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Warren Buffett’s 2016 Letter to Shareholders: Performance, Share Repurchase, Active/Passive Investing

Warren Buffett’s Letter to Shareholders, February 25, 2017

Performance

  • In 2016, Berkshire’s gain in net worth was $27.5B which increased per-share book value by 10.7% (per-share market value of Berkshire increased 23.4% versus S&P with dividends of 12% in 2016)
  • Over the last 52 years, per-share book value has grown from $19 to $172,108, a rate of 19% compounded annually

What We Hope to Accomplish

  • Buffett and Charlie Munger expect Berkshire’s normalized earning power per share to increase every year; actual earnings will sometimes decline because of periodic weakness in US economy; insurance-specific events may occasionally reduce earnings
  • Berkshire gradually shifted from a company obtaining most of its gains from investment activities to one that grows in value by owning businesses; took baby steps initially by making small acquisitions
    • Despite the cautious approach, made one particularly egregious error, acquiring Dexter Shoe for $434MM in 1993
    • Dexter’s value went to zero; story gets worse: used stock for the purchase, giving the sellers 25,203 shares of Berkshire that at yearend 2016 were worth more than $6B
  • This wreck was followed by three happenings: two positive and one negative:
    • Acquired half of GEICO that wasn’t already owned in 1996, a cash transaction that changed the holding from a portfolio investment into a wholly-owned operating business: quickly became the world’s premier property/casualty business
    • Unfortunately, followed the GEICO purchase by foolishly using Berkshire stock to buy General Reinsurance in 1998: General Re was a good investment but Berkshire issued 272,000 shares which increased outstanding shares by 21.8%; error caused shareholders to give more than they received
    • In 2000, bought 76% of MidAmerican Energy in cash: firmly launched Berkshire on its present course of 1) continuing to build insurance operation; 2) energetically acquiring large and non-insurance businesses; and 3) largely making deals from internally-generated cash
  • Portfolio of bonds and stocks, deemphasized though it is, has continued in the post-1998 period to grow and to deliver hefty capital gains, interest, and dividends; portfolio earnings have provided major help in financing the purchase of businesses
  • Expectation is that investment gains will continue to be substantial and that these will supply significant funds for business purchases; by avoiding issuance of Berkshire stock, any improvement in earnings will translate into equivalent per-share gains
  • “Early Americans, we should emphasize, were neither smarter nor more hard working than those people who toiled century after century before them. But those venturesome pioneers crafted a system that unleashed human potential, and their successors built upon it. This economic creation will deliver increasing wealth to our progeny far into the future. Yes, the build-up of wealth will be interrupted for short periods from time to time. It will not, however, be stopped. I’ll repeat what I’ve both said in the past and expect to say in future years: Babies born in America today are the luckiest crop in history

Share Repurchases

  • Assessing the desirability of repurchases isn’t that complicated
    • From the standpoint of existing 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; when that rule is followed, remaining shares experience an immediate gain in intrinsic value
  • Puzzling that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed; when CEO’s or boards are buying a small part of their own company, they all too often seem oblivious to price – would they behave similarly if they were managing a private company with just a few owners and were evaluating the wisdom of buying out one of them?
  • There are two occasions in which repurchases should not take place:
    • When a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt
    • When a business acquisition offers far greater value than do the undervalued shares of the potential repurchase
  • Berkshire’s own repurchase policy: authorized to buy large amounts of shares at 120% or less of book value
  • As the subject of repurchases has come to boil, some people have come close to calling them un-American – characterizing them as corporate misdeeds that divert funds needed for productive endeavors
    • Simply isn’t the case: both American corporations and private investors are today awash in funds looking to be sensibly deployed; not aware of any enticing project that in recent years has died for lack of capital

“The Bet” (or how your money finds its way to Wall Street)

  • Story of an investment bet I made nine years ago: Long Bets
    • Seeded by Jeff Bezos of Amazon and operates as a non-profit that administers what you’d guess: long-term bets
    • “Proposers” post a proposition at Longbets.org that will be proved right or wrong at a distant date; they then wait for a contrary-minded party to take the other side of the bet
    • When a “doubter” steps forward, each side names a charity that will be the beneficiary if its side wins; parks its wager with Long Bets and posts a short essay defending its position
  • I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees
    • Suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender
    • What followed was the sound of silence
    • Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge; Ted was a co-manager of Protégé Partners (fund of funds)
    • Ted picked five fund-of-funds: those five fund-of-funds invested their money in more than 100 hedge funds
    • Results for the first nine years of the bet: S&P Index Fund: 85.4%; FoF A: 8.7%; FoF B: 28.3%; FoF C: 62.8%; FoF D: 2.9%; FoF E: 7.5%
    • This means $1 million invested in those funds would have gained $220k while index fund would have gained $854k
    • Certain that in almost all cases the managers were honest and intelligent people – but the result for their investors were really dismal; huge fixed fees charged by all of the funds and fund-of-funds were such that their managers were showered with compensation over the nine years that have passed
  • The disappointing results for hedge fund investors that this bet exposed are almost certain to recur in the future
    • No doubt that hundreds of people are highly likely to outperform S&P over long stretches; the problem simply is that the great majority of managers who attempt to over-perform will fail
    • 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
  • Over the years, my regular recommendation has been a low-cost S&P 500 index
    • My friends who possess only modest means have usually followed my suggestion
    • None of the mega-rich individuals, institutions or pension funds has followed that same advice; the wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it – for this reason, financial elites have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars

