Warren Buffett's Berkshire Hathaway shareholder letter offers a vast amount of insights into business, life and investing every year. The 2016 Berkshire Hathaway shareholder letter is no exception. We have distilled the 29 page letter into key takeaways with added commentary below.
The italicized text is what we have added, while the normal font is directly taken from Warren Buffett's Berkshire Hathaway shareholder letter. You can find all of Warren's other shareholder letters on the company aggregated in a book.
Berkshire Hathaway's 2016 Shareholder Letter Takeaways
Over time stock prices gravitate towards intrinsic value. That's what has happened at Berkshire, a fact explaining why the company's 52-year market-price gain- shown on the facing page- materially exceeds its book-value gain.
Intrinsic value is the true inherent value of a business when considering both tangible and intangible factors. The book value is the value as depicted by the businesses' books, which can be subject to accounting quirks. For example, amortization and depreciation expense. Later described below. The market price may or may not reflect true intrinsic value. In the long run, the price of a company gravitates to its intrinsic value.
Unfortunately, I followed the GEICO purchase by foolishly using Berkshire stock – a boatload of stock – to buy General Reinsurance in late 1998. After some early problems, General Re has become a fine insurance operation that we prize. It was, nevertheless, a terrible mistake on my part to issue 272,200 shares of Berkshire in buying General Re, an act that increased our outstanding shares by a whopping 21.8%. My error caused Berkshire shareholders to give far more than they received (a practice that – despite the Biblical endorsement – is far from blessed when you are buying businesses).
Warren has made several mistakes in paying for companies using Berkshire stock. Included of which was Dexter Shoes, whereby the business went to zero. To compound that mistakes, he paid in Berkshire stock, which is now worth tens of billions. He gave up more than he got. As Berkshire gets larger and their cash balance builds, they are less likely to pay for acquisitions with share than with cash.
You need not be an economist to understand how well our system has worked. Just look around you. See the 75 million owner-occupied homes, the bountiful farmland, the 260 million vehicles, the hyper-productive factories, the great medical centers, the talent-filled universities, you name it – they all represent a net gain for Americans from the barren lands, primitive structures and meager output of 1776. Starting from scratch, America has amassed wealth totaling $90 trillion.
However our wealth may be divided, the mind-boggling amounts you see around you belong almost exclusively to Americans.
Warren has often said that the luckiest humans are the ones who are born today. The reason is because we've made tremendous strides in all facets of life. The issue we have to deal with is how all that wealth is divided. Right now it is concentrated in a small group as compared to the entire U.S. population.
During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.
This is counter-intuitive and precisely why you'll make money if you follow it. Warren often says, "Be fearful when others are greedy and greedy when others are fearful." In the long-run if you buy good businesses, you'll do well.
For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.
Not all share repurchases are equal. Ideally, you'd want the business to repurchase shares when they are below intrinsic value. Otherwise it is just like buying an overpriced business.
To recap Berkshire’s own repurchase policy: I am authorized to buy large amounts of Berkshire shares at 120% or less of book value because our Board has concluded that purchases at that level clearly bring an instant and material benefit to continuing shareholders.
Berkshire's total shareholder equity is approximately $286B as of 12/31/16. Per Google Finance, the total market cap is $420B, so we are significantly above book value. A market cap of $343B or 120% of shareholder equity, would be a good time to buy Berkshire shares.
One reason we were attracted to the P/C business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit.
At bottom, 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; and (4) be willing to walk away if the appropriate premium can’t be obtained. Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance.
Warren distills all insurance business models in these two paragraphs. What differentiates successful insurance companies from unsuccessful ones is their ability to underwrite to obtain the appropriate premium. A lot of businesses will underwrite even at a loss. What happens is those companies eventually they have to pay out and they can lose significant amounts of money. Such was the case with Genworth (GNW), which at one point underwrote their insurance at a huge loss.
It was clear to me that GEICO would succeed because it deserved to succeed.
Charlie Munger often echos this similar thought. The best way to get something is to deserve it. For example, to deserve a great partner in life, you need to be a great partner.
Regulated, Capital-Intensive Businesses
All told, BHE and BNSF invested $8.9 billion in plant and equipment last year, a massive commitment to their segments of America’s infrastructure. We relish making such investments as long as they promise reasonable returns – and, on that front, we put a large amount of trust in future regulation.
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! Furthermore, railroads alleviate highway congestion – and the taxpayer-funded maintenance expenditures that come with heavier traffic – in a major way.
The railroad business is a great business. There are huge barriers to entry including the capital investment piece (which could be a double edge sword) and the fact that you can only have one railroad in one place. It is similar to that of the electric utilities business, whereby it's impractical to have multiple electricity lines going to and from the same places. Warren has shifted towards these high capital intensive businesses because of how big Berkshire has gotten.
