Berkshire Hathaway 50-Year Anniversary: 2014 Annual Letter

Dear all,

Every year over the past 14 years or so, I read and summarise to my staff, family and friends aspects I find interesting from Warren Buffett's Annual Letter (Berkshire Hathaway). This year's letter is particularly interesting because 2014 represents the 50 Year Anniversary of Berkshire Hathaway under Warren Buffett's ownership and leadership. I summarise the letter below, hot off the press (just released over 3 hours ago). 

I summarise below aspects I found interesting from the letter. Somewhat different from previous years' conventions, I will start summarising the back end of the letter first, where Warren Buffett and Charlie Munger (separately) wrote thoughtful reflections about what made Berkshire ticked. I have found these letters highly illuminating and insightful, as I hope you will, too. 

Enjoy reading. 

Warren Buffett's Reflection: Berkshire's Past, Present and Future

• Buffett's Mistake #1 Confession: Should not have gone into Berkshire Hathaway (textile business) in the first place: "That was a monumentally stupid decision... Berkshire was then a northern textile manufacturer mired in a terrible business. The industry in which it operated was heading south... And Berkshire, for a variety of reasons, was unable to change course.... During the 18 years following 1966, we struggled unremittingly with the textile business, all to no avail. But stubbornness - stupidity? - has its limits. In 1985, I finally threw in the towel and closed the operation."

• Mistake #2 - even worse than Mistake #1: Should have bought National Indemnity Company (in 1967) outside of Berkshire Hathaway: "...my second blunder was far more serious than the first, eventually becoming the most costly in my career. Early in 1967, I had Berkshire pay $8.6 million to buy National Indemnity Company ("NICO"), a small but promising Omaha-based insurer... So why did I purchase NICO for Berkshire rather than for Buffett Partnership ("BPL")? I've had 48 years to think about that question, and I've yet to come up with a good answer. I simply made a colossal mistake... I opted to marry 100% of an excellent business (NICO) to a 61%-owned terrible business (Berkshire Hathaway), a decision that eventually diverted $100 billion or so from BPL partners to a collection of strangers."

• Mistake #3 - buying other dying businesses: "Can you believe that in 1975 I bought Waumbec Mills, another New England textile company? Of course, the purchase was a "bargain" price based on assets we received and the projected synergies with Berkshire's existing textile business. Nevertheless - surprise, surprise - Waumbec was a disaster, with the mill having to be closed down not many years later."

• "Charlie [Munger] Straightens me Out": "Cigar-butt investing was scalable only to a point. With large sums, it would never work well... It took Charlie Munger to break my cigar-butt habits ... The blueprint [Charlie] gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices."... "I had enjoyed reasonable success without Charlie's input, so why should I listen to a lawyer who had never spent a day in business school... But Charlie never tired of repeating his maxims about business and investing to me, and his logic was irrefutable. Consequently, Berkshire has been built on Charlie's blueprint"... "The year 1972 was a turning point for Berkshire... We had the opportunity then to buy See's Candy... The family controlling See's wanted $30 million for the business, and Charlie rightly said it was worth that much. But I didn't want to pay more than $25 million and wasn't all that enthusiastic even at that figure. (A price that was three times net tangible assets made me gulp.) My misguided caution could have scuttled a terrific purchase. But, luckily, the sellers decided to take our $25 million bid. To date, See's has earned $1.9 billion pre-tax, with its growth having required added investment of only $40 million...I gained a business education about the value of powerful brands..."

• Today: Berkshire's Conglomerates Structure have Significant Advantages: "If the conglomerate form is used judiciously, it is an ideal structure for maximizing long-term capital growth... At Berkshire, we can - without incurring taxes or much in the way of other costs - move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That's important: If horses had controlled investment decisions, there would have been no auto industry."... and "Another major advantage we possess is the ability to buy pieces of wonderful businesses - a.k.a. common stocks."... and "Berkshire has one further advantage that has become increasingly important over the years: We are now the home of choice for the owners and managers of many outstanding businesses."