Insurance

  • P/C branch of the insurance industry has been the engine that has propelled growth since 1967 when National Fire & Marine was acquired for $8.6 million; today, National Indemnity is the largest P/C company in the world by net worth
  • Attracted to P/C business because of its financial characteristics: P/C insurers receive premiums upfront and pay claims later; collect-now, pay-later model leaves P/C companies holding large sums (float) that will eventually go to others; insurers get to invest this float for their own benefit
  • Nature of our insurance contracts is such that we can never be subject to immediate or near-term demands for sums that are of significance to our cash resources; this structure is by design and is a key component in the unequaled financial strength of our insurance companies
  • Berkshire’s P/C companies have an excellent underwriting record: operated at an underwriting profit for 14 years and pre-tax gain for the period having totaled $28B
  • How does our float affect intrinsic value?
    • When Berkshire’s book value is calculated, full amount of our float is deducted as liability, just as if we had to pay it out tomorrow and could not replenish it; but to think of float as a typical liability is a major mistake – it should be viewed as a revolving fund
    • If revolving float is both costless and long-enduring, the true value of this liability is dramatically less than the accounting liability; owing $1 that in effect will never leave the premises
    • Partial offset to this overstated liability is a $15.5 billion “goodwill” asset that Berkshire incurred in buying insurance companies
    • This goodwill represents the price we paid for the float-generating capabilities of our insurance operations; if an insurance company sustains large and prolonged underwriting losses, any goodwill should be deemed valueless
  • Berkshire is far more conservative in avoiding risk than most large insurers
    • For example, if insurance industry should experience some mega-catastrophe, Berkshire as a whole would likely record a large profit for the year; Berkshire’s many streams of non-insurance earnings would see to that; additionally, would remain awash in cash and be eager to write business in an insurance market that might well be in disarray

Regulated, Capital-Intensive Businesses

  • BNSF railroad and Berkshire Hathaway Energy (90%-owned utility business): these two account for 33% of Berkshire’s after-tax operating earnings
  • 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 that is not guaranteed by Berkshire; each company has earning power that even under terrible economic conditions would far exceed its interest requirements
  • BHE and BNSF invested $8.9B in plant and equipment last year; we relish making such investments as long as they promise reasonable returns
  • HomeService came with the purchase of MidAmerican (now BHE); HomeService owns 38 realty companies with more than 29,000 agents who operate in 28 states; also franchises many operations throughout the country

Manufacturing, Service and Retailing Operations

  • Sell products ranging from lollipops to jet airplanes; 44 businesses; most are solid businesses generating good returns in the area of 12% to 20%
  • Have made some serious blunders in capital allocation and have produced very poor returns; we are now paying the price for such misjudgments
  • Have paid substantial premiums to net tangible assets for most of our businesses; overall, we are getting a decent return on the capital we have deployed
  • Absent a recession, earnings from the group will likely grow in 2017, in part because Duracell and Precision Castparts will for the first time contribute a full year’s earnings

Finance and Financial Products

  • Three leasing and rental operations are conducted by CORT (furniture), XTRA (semi-trailers), and Marmon (primarily tank cars but also freight cars, intermodal tank containers and cranes); also include Clayton Homes in this section
  • Last year, Clayton became America’s largest home builder
  • Marmon’s railcar business experienced a major slowdown in demand last year, which will cause earnings to decline in 2017; fleet utilization was 91% in December, down from 97% a year earlier; crane and container rentals have weakened as well

Investments

  • List of fifteen common stock investments that at yearend had the largest market value (excluding Kraft Heinz because Berkshire is part of a control group): American Express, Apple, Charter Communications, Coca-Cola Company, Delta Airlines, Goldman Sachs, IBM, Moody’s, Phillips 66, Sanofi, Southwest Airlines, US Bancorp, United Continental, USG, Wells Fargo
  • Some of the stocks are the responsibility of either Todd Combs or Ted Weschler; each independently manages more than $10B
  • Not included in the top 15 is ownership of $5B of preferred stock issued by Bank of America (pays us $300 million per year and also carries a valuable warrant allowing Berkshire to purchase 700 million common shares for $5B at any time before 9/2/21 – this would have delivered a profit of $10.5B)
  • 95% of the $86B of “cash and equivalents” shown on balance sheet are held in the US and are not subject to repatriation tax
  • Like most corporations, Berkshire nets more from a dollar of dividends than it reaps from a dollar of capital gains:
    • Corporate math: every $1 of capital gains that a corporation realizes carries with it 35 cents of federal income tax; tax on dividends received from domestic corporations, however, is consistently lower
    • Berkshire (non-insurance company): federal tax rate is effectively 10.5 cents per $1 of dividends; a non-insurance company that owns more than 20% of an investee owes taxes of only 7 cents per $1 of dividends (this applies to Kraft Heinz)
    • Berkshire’s insurance subsidiaries pay a tax rate on dividends that is somewhat higher than that applying to non-insurance companies (the rate is still below 35% hitting capital gains); P/C companies owe about 14% in taxes on most dividends they receive
Image Source: The Investor’s Podcast

 

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