Manufacturing, Service and Retailing Operations
This collection of businesses is truly a motley crew. Some operations, measured by earnings on unleveraged net tangible assets, enjoy terrific returns that, in a couple of instances, exceed 100%. Most are solid businesses generating good returns in the area of 12% to 20%.
Of course, a business with terrific economics can be a bad investment if it is bought at too high a price.
In its essence, the less capital you invest with greater cash generation, the better the business. However, you can pay too much for a business and that becomes a bad investment. When you pay up for a business, you are paying for future earnings and it could take years before the business' intrinsic value catches up to the price you pay. During that time, you may realize less than desirable returns.
On that page, we show that the 2016 amortization charge to GAAP earnings was $1.5 billion, up $384 million from 2015. My judgment is that about 20% of the 2016 charge is a “real” cost.
But the problem still prevails, big time, in the railroad industry, where current costs for many depreciable items far outstrip historical costs. At BNSF, to get down to particulars, our GAAP depreciation charge last year was $2.1 billion. But were we to spend that sum and no more annually, our railroad would soon deteriorate and become less competitive.
Accounting has some peculiarities. You may purchase software and based on past experiences let's say you need to replace it after 5 years. So you pay upfront for the software costs, but the costs on the books is taken over the 5 years. Five years later, the technology didn't change that much and you are still using that software. While your initial cash out is a true cost, the amortization doesn't reflect true economic cost because there is no replacement cost or maybe it might cost you half the amount. In railroad, depreciation expense is different as Warren has described above.
Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.
When companies are pressured either from internal or external forces to meet numbers, they have a tenancy to be tempted to make up the numbers when they aren't really met. This can lead to a whole slew of issues including whether or not shareholders can trust management. For example, Comscore Inc.(SCOR) recently misreported revenues and its stock price took a huge hit and is currently trading over the counter. It subsequently missed its required SEC filings due dates.
Listen carefully while I tell these enablers that stock-based compensation usually comprises at least 20% of total compensation for the top three or four executives at most large companies.
Back to reality: If CEOs want to leave out stock-based compensation in reporting earnings, they should be required to affirm to their owners one of two propositions: why items of value used to pay employees are not a cost or why a payroll cost should be excluded when calculating earnings.
Many companies show stock-based compensation as not true costs. In GAAP (Generally Accepted Accounting Principals), the expense you incur from issuing stock as compensation to your employees/director is considered an expense. After all, accounting says you are giving up a part of the business. Many companies will show Non-GAAP measures in order to bolster what they believe is the "true cost" of the business.
Finance and Financial Products
Clayton’s earnings in recent years have materially benefited from extraordinarily low interest rates. The company’s mortgage loans to home-buyers are at fixed-rates and for long terms (averaging 25 years at inception). But Clayton’s own borrowings are short-term credits that re-price frequently. When rates plunge, Clayton’s earnings from its portfolio greatly increase. We normally would shun that kind of lend-long, borrowshort approach, which can cause major problems for financial institutions. As a whole, however, Berkshire is always asset-sensitive, meaning that higher short-term rates will benefit our consolidated earnings, even as they hurt at Clayton."
Given that you consolidate Clayton into Berkshire, how does higher short-term rates benefit the consolidated earnings if it hurts Clayton? Maybe Warren is looking at the fact that overall, higher short-term rates is better for other pieces of Berkshire. Therefore, he dismisses Clayton's use of short-term borrowing. Feel free to chime in on this.
Sometimes the comments of shareholders or media imply that we will own certain stocks “forever.” It is true that we own some stocks that I have no intention of selling for as far as the eye can see (and we’re talking 20/20 vision). But we have made no commitment that Berkshire will hold any of its marketable securities forever. That principle covers controlled businesses, not marketable securities.
Well this debunks the myth that everyone thinks Buffett holds businesses forever. When Berkshire buys controlled businesses, they evidently become the majority stakeholder if not 100% owner. There's a different aspect involved when you are in charge of the livelihood of all its employees and such versus being a minority shareholder in a large corporation.
Before we leave this investment section, a few educational words about dividends and taxes: Berkshire, like most corporations, nets considerably more from a dollar of dividends than it reaps from a dollar of capital gains. That will probably surprise those of our shareholders who are accustomed to thinking of capital gains as the route to tax-favored returns.The rationale for the low corporate taxes on dividends is that the dividend-paying investee has already paid its own corporate tax on the earnings being distributed.
This is an interesting tidbit that I otherwise would not have known.
“The Bet” (or how your money finds its way to Wall Street)
Now, to my bet and its history. In Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund. (See pages 114 - 115 for a reprint of the argument as I originally stated it in the 2005 report.)
Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!). 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.
The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.
So basically just invest in low-cost index funds if you don't have the desire or want to research companies.
Labels: Value Investing, Warren Buffett