, both in the till and on deposit, totaled $50. Louie Blumkin, Mrs. B’s only son, had rejoined the store after four years in the U.S. Army. Once Mrs. B and Louie were reunited, there was no stopping NFM. NFM now owns the three largest home-furnishings stores in the U.S. Each set a sales record in 2020, a feat achieved despite the closing of NFM’s stores for more than six weeks.

Aphorisms

Indeed, a patient and level-headed monkey, who constructs a portfolio by throwing 50 darts at a board listing all of 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.”

Productive assets such as farms, real estate and, yes, business ownership produce wealth – lots of it. Most owners of such properties will be rewarded. All that’s required is the passage of time, an inner calm, ample diversification and a minimization of transactions and fees. Still, investors must never forget that their expenses are Wall Street’s income. And, unlike my monkey, Wall Streeters do not work for peanuts.

Power of retained earnings and insurance business

To take the idea Edgar Lawrence Smith, an economist and financial advisor, wrote Common Stocks as Long Term Investments and argued that stocks would perform better than bonds during inflationary periods and that bonds would deliver superior returns during deflationary times.

Keynes noted on retained earnings that well-managed industrial companies do not distribute to the shareholders the whole of their earned profits. In good 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 favor 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.

Power Sector and BHE – What BHE does that others don’t?

In 2000, the company’s residential customers in Iowa paid an average of 8.8 cents per kilowatt-hour (kWh). Prices for residential customers have since risen less than 1% a year, and we have promised that there will be no base rate price increases through 2028. The competitor charged its residential customers were 61% higher than BHE’s.

The extraordinary differential between BHE’s rates and theirs is largely the result of our huge accomplishments in converting wind into electricity. In 2021, BHE’s operation to generate about 25.2 million megawatt-hours of electricity (MWh) in Iowa from wind turbines that it both owns and operates. That output will totally cover the annual needs of its Iowa customers, which run to about 24.6 million MWh. In other words, utility will have attained wind self-sufficiency in the state of Iowa.

BHE has never paid Berkshire Hathaway a dividend since the purchase and has, as the years have passed, retained $28 billion of earnings. That pattern is an outlier in the world of utilities, whose companies customarily pay big dividends – sometimes reaching, or even exceeding, 80% of earnings.

Cheap power, strong balance sheet, growth from internal accruals and able management helps drive BHE to one of the most efficient power firms in the world.

American Express and GEICO - Trees in forest groves !

Simple not easy !

“What we see in our holdings, rather, is an assembly of companies that we partly own and that, on a weighted basis, are earning more than 20% on the net tangible equity capital required to run their businesses. These companies, also, earn their profits without employing excessive levels of debt.”

A venerable caution will forever be true when advice from Wall Street is contemplated: Don’t ask the barber whether you need a haircut.

The knowledge these letters serve is impeccable and best literature source available till date. I highly recommend all of you to read all the letters from 1990 till 2022.

 Book value

1. Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses.

2.While the equity holdings are valued at market prices, accounting rules require the collection of operating companies to be included in book value at an amount far below their current value.

3.Over time Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down.

Focus on the Forest – Forget the Trees

Forest contains five “groves” of major importance. Four of those groves are differentiated clusters of businesses and financial assets that are easy to understand. The fifth –  huge and diverse insurance operation – delivers great value to Berkshire in a less obvious manner. These are discussed in detail in previous blogs.

On EBIDTA –

Presentations feature “adjusted EBITDA,” a measure that redefines “earnings” to exclude a variety of all-too-real costs. Managements sometimes assert that their company’s stock-based compensation shouldn’t be counted as an expense.

American Express

Berkshire’s holdings of American Express have remained unchanged over the past eight years. Meanwhile, ownership increased from 12.6% to 17.9% because of repurchases made by the company. When earnings increase and shares outstanding decrease, owners – over time – usually do well.

Level of equity capital is a different story: Berkshire’s $349 billion is unmatched in corporate America. By retaining all earnings for a very long time, and allowing compound interest to work its magic.

GEICO and Tony Nicely

GEICO, after a four decade record of both rapid growth and outstanding underwriting results, suddenly found itself near bankruptcy. A recently-installed management had grossly underestimated GEICO’s loss costs and consequently underpriced its product. It would take many months until those loss-generating policies on GEICO’s books – there were no less than 2.3 million of them – would expire and could then be repriced.

Berkshire bought ½ of the GEICO’s shares and managed to run the business till 1993. In 1993, when Tony Nicely was promoted to CEO. At that point, GEICO’s reputation and profitability had been restored – but not its growth. GEICO was completely bought by Berkshire

Fast forward - GEICO is now America’s Number Two auto insurer, with sales 1,200% greater than it recorded in 1995. Underwriting profits have totaled $15.5 billion (pre-tax) since our purchase, and float available for investment has grown from $2.5 billion to $22.1 billion.

