Warren Buffett's letter to shareholders (Part 2)
This is part two of the series in which I have tried to combine and sort them topicwise.
Black Sholes
The Black-Scholes formula has approached the status of holy
writ in finance, and is used when valuing equity put options for financial
statement purposes. Key inputs to the calculation include a contract’s
maturity and strike price, as well as the analyst’s expectations for
volatility, interest rates and dividends.
If the formula is applied to extended time periods, however,
it can produce absurd results. In fairness, Black and Scholes almost certainly
understood this point well.
The ridiculous premium that Black-Scholes dictates in my
extreme example is caused by the inclusion of volatility in the formula and by
the fact that volatility is determined by how much stocks have moved around in
some past period of days, months or years. This metric is simply irrelevant in
estimating the probability weighted range of values of business 100 years from
now.
The 2008 letter packs a lot on Derivatives, leverage and
absurd assumptions while formulating ideas in finance. 2008 letter (published
in Feb 2009) is a must read for investors as well as speculators as it throws
the light on the odds and assumptions involved in speculation.
All I want to know
is where I’m going to die -2009
It is quite interesting to note how year after
year Berkshire focus on book value rather than market prices as it holds true
for any asset holding company with incremental cash flows YoY.
In the time after 2000s, Berkshire’s performance clearly
outperforms S&P 500 (over 45 years) but size disadvantage continues to
produce better than average results.
Long ago, Charlie laid out his strongest ambition: “All I
want to know is where I’m going to die, so I’ll never go there.” That bit of
wisdom was inspired by Jacobi, the great Prussian mathematician, who counseled
“Invert, always invert” as an aid to solving difficult problems.
What We Don’t Do
1. Avoid businesses whose
future is too tough to evaluate. Eg autos (in 1910), aircraft (in 1930) and
television sets (in 1950)
2. Never become dependent
on the kindness of strangers. Have reserves to fund any huge amount of with
drawl.
3. Rather suffer the
visible costs of a few bad decisions than incur the many invisible costs that
come from decisions made too slowly – or not at all.
4. Make no attempt to woo
Wall Street. Need partners over investors.
5. Never predict about
stock markets but broader economy
Warren like always lays down the earnings for big four
businesses (Insurance- Underwriting, management and float advantage)
“Ajit’s business is just the opposite of GEICO’s. At that
company, we have millions of small policies that largely renew year after year.
Ajit writes relatively few policies, and the mix changes significantly from
year to year. Throughout the world, he is known as the man to call when
something both very large and unusual needs to be insured.”
Churning
In 2009, Berkshire’s largest sales were in ConocoPhillips,
Moody’s, Procter & Gamble and Johnson & Johnson. Charlie and Buffett
believe that all of these stocks will likely trade higher in the future.
They made some sales early in 2009 to raise cash for Dow and
Swiss Re purchases and late in the year made other sales in anticipation of
BNSF purchase.
Banking
A large well-run bank that for decades had been statutorily
prevented from acquisitions soon began looking for possible purchases. They
soon focused on a much smaller bank, also well-run and having similar financial
characteristics in such areas as return on equity, interest margin, loan
quality, etc.
The seller of the smaller bank – no fool – then delivered
one final demand in his negotiations. “After the merger m going to be a large
shareholder of your bank, and it will represent a huge portion of my net
worth.” The merger went through. The owner of the small bank became richer,
majority shareholders became poorer, and the managers of the big bank – newly
bigger – lived happily ever after.
2009 letters shows how Buffett used to own chunks in many businesses
and the transition to later what he calls as the “family jewels”. Old
vs New Buffett can be compared and contrasted using pre 2015 and post 2015
style of investing.
Leverage is
injurious for wealth
With the regular points about performance, intrinsic
value and management ethos and what differentiates Berkshire from the rest.(top
notch management, loads of cash and hard to replicate culture)
Culture and role it play in running successful
businesses, like for instance Berkshire gives no stocks to directors rather
they own Berkshire stock and work like they own the business.
On Management’s importance
If a CEO can be expected to do this job well, the
reinvestment prospects add to the company’s current value; if the CEO’s talents
or motives are suspect, today’s value must be discounted. The difference in
outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or
Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a
dollar entrusted to Sam Walton.
GEICO story as how he bought the entire company in 2 phases
and how insurance companies operate.
