Thursday, March 8th, 2018
At this time of year, it is always worth reviewing Warren Buffett’s Chairman’s letter to Berkshire Hathaway Inc. shareholders. The letter is widely read and discussed, even though it is addressed to Berkshire shareholders or investment partners as Warren Buffett often notes.
This year’s letter was quite short at just 17 pages. Indeed, the letter did not state much that had not be written about in prior years. In our view, it was the brief presentation of the operating results of the many diversified Berkshire non-insurance investments which was particularly enlightening. The operating results of subsidiaries showed low levels of growth (below 5% in 2017), while the investment returns on the passive long-term portfolio were significant (see below).
As Buffett noted “In America, equity investors have the wind at their back.” And Berkshire’s portfolio was a significant beneficiary.
Warren Buffett and Charlie Munger
An expensive equity market
As we noted in our review of last year’s letter, Berkshire Hathaway Inc. is akin to a listed mutual investment and insurance company. The immediate claims on cash profits (either investment or underwriting) are only those of policy holders or counterparties for Berkshire’s immense reinsurance contracts. Shareholders in Berkshire do not receive a dividend, and this allows the power of investment compounding to occur. However, the actual compounding slows when cash builds up, and there was a massive $30 billion growth in net cash to $116 billion over 2017. With cash rates and treasury bill rates low, the hurdle for investment could be adjusted down, but this is not what Berkshire will ever do. In 2017, Buffett noted simply that bargains or value were hard to find.
“In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price. That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.”
2017 was a barren year for Berkshire in acquiring stand-alone businesses. The purchase of businesses is a key plank for generating long-term investment returns. These standalone companies grow profits and pay dividends to Berkshire that is reinvested (compounded) across the investment portfolio.
“Berkshire’s goal is to substantially increase the earnings of its non-insurance group. For that to happen, we will need to make one or more huge acquisitions. We certainly have the resources to do so. At yearend Berkshire held $116.0 billion in cash and U.S. Treasury Bills (whose average maturity was 88 days), up from $86.4 billion at yearend 2016. This extraordinary liquidity earns only a pittance and is far beyond the level Charlie and I wish Berkshire to have. Our smiles will broaden when we have redeployed Berkshire’s excess funds into more productive assets.”
Accounting rules create misleading results
The letter reflected Buffett’s annoyance (which we share) at the changing of accounting and profit reporting rules. In Buffett’s view, the reporting of realised and unrealised (mark to market) profit will distort results and confuse investors – “With the new rule about unrealized gains exacerbating the distortion caused by the existing rules applying to realized gains, we will take pains every quarter to explain the adjustments you need to make sense of our numbers.”
Buffett’s annoyance flows from the new requirement to mark his long-term investments to market prices. The marking is through the profit and loss statement and so Berkshire will now exhibit a volatile profit stream that is contrary to over fifty years of experience.
“Stocks surge and swoon, seemingly untethered to any year-to-year build-up in their underlying value. Over time, however, Ben Graham’s oft-quoted maxim proves true: “In the short run, the market is a voting machine; in the long run, however, it becomes a weighing machine.”
These distortions which the accounting profession seems to persistently encourage, will give the news wires fodder to create headlines that will both mislead and frighten investors –
“But televised commentary on earnings releases is often instantaneous with their receipt, and newspaper headlines almost always focus on the year-over-year change in GAAP net income. Consequently, media reports sometimes highlight figures that unnecessarily frighten or encourage many readers or viewers.”
Presenting information in a way that all shareholders are treated fairly
Buffett reiterated his long-held view that his shareholders and indeed investors that review Berkshire’s results deserve to be treated fairly. All should and are given ample time to consume Berkshire’s results before trading occurs in the stock on the market –
“We will attempt to alleviate this problem by continuing our practice of publishing financial reports late on Friday, well after the markets close, or early on Saturday morning. That will allow you maximum time for analysis and give investment professionals the opportunity to deliver informed commentary before markets open on Monday. Nevertheless, I expect considerable confusion among shareholders for whom accounting is a foreign language.”
It is both interesting and disturbing that Buffett’s well documented respect for his shareholders (Berkshire’s investment partners) is not a common trait seen across major public companies, either in the US or Australia. Neither of our regulators of markets or the market owners/operators (the listed ASX) require companies to provide sufficient and reasonable time for investors to digest information, to ensure that markets are traded in a fair way.