• Family Businesses often only have multiple options when contemplating sale: "Families that own successful businesses have multiple options when they contemplate sale. Frequently, the best decision is to do nothing... When one part of family wishes to sell while others wish to continue, a public offering often makes sense. But, when owners wish to cash out entirely, they usually consider one of two paths.... The first is sale to a competitor who is salivating at the possibility of wringing "synergies" from the combining of the two companies. This buyer invariably contemplates getting rid of large numbers of the seller's associates, the very people who have helped the owner build his business. A caring owner, however, [does not want to do this]... The second choice for sellers is the Wall Street buyer ..."private-equity."... Berkshire offers a third choice to the business owner who wishes to sell: a permanent home, in which the company's people and culture will be retained (though, occasionally, management changes will be needed). Beyond that, any business we acquire dramatically increases its financial strength and ability to grow. Its days of dealing with banks and Wall Street analysts are also forever ended."

• Choosing future CEO is important in Berkshire's future: "Choosing the right CEO is all-important and is a subject that commands much time at Berkshire board meetings. Managing Berkshire is primarily a job of capital allocation, coupled with the selection and retention of outstanding managers to captain our operating subsidiaries. Obviously, the job also requires the replacement of a subsidiary’s CEO when that is called for. These duties require Berkshire’s CEO to be a rational, calm and decisive individual who has a broad understanding of business and good insights into human behavior. It’s important as well that he knows his limits. (As Tom Watson, Sr. of IBM said, “I’m no genius, but I’m smart in spots and I stay around those spots.”)...  Character is crucial: A Berkshire CEO must be “all in” for the company, not for himself... He can’t help but earn money far in excess of any possible need for it. But it’s important that neither ego nor avarice motivate him to reach for pay matching his most lavishly-compensated peers, even if his achievements far exceed theirs. A CEO’s behavior has a huge impact on managers down the line: If it’s clear to them that shareholders’ interests are paramount to him, they will, with few exceptions, also embrace that way of thinking.... My successor will need one other particular strength: the ability to fight off the ABCs of business decay, which are arrogance, bureaucracy and complacency. When these corporate cancers metastasize, even the strongest of companies can falter."

• Berkshire avoids Bureaucracy: "Fortunately, the structure our future CEOs will need to be successful is firmly in place. The extraordinary delegation of authority now existing at Berkshire is the ideal antidote to bureaucracy... To an unusual degree, however, we trust our managers to run their operations with a keen sense of stewardship."

• Other Future Characteristics of Future Berkshire CEO: "Our directors believe that our future CEOs should come from internal candidates whom the Berkshire board has grown to know well. Our directors also believe that an incoming CEO should be relatively young, so that he or she can have a long run in the job. Berkshire will operate best if its CEOs average well over ten years at the helm. (It’s hard to teach a new dog old tricks.)"

• But Capital Allocation (Investments) will always be important at Berkshire: "Investments will always be of great importance to Berkshire and will be handled by several specialists. They will report to the CEO because their investment decisions, in a broad way, will need to be coordinated with Berkshire’s operating and acquisition programs. Overall, though, our investment managers will enjoy great autonomy."

Charlie Munger's Reflection: What is the secret of the "Berkshire System"?

• Elements of the "Berkshire System": "I closely watched the 50-year history of Berkshire’s uncommon success under Warren Buffett. And it now seems appropriate that I independently supplement whatever celebratory comment comes from him... The management system and policies of Berkshire under Buffett (herein together called “the Berkshire system”) were fixed early and are described below: [Tri: I only include some of his points]

(1) Berkshire would be a diffuse conglomerate, averse only to activities about which it could not make useful predictions.-

(3) There would be almost nothing at conglomerate headquarters except a tiny office suite containing a Chairman, a CFO, and a few assistants who mostly helped the CFO with auditing, internal control, etc.

(4) Berkshire subsidiaries would always prominently include casualty insurers. Those insurers as a group would be expected to produce, in due course, dependable underwriting gains while also producing substantial “float” (from unpaid insurance liabilities) for investment.

(6) Berkshire’s Chairman would reserve only a few activities for himself.

(i) He would manage almost all security investments, with these normally residing in Berkshire’s casualty insurers.

(ii) He would choose all CEOs of important subsidiaries, and he would fix their compensation and obtain from each a private recommendation for a successor in case one was suddenly needed.

(iii) He would deploy most cash not needed in subsidiaries after they had increased their competitive advantage, with the ideal deployment being the use of that cash to acquire new subsidiaries.

(iv) He would make himself promptly available for almost any contact wanted by any subsidiary’s CEO, and he would require almost no additional contact.