A main accounting tip which Warren shares is regarding
goodwill “on our books at only $1.4 billion, an amount that will remain
unchanged no matter how much the value of GEICO increases.”
Like all previous letters, Buffett here lays down the
performance, what they did right and challenges highlights under Manufacturing,
regulated capital intensive and financial services businesses like BNSF, Mid
American Energy, NetJets, See’s, Insurance bundle, Marmon, CTB, TTI, Forest
River, Clayton etc
Life and Debt
When leverage works, it magnifies your gains. However
impressive the numbers may be, evaporates when multiplied by a single zero.
History tells us that leverage all too often produces zeroes, even when it is
employed by very smart people.
Leverage, of course, can be lethal to businesses as well.
Companies with large debts often assume that these obligations can be
refinanced as they mature.
On cash – “During the episodes of financial
chaos that occasionally erupt in our economy, we will be equipped both
financially and emotionally to play offense while others scramble for survival.
That’s what allowed us to invest $15.6 billion in 25 days of panic following
the Lehman bankruptcy in 2008.”
2010 letter sounds a bit of repetitive but cover some
important points on culture and debt, leverage as double edged sword and
importance of surplus cash in investment business.
Warren as usual describes earning sources and
increment in Book value of the company. How diversified and well managed firms
with continued reinvestment turn to cash throwing machines over time and create
a positive lollapalooza on the portfolio.
“We view these holdings as partnership interests in
wonderful businesses, not as marketable securities to be bought or sold based
on their near-term prospects.”
IBM Case Study
If IBM’s stock price averages, say, $200 during the period,
the company will acquire 250 million shares for its $50 billion. There would
consequently be 910 million shares outstanding, and Berkshire would own about
7% of the company(from 5.5%).
If the stock conversely sells for an average of $300
during the five-year period, IBM will acquire only 167 million shares. That
would leave about 990 million shares outstanding after five years, of which
Berkshire would own 6.5%.
If IBM were to earn, say, $20 billion in the fifth
year, share of those earnings would be a full $100 million greater under the
“disappointing” scenario of a lower stock price than they would have been at
the higher price. At some later point our shares would be worth perhaps
$1 1⁄2 billion more than if the “high-price” repurchase
scenario had taken place.
The logic is simple: If you are going to be a net buyer of
stocks in the future, either directly with your own money or indirectly
(through your ownership of a company that is repurchasing shares), you are hurt
when stocks rise. You benefit when stocks swoon. Emotions, however, too often
complicate the matter: Most people, including those who will be net buyers in
the future, take comfort in seeing stock prices advance. These shareholders
resemble a commuter who rejoices after the price of gas increases, simply
because his tank contains a day’s supply.
Further Buffett talks about insurance, manufacturing,
financial and other business which the firm continues to own. This part by Buffett
every year help us understand what are the major changes through which the
different industry is going through. Warren never stops praising the insurance
business and consumer driven regulated and capital intensive businesses which
he aspires to own for long period of time.
Newspapers,
Dividends and Accounting
Back in 2012, how Buffett used to own companies other
than insurance and laid out the expected earnings is shown in the letter.
He calls these firms as “powerhouse five” which
include BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy collectively
had aggregate earnings of $10.1 billion.
His approach towards business buying and earnings projection
is explained with a few errors of omission are examined with numbers and thesis
pointers.
“Charlie and I love these acquisitions: Usually they are
low-risk, burden headquarters not at all, and expand the scope of our proven
managers.”
How the loop works ?
Warren continues to repurchases in “Big four” American
Express, Coca-Cola, IBM and Wells Fargo. The earnings that the four companies
retain are often used for repurchases – which enhance the share of future
earnings – and also for funding business opportunities that are usually
advantageous.
Intrinsic Value Matters
(1) improving the earning power of
the many subsidiaries;
(2) further increasing their earnings
through bolt-on acquisitions;
(3) participating in the growth of
the investees;
(4) repurchasing Berkshire shares
when they are available at a meaningful discount from intrinsic value; and
(5) making an occasional large
acquisition.
Like every letters, Warren talks about Insurance verticals
and management associated with each vertical and reiterates the anti fragile
nature of business at Berkshire
Interest Coverage Ratio –Warren uses pre-tax
earnings/interest, not EBITDA/interest, a commonly-used measure.
Amortization, Accounting and IT
“Non-real” amortization expense looms at IBM, Wells Fargo.