“While I’m on the subject of our owners’ gaining knowledge, let me remind you that Charlie and I believe all shareholders should simultaneously have access to new information that Berkshire releases and, if possible, should also have adequate time to digest and analyze that information before any trading takes place…We do not follow the common practice of talking one-on-one with large institutional investors or analysts, treating them instead as we do all other shareholders. There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his or her savings. As I run the company day-to-day – and as I write this letter – that is the shareholder whose image is in my mind.”
The belief that markets can immediately respond correctly to information is rubbish and serves only to benefit speculators, commission brokerage houses and market operators rewarded by volumes of senseless trade. In our view, the listing and trading rules should require a 3-hour period (at least) after the release of results before shares are traded. It is common for listed Australian companies to conduct phone briefings and closed presentations on results immediately after their release. Thus, a regulated delay would certainly allow the proper dissemination and analysis of results to occur with an orderly market resulting.
Insurance has its up and downs
2017 was a tough year for Berkshire’s insurance operations –
“Prior to 2017, Berkshire had recorded 14 consecutive years of underwriting profits, which totalled $28.3 billion pre-tax. I have regularly told you that I expect Berkshire to attain an underwriting profit in a majority of years, but also to experience losses from time to time. My warning became fact in 2017, as we lost $3.2 billion pre-tax from underwriting.”
After complaining about accounting standards that confuse and mislead investors, Buffett took aim at many of his insurance peers and the poor auditing of their accounts.
“As well-known analyst V.J. Dowling has pointed out, the loss reserves of an insurer are similar to a self-graded exam. Ignorance, wishful thinking or, occasionally, downright fraud can deliver inaccurate figures about an insurer’s financial condition for a very long time.”
Berkshire has a simple insurance underwriting process. It attempts to make an underwriting profit in most years and employs insurance analysts that can achieve this. From these profits and from its immense cash float (the access to prepaid premiums of policy holders), it conducts a fundamental investment process. It invests capital to achieve a targeted rate of return well above inflation. It holds liquid reserves to meet insurance needs (underwriting claims) and invests retained profits (long-term reserves that become shareholder equity) in high growth assets – mainly equities.
When investors scan other insurers across the world many fail because they are listed insurance companies that struggle to meet the concurrent needs of policy holders and shareholders. Berkshire has the unfair advantage of being granted the freedom to not pay dividends.
Berkshire Hathaway shares have risen from $12,500 in 1993 to $314,345 today (a period of 25 years). That is an average annual compounded increase of 13.76% per annum.
Source: Financial Times
A tough year for non-insurance operations but great for investments
As noted above, 2017 was not a great year for Berkshire’s non-insurance operations with operating earnings growth of about 5% recorded. The steadily growing US economy did not produce stellar growth in earnings.
“Viewed as a group – and excluding investment income – our operations other than insurance delivered pre-tax income of $20 billion in 2017, an increase of $950 million over 2016. About 44% of the 2017 profit came from two subsidiaries. BNSF, our railroad, and Berkshire Hathaway Energy (of which we own 90.2%).”
Also, the Berkshire investees were big consumers of capital and free cashflow was lower than reported profits as significant investment was undertaken by Berkshire’s operations –
“Depreciation charges for all of these non-insurance operations totalled $7.6 billion; capital expenditures were $11.5 billion. Berkshire is always looking for ways to expand its businesses and regularly incurs capital expenditures that far exceed its depreciation charge. Almost 90% of our investments are made in the United States. America’s economic soil remains fertile.”
But away from operations, it was a stellar year for investment returns as the US equity market powered higher. We can see this by comparing Berkshire’s top 15 investments from 2016 with 2017.
The tables below show that the portfolio’s market value jumped by over 40% (including investments made) and there were significant changes made over the year.
These included –
- A substantially increased investment in Apple Inc. of $14 billion;
- The sell down of International Business Machines Corp of about $13 billion;
- The introduction of more banks into the portfolio with a small reduction in Wells Fargo. Notably, the conversion of Bank of America warrants (pursuant to Berkshire’s bailout of the bank in 2008) has produced a $15 billion capital gain.
The portfolio in the main was remarkably stable with a net investment of $9 billion producing a net gain of about $38 billion in the year. The Bank of America deal (conversion of warrants) was the big contributor followed by American Express and Apple.
A final thought
“Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that this objective won’t be attained. … I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.”
There can be no doubt that Warren Buffett and his partner Charlie Munger are extraordinary investors with an incredible track record. But they make no secret of the rules they follow and the disciplines they employ in selecting investments. Here at Clime, we value their insights highly and share many of their long-held beliefs – and we strive to employ the sagacity these men have shown over decades in the construction of your portfolio.