(vi) He would try to be an exemplar in a culture that would work well for customers, shareholders, and other incumbents for a long time, both before and after his departure.

(vii) His first priority would be reservation of much time for quiet reading and thinking, particularly that which might advance his determined learning, no matter how old he became;

(8) 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.

(9) In buying a new subsidiary, Berkshire would seek to pay a fair price for a good business that the Chairman could pretty well understand. Berkshire would also want a good CEO in place, one expected to remain for a long time and to manage well without need for help from headquarters.

(10) In choosing CEOs of subsidiaries, Berkshire would try to secure trustworthiness, skill, energy, and love for the business and circumstances the CEO was in.

(14) Berkshire would have little debt outstanding as it tried to maintain (i) virtually perfect creditworthiness under all conditions and (ii) easy availability of cash and credit for deployment in times presenting unusual opportunities.

(15) Berkshire would always be user-friendly to a prospective seller of a large business. An offer of such a business would get prompt attention.

... Almost every element was chosen because Buffett believed that, under him, it would help maximize Berkshire’s achievement. He was not trying to create a one-type-fits-all system for other corporations. Indeed, Berkshire’s subsidiaries were not required to use the Berkshire system in their own operations. And some flourished while using different systems.

What was Buffett aiming at as he designed the Berkshire system?

Well, over the years I diagnosed several important themes:

(1) He particularly wanted continuous maximization of the rationality, skills, and devotion of the most important people in the system, starting with himself.

(2) He wanted win/win results everywhere--in gaining loyalty by giving it, for instance.

(3) He wanted decisions that maximized long-term results, seeking these from decision makers who usually stayed long enough in place to bear the consequences of decisions.

(4) He wanted to minimize the bad effects that would almost inevitably come from a large bureaucracy at headquarters.

(5) He wanted to personally contribute, like Professor Ben Graham, to the spread of wisdom attained.

... In particular, Buffett’s decision to limit his activities to a few kinds and to maximize his attention to them, and to keep doing so for 50 years, was a lollapalooza. Buffett succeeded for the same reason Roger Federer became good at tennis.

Buffett was, in effect, using the winning method of the famous basketball coach, John Wooden, who won most regularly after he had learned to assign virtually all playing time to his seven best players. That way, opponents always faced his best players, instead of his second best. And, with the extra playing time, the best players improved more than was normal.

And Buffett much out-Woodened Wooden, because in his case the exercise of skill was concentrated in one person, not seven, and his skill improved and improved as he got older and older during 50 years, instead of deteriorating like the skill of a basketball player does.

Moreover, by concentrating so much power and authority in the often-long-serving CEOs of important subsidiaries, Buffett was also creating strong Wooden-type effects there. And such effects enhanced the skills of the CEOs and the achievements of the subsidiaries.

... Why did Berkshire’s acquisition of companies outside the insurance business work out so well for Berkshire shareholders when the normal result in such acquisitions is bad for shareholders of the acquirer?

Well, Berkshire, by design, had methodological advantages to supplement its better opportunities. It never had the equivalent of a “department of acquisitions” under pressure to buy. And it never relied on advice from “helpers” sure to be prejudiced in favor of transactions. And Buffett held self-delusion at bay as he underclaimed expertise while he knew better than most corporate executives what worked and what didn’t in business, aided by his long experience as a passive investor. And, finally, even when Berkshire was getting much better opportunities than most others, Buffett often displayed almost inhuman patience and seldom bought. For instance, during his first ten years in control of Berkshire, Buffett saw one business (textiles) move close to death and two new businesses come in, for a net gain of one."

• Final Advice from Charlie: Avoid Bureaucracy! "In its early Buffett years, Berkshire had a big task ahead: turning a tiny stash into a large and useful company. And it solved that problem by avoiding bureaucracy and relying much on one thoughtful leader for a long, long time as he kept improving and brought in more people like himself.... I believe that versions of the Berkshire system should be tried more often elsewhere and that the worst attributes of bureaucracy should much more often be treated like the cancers they so much resemble. A good example of bureaucracy fixing was created by George Marshall when he helped win World War II by getting from Congress the right to ignore seniority in choosing generals."