IBM has made many small acquisitions in recent years and regularly reports
“adjusted operating earnings,” a non-GAAP figure that excludes certain
purchase-accounting adjustments.
A “non-real” amortization charge at Wells Fargo -
“amortization of core deposits” charge, the implication being that these
deposits are disappearing at a fairly rapid clip yet core deposits regularly
increase.
Addition of such exceptional expenses - In no sense, except
GAAP accounting, such whopping charge an expense.
Warren also clarifies his stance as well as position of
Berkshire on long term options. He has no intent to go heavy in derivatives
market but uses long term options to hedge oil and other capital intensive
businesses.
Newspaper Spree
In 2011-12, acquired 28 daily newspapers at a cost of $344
million.
Why?
(1) Infinite Demand -What people
don’t know that they want to know. And people will seek their news – what’s
important to them – from whatever sources provide the best combination of
immediacy, ease of access, reliability, comprehensiveness and low cost.
(2) Certain profit pool- Advertisers
typically paid almost all of the product’s cost, and readers rode their
coattails.
(3) Proxy Play - Local paper was
indispensable to advertisers. Big department stores and grocers vied to
outshout their competition with multi-page spreads.
(4) A business which even an idiot
could run
(5) Monopoly or Oligopoly kind of
business.
Papers delivering comprehensive and reliable information to
tightly-bound communities and having a sensible Internet strategy will remain
viable for a long time
Dividends
Dividends are invested back in the business – for wideninf
the existing moat and owning greater share of the business. Record $12.1
billion of fixed-asset investments and bolton acquisitions in 2012 demonstrate
that this is a fertile field for capital allocation at Berkshire
Most companies pay consistent dividends, generally trying to
increase them annually and cutting them very reluctantly.
Buffett explains the point by a lot of number crunching and
putting up a case study to prove how investment of dividends back ij the firm
will overtime benefit shareholders in compounding the wealth at a bit faster
rate.
Wishing makes dreams come true only in Disney movies; it’s
poison in business
2013
2013 letter covers an entire capital cycle from 2007 to 2013
and sums up how in loop, passing black swans and economic boom and bust,
Berkshire outperformed S&P 500.
Two of the major acquisitions were done during 2013 namely
NV Energy and Heinz to add up to their portfolios. Company also did a number of
bolt on acquisitions as they “deploy capital in activities that fit with the
existing businesses and that will be managed by the corps of expert managers.”
Berkshire increased its ownership interest in each of its
“Big Four” investments – American Express, Coca-Cola, IBM and Wells Fargo.
Wells Fargo (increasing ownership to 9.2% versus 8.7% at yearend 2012) and IBM
(6.3% versus 6.0%). Meanwhile, stock repurchases at Coca-Cola and American
Express raised percentage ownership. Equity in CocaCola grew from 8.9% to 9.1%
and in American Express from 13.7% to 14.2%.
Warren like every year explains and reiterate the facts and
numbers of various businesses like insurance (BH Re, GEICO, General Re),
manufacturing, capital intensive regulated (BNSF, MidAmerican) and minority
investments.
Insurance is the sale of promises. The “customer” pays money
now; the insurer promises to pay money in the future if certain events occur.
“Clayton’s loan portfolio will likely grow to at least $5
billion in not too many years and, with sensible credit standards in place,
should deliver significant earnings.” — 2003 Annual Report
2014 Newsletter – Berkshire Present Past and Future
Thus letter marks 50 year anniversary of the partnership and
has some deep insights from Buffett and his right hand man Charlie Genius
Munger. The letters covers the story of Berkshire and Warren experiences precisely
in 42 pages and is a must read for every aspiring investor, admirer or anyone
who likes sports.
In Berkshire’s per-share intrinsic value over the past 50
years is roughly equal to the 1,826,163% gain in market price of the company’s
shares.
2014 Powerhouse Five Berkshire Hathaway Energy (formerly
MidAmerican Energy), BNSF, IMC (Iscar ), Lubrizol and Marmon which later on
outperformed (2022 Newsletter)
$ 84bn float in insurance business and increased
shareholding in the existing businesses (Big four)- American Express,
Coca-Cola, IBM and Wells Fargo so that willingness to invest large sums
passively in non-controlled businesses – gives them a significant advantage
over companies that limit themselves to acquisitions they can operate.