What Tony did - Tony’s management of GEICO has increased Berkshire’s intrinsic value by more than $50 billion. On top of that, he is a model for everything a manager should be, helping his 40,000 associates to identify and polish abilities they didn’t realize they possessed.

Finally Buffett as always reiterates his Never bet against America, this time in different manner and prescribed it as the American Tailwind

“Since 1942, we have had seven Republican presidents and seven Democrats. In the years they served, the country contended at various times with a long period of viral inflation, a 21% prime rate, several controversial and costly wars, the resignation of a president, a pervasive collapse in home values, a paralyzing financial panic and a host of other problems. All engendered scary headlines; all are now history.”

GEICO grows because it saves money for motorists. No one likes to buy auto insurance. But virtually everyone likes to drive. So, sensibly, drivers look for the lowest-cost insurance consistent with first-class service. Efficiency is the key to low cost, and efficiency is Tony’s specialty.

Reinsurance is a business of long-term promises, sometimes extending for fifty years or more. This past year has retaught clients a crucial principle: A promise is no better than the person or institution making it. That’s where General Re excels: It is the only reinsurer that is backed by an AAA corporation. Ben Franklin once said, “It’s difficult for an empty sack to stand upright.”

When it comes to insurance business management, Buffett in almost every letter praises the guy Ajit Jain, one of kind guy who had nearly no knowledge of insurance before joining Berkshire. From year to year, Ajit’s business is never the same. It features very large transactions, incredible speed of execution and a willingness to quote on policies that leave others scratching their heads.

GEICO and Auto insurance Business - 2017

Auto insurance is a major expenditure for most families. Savings matter to them – and only a low-cost operation can deliver those.

GEICO’s low costs create a moat – an enduring one – that competitors are unable to cross. As a result, the company gobbles up market share year after year, ending 2016 with about 12% of industry volume.

That’s up from 2.5% in 1995, the year Berkshire acquired control of GEICO. Employment, meanwhile, grew from 8,575 to 36,085. GEICO’s growth accelerated dramatically during the second half of 2016.

Loss costs throughout the auto-insurance industry had been increasing at an unexpected pace and some competitors lost their enthusiasm for taking on new customers. GEICO’s reaction to the profit squeeze, however, was to accelerate its new-business efforts.

Berkshire’s great managers, premier financial strength and a range of business models protected by wide moats amount to something unique in the insurance world.

“We like to make hay while the sun sets, knowing that it will surely rise again.”

Insurance, Investing and Acquisition - Warren Buffett way !

 Acquisitions

There are four building blocks that add value to Berkshire:

(1) sizable stand-alone acquisitions;

(2) bolt-on acquisitions that fit with businesses we already own;

(3) internal sales growth and margin improvement at our many and varied businesses; and

(4) investment earnings from our huge portfolio of stocks and bonds.

In 2017, the ample availability of extraordinarily cheap debt fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed.

Warren evaluates acquisitions on an all-equity basis. “It is insane to risk what you have and need in order to obtain what you don’t need.”

The examples of Pilot Flying J, Clayton Homes, U.S. Floors, HomeServices and Precision Castparts guides how Berkshire goes on acquisition and what the firm is looking for.

Further, the insurance business is, this letter reiterates same facts and insights about insurance business. This is a business in which there are no trade secrets, patents, or locational advantages. What counts are brains and capital. The managers of Berkshire’s various insurance companies supply the brains and Berkshire provides the capital.

The bet illuminated another important investment lesson: Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.

 Peace amidst chaos – 2008

In 2008, as the year progressed, a series of life-threatening problems within many of the world’s great financial institutions was unveiled. This led to a dysfunctional credit market that in important respects soon turned non-functional. By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. Fear led to business contraction, and that in turn led to even greater fear.

Focus on what can be controlled :

In good years and bad, Charlie and Buffett simply focus on four goals:

1.Maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash.

2.Widening the “moats” around our operating businesses that give them durable competitive advantages.

3.Acquiring and developing new and varied streams of earnings.

4.Expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered exceptional results.

Retail business groups were greatly impacted due to hard hit on general economy and distorted credit cycle while insurance and utility groups – produce earnings that are not correlated to those of the general economy.

When investing, pessimism is your friend, euphoria the enemy. Some holdings and thesis as mentioned by Warren :

1. Ownership of MidAmerican for two of its terrific managers, Dave Sokol and Greg Abel. MidAmerican also owns the second largest real estate brokerage firm in the U.S., HomeServices of America. This company operates through 21 locally-branded firms that have 16,000 agents. In 2008, company had a terrible year for home sales, and 2009 looked no better. But Buffett continued to acquire quality brokerage operations when they were available at sensible prices.