Reiterates all types of insurance Berkshire owns and the qualities of
respective managers. “Berkshire’s great managers, premier financial strength
and a variety of business models protected by wide moats amount to something
unique in the insurance world.”
Way Forward
For the great majority of investors, however, who can – and
should – invest with a multi-decade horizon, quotational declines are
unimportant. Their focus should remain fixed on attaining significant gains in
purchasing power over their investing lifetime. For them, a diversified equity
portfolio, bought over time, will prove far less risky than dollar-based
securities. Investors, of course, can, by their own behavior, make stock
ownership highly risky. Ben Graham pinpointed the blame for
investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is
not in our stars, but in ourselves.”
ACQUISITION CRITERIA
(1) Large purchases (at least $75
million of pre-tax earnings unless the business will fit into one of our
existing units),
(2) Demonstrated consistent earning
power
(3) Businesses earning good returns
on equity while employing little or no debt,
(4) Management in place
(5) Simple businesses
(6) An offering price (we don’t want
to waste our time or that of the seller by talking, even preliminarily, about a
transaction when price is unknown).
(7) The intrinsic value of the shares
you give in an acquisition must not be greater than the intrinsic value of the
business you receive.(from Dexter Shoes blunder which Warren made)
On volatility and spin off’s
Periodically, financial markets will become divorced from
reality. “The press will hang on their every word. Bankers will fight for their
business. What they are saying will recently have “worked.” Their early
followers will be feeling very clever. Our suggestion: Whatever their line,
never forget that 2+2 will always equal 4. And when someone tells you how
old-fashioned that math is --- zip up your wallet, take a vacation and come
back in a few years to buy stocks at cheap prices.”
Repurchase
In both 2015 and 2016 Berkshire ranked first among
American businesses in the dollar volume of earnings retained, in
each year reinvesting many billions of dollars more than did the runner-up.
Wisdom of a decade – “Charlie and I have no magic plan to
add earnings except to dream big and to be prepared mentally and
financially to act fast when opportunities present themselves. Every
decade or so, dark clouds will fill the economic skies, and they will briefly
rain gold. When downpours of that sort occur, it’s imperative that we
rush outdoors carrying washtubs, not teaspoons.”
The letter states about the mistakes he made while acquiring
companies like General Re and GEICO by using Berkshire shares. By avoiding the
issuance of Berkshire stock, any improvement in earnings will translate into
equivalent per-share gains which he realized later on.
Share Repurchases
From the standpoint of exiting shareholders, repurchases are
always a plus. Though the day-to-day impact of these purchases is usually
minuscule, it’s always better for a seller to have an additional buyer in the
market. For continuing shareholders, however, repurchases only make sense if
the shares are bought at a price below intrinsic value.
No repurchase when –
1. A business both needs
all its available money to protect or expand its own operations and is also
uncomfortable adding further debt.
2. When a business
acquisition (or some other investment opportunity) offers far greater value
than do the undervalued shares of the potential repurchase.
This letter again reiterates the legacy of insurance
business, accounting norms for float as goodwill asset and the competency of
management (Ajit Jain). It has been discussed in detail in earlier blogs.
To sum up, a sound insurance operation needs to adhere to
four disciplines. It must
1) Understand all
exposures that might cause a policy to incur losses.
2) Conservatively assess
the likelihood of any exposure actually causing a loss and the probable cost if
it does
3) Set a premium that,
on average, will deliver a profit after both prospective loss costs and
operating expenses are covered.
4) Be willing to walk away
if the appropriate premium can’t be obtained.
Berkshire Today
(1) an unmatched collection of businesses,
most of them now enjoying favorable economic prospects;
(2) a cadre of outstanding managers
who, with few exceptions, are unusually devoted to both the subsidiary they
operate and to Berkshire;
(3) an extraordinary diversity of
earnings, premier financial strength and oceans of liquidity
(4) a first-choice ranking among many
owners and managers who are contemplating sale of their businesses and
(5) a culture, distinctive in many
ways from that of most large companies, that they have worked 50 years to
develop and that is now rock-solid.
Next 50 Years (What makes Berkshire unique ?
(1) Permanent capital loss for
patient Berkshire shareholders is as low-Intrinsic value matters. a sound
investment can morph into a rash speculation if it is bought at an elevated
price.
(2) Financial staying power requires
a company to maintain three strengths under all circumstances:
a. a large and reliable
stream of earnings;
b. massive liquid assets
c. no significant
near-term cash requirements.
(3) Probably between ten and twenty
years from now – Berkshire’s earnings and capital resources will reach a level
that will not allow management to intelligently reinvest all of the company’s
earnings.
(4) There would be no significant
system-wide personnel system, stock option system, other incentive system,
retirement system, or the like, because the subsidiaries would have their own
systems, often different.
(5) Its top company would do almost
all business through separately incorporated subsidiaries whose CEOs would
operate with very extreme autonomy
(6) Berkshire would not pay dividends
so long as more than one dollar of market value for shareholders was being
created by each dollar of retained earnings.
Warren and Charlie never refrain from giving bold interviews
and being brutally honest in their letter to shareholders. Each year the letter
starts with the annual report card of Berkshire from 1965 to present date.
Warren at 90 have the guts to accept his mistake and apologize publically to
his shareholders.
Some key learning from 2022 letter are :
1. Simple investment philosophy –Buffett has been
an advocate of simplicity and circle of competence from a long time now. As he
says “our goal is to have meaningful investments in businesses with both
durable economic advantages and a first-class CEO.”
2. He views market as “Weighing machine” –“ :
Charlie and I are not stock-pickers; we are business-pickers.”
3. Tells the tale of merger of Berkshire and
Hathaway and how bad things can go for shareholders if a bad management runs a
fair business
4. On insurance business- combination of large
enough float and competent management (Ajit Jain), Buffett tells the hiring
story of Ajit and the longevity in Bershire’s insurance business. “The product
will never be obsolete, and sales volume will generally increase along with
both economic growth and inflation.”
5. Apple - 0.1% of Apple’s 2021 earnings amounted
to $100 million. Firm owns 5.55% in the company.
6. BNSF –Old is gold pick - had record earnings
of $6 billion in 2021
7. BHE - earned a record $4 billion in 2021
(30-fold from the $122 million earned in 2000, the year that Berkshire first
purchased a BHE stake)
8. $144 billion in cash and cash equivalents -
failure to find entire companies or small portions thereof (that is, marketable
stocks) which meet our criteria for longterm holding
9. Long-term interest rates that are low push the
prices of all productive investments upward, whether these are stocks,
apartments, farms, oil wells, whatever. Other factors influence valuations as
well, but interest rates will always be important.
10. High price of Berkshire stock - Berkshire’s buyback
opportunities are limited because of its high-class investor base. If our
shares were heavily held by short-term speculators, both price volatility and
transaction volumes would materially increase
11. A wonderful man and wonderful business –The story
of TTI and Paul Andrews, a man of honor and integrity, how he sells his
business to Warren just for the sake of his employees while he himself got
indulged in giving back to the society.
12. The orangutan effect: If you sit down with an
orangutan and carefully explain to it one of your cherished ideas, you may
leave behind a puzzled primate, but will yourself exit thinking more clearly.
AGM 2022
190 - Combined age of Charlie and Warren, sitting in an AGM
at 91 and 98 years of age, a conversation filled with sarcasm, wit and wisdom
of sages.
1) Buying Allegany Corp after letter to shareholders for $11bn .
2) Occidental Petroleum - Buying 14% in company within 2 weeks - speculators
role
3) Share Buyback advantage - Explained using American Express case study - 1998
bought the last shares and owned 11.2% - 2022 own 20%. Dividend and longevity
as the driving factors for the long term. NOTHING BETTER THAN BUYING YOUR OWN
BUSINESS.
4) Auto insurance- GEICO vs Progressive - Ajit iterates the USE OF TELEMATICS
by the competitor leads for better growth and margins.
5) Market Timing - Getting out in 69 to back in 72,74 till recently sitting on
huge pile of cash when market's are falling like anything ."We never buy
or sell on what the market is going to do or economy is going to do."
6) Inflation - The best thing to invest during inflation is yourself. Being
best at something. Something which others want you to be done and you can
deliver.
7) Grossly overdoing good ideas ruins it. Doing mistakes and getting those
mistakes is a blessing.
8) Nothing in economy is same - The first effects people's attitude and second
time attitudes always influence the activity itself.
9) Bitcoin - "In my life I try to avoid things which are stupid and evil
and make me look bad in comparison with someone else and bitcoin does all
three." -Charlie. It undermines the importance of federal reserve. Warren
throws light on "Tribal behavior" of people explained using Roosevelt
analogy - one set hates him while others cherish.