2.In regulated electric utilities and natural gas pipelines - Kern River and Northern Natural, both acquired in 2002, in Mastio’s 2009 report, Kern River ranked 1st and Northern Natural 3^rd.(Mastio regularly ranks pipelines for customer satisfaction)

In energy segment – One thing common among all Berkshire holdings is priority to customer satisfaction, low cost producers (wind energy transition) and stable prices for an extended period of time.

Mantra that workers year after year

“Our long-avowed goal is to be the “buyer of choice” for businesses – particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises; avoid leveraging up acquired businesses; grant unusual autonomy to our managers; and hold the purchased companies through thick and thin.”

On PE firms

A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.

Regulated, Capital-Intensive Businesses - BNSF railroad and Berkshire Hathaway Energy

A key characteristic of both companies is their huge investment in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt.

At BHE, meanwhile, two factors ensure the company’s ability to service its debt under all circumstances.

1.      Recession-resistant earnings, which result from these companies offering an essential service for which demand is remarkably steady.

2.      The second is enjoyed by few other utilities: an ever-widening diversity of earnings streams, which shield BHE from being seriously harmed by any single regulatory body. These many sources of profit, supplemented by the inherent advantage of the company being owned by a strong parent, have allowed BHE and its utility subsidiaries to significantly lower their cost of debt. That economic fact benefits both owners and customers.

At BNSF, price comparisons between major railroads are far more difficult to make because of significant differences in both their mix of cargo and the average distance the load is carried.

BNSF, like other Class I railroads, uses only a single gallon of diesel fuel to move a ton of freight almost 500 miles. Those economics make railroads four times as fuel-efficient as trucks.

“A business with terrific economics can be a bad investment if it is bought at too high a price.”

On Capital intensive businesses which company owns :

The best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow.

However, that Berkshire will generate ever-increasing amounts of cash, Buffett, today, is quite willing to enter businesses that regularly require large capital expenditures.

“We expect only that these businesses have reasonable expectations of earning decent returns on the incremental sums they invest. If our expectations are met – and we believe that they will be – Berkshire’s ever-growing collection of good to great businesses should produce above-average, though certainly not spectacular, returns in the decades ahead.

“We expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens – yes, tens – of billions of dollars of incremental equity capital.”

Buffett explains the thesis for holding retail and manufacturing firms, from making cutting tools to airlines (Iscar to NetJets)

BNSF carries about 15% (measured by ton-miles) of all inter-city freight, whether it is transported by truck, rail, water, air, or pipeline. BNSF also moves its cargo in an extraordinarily fuel-efficient and environmentally friendly way, carrying a ton of freight about 500 miles on a single gallon of diesel fuel. Trucks taking on the same job guzzle about four times as much fuel.

Hedge funds

“If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win.”

The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.

There are three connected realities that cause investing success to breed failure.

1.      First, a good record quickly attracts a torrent of money.

2.      Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions.

3.      Third, most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees.

Clayton, Sub Prime and Black Sholes problem .

Home finance crisis :

Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage. The later part of this blog will cover it in detail.

On Housing

Wise monetary and fiscal policies play an important role in tempering recessions, but these tools don’t create households nor eliminate excess housing units. Fortunately, demographics and market system will restore the needed balance – probably before long.

The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.

 Home finance crisis – 1998 Clayton Case Study

Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage.

Impossible-to-meet monthly payments were being agreed to by borrowers who signed up because they had nothing to lose. The resulting mortgages were usually packaged (“securitized”) and sold by Wall Street firms to unsuspecting investors. This chain of folly had to end badly, and it did.

Warren describes the period as  “borrowers who shouldn’t have borrowed being financed by lenders who shouldn’t have lent.”

Investors, government and rating agencies learned exactly nothing from the manufactured-home debacle from 1997-2000.

Sub Prime Crisis :

The same mistakes were repeated with conventional homes in the 2004-07 period: Lenders happily made loans that borrowers couldn’t repay out of their incomes, and borrowers just as happily signed up to meet those payments. Both parties counted on “house-price appreciation” to make this otherwise impossible arrangement work.

Scarlett O’Hara : “I’ll think about it tomorrow.” The consequences of this behavior was then reverberating through every corner of economy.

Median FICO score was 644, compared to a national median of 723, and about 35% were below 620, the segment usually designated “sub-prime.” Many disastrous pools of mortgages on conventional homes were populated by borrowers with far better credit, as measured by FICO scores (a standard measure of credit risk).

Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they can’t make the monthly payments.

Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact.

Key is simple - Home buyers, lenders, brokers and government should keep in mind some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.

“Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols.

Buffett advices: Beware of geeks bearing formulas.

“Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”

Credit default swaps – It is simply credit insurance, except to bear the credit risk of corporations rather than of tax-exempt issuers.