Berkshire Hathaway's 2014 Performance: Buffett's Annual Letter Summary

• Gain in Net Worth: "Berkshire’s gain in net worth during 2014 was $18.3 billion, which increased the per-share book value of both our Class A and Class B stock by 8.3%. Over the last 50 years (that is, since present management took over), per-share book value has grown from $19 to $146,186, a rate of 19.4% compounded annually.*

• "Powerhouse Five" overall doing Well: "Our “Powerhouse Five” – a collection of Berkshire’s largest non-insurance businesses – had a record $12.4 billion of pre-tax earnings in 2014, up $1.6 billion from 2013. The companies in this sainted group are Berkshire Hathaway Energy (formerly MidAmerican Energy), BNSF, IMC (I’ve called it Iscar in the past), Lubrizol and Marmon... Of the five, only Berkshire Hathaway Energy, then earning $393 million, was owned by us a decade ago."

• Issues at BNSF in 2014 - needs to get better: " Our bad news from 2014 comes from our group of five as well and is unrelated to earnings. During the year, BNSF disappointed many of its customers. These shippers depend on us, and service failures can badly hurt their businesses... BNSF is, by far, Berkshire’s most important non-insurance subsidiary and, to improve its performance, we will spend $6 billion on plant and equipment in 2015. That sum is nearly 50% more than any other railroad has spent in a single year and is a truly extraordinary amount, whether compared to revenues, earnings or depreciation charges... our responsibility is to do whatever it takes to restore our service to industry-leading levels. That can’t be done overnight: The extensive work required to increase system capacity sometimes disrupts operations while it is underway."

• Insurance division doing well: "Berkshire’s huge and growing insurance operation again operated at an underwriting profit in 2014 – that makes 12 years in a row – and increased its float. During that 12-year stretch, our float – money that doesn’t belong to us but that we can invest for Berkshire’s benefit – has grown from $41 billion to $84 billion... Meanwhile, our underwriting profit totaled $24 billion during the twelve-year period, including $2.7 billion earned in 2014. And all of this began with our 1967 purchase of National Indemnity for $8.6 million."

• Subsidiaries actively looking for (and doing) Acquisitions: "While Charlie and I search for new businesses to buy, our many subsidiaries are regularly making bolt-on acquisitions. Last year was particularly fruitful: We contracted for 31 bolt-ons, scheduled to cost $7.8 billion in aggregate. The size of these transactions ranged from $400,000 to $2.9 billion. However, the largest acquisition, Duracell, will not close until the second half of this year. ... Charlie and I encourage bolt-ons, if they are sensibly-priced. (Most deals offered us aren’t.)"

• Expecting more Deals with 3G Capital: "Two years ago my friend, Jorge Paulo Lemann, asked Berkshire to join his 3G Capital group in the acquisition of Heinz. My affirmative response was a no-brainer: I knew immediately that this partnership would work well from both a personal and financial standpoint. And it most definitely has...They [in managing Heinz] hold themselves to extraordinarily high performance standards and are never satisfied, even when their results far exceed those of competitors. We expect to partner with 3G in more activities. Sometimes our participation will only involve a financing role, as was the case in the recent acquisition of Tim Hortons by Burger King. Our favored arrangement, however, will usually be to link up as a permanent  equity partner (who, in some cases, contributes to the financing of the deal as well). Whatever the structure, we feel good when working with Jorge Paulo."

• New Acquisition "car guys": "In October, we contracted to buy Van Tuyl Automotive, a group of 78 automobile dealerships that is exceptionally well-run. Larry Van Tuyl, the company’s owner, and I met some years ago. He then decided that if he were ever to sell his company, its home should be Berkshire. Our purchase was recently completed, and we are now “car guys.”... With the acquisition of Van Tuyl, Berkshire now owns 91⁄2  companies that would be listed on the Fortune 500 were they independent (Heinz is the 1⁄2). That leaves 4901⁄2  fish in the sea. Our lines are out."

• Important to have hands-on Business Managing Experience to supplement Investment experience: "I’ve mentioned in the past that my experience in business helps me as an investor and that my investment experience has made me a better businessman. Each pursuit teaches lessons that are applicable to the other.... "There are certain things that cannot be adequately explained to a virgin either by words or pictures.”... I therefore think it’s worthwhile for Todd Combs and Ted Weschler, our two investment managers, to each have oversight of at least one of our businesses. A sensible opportunity for them to do so opened up a few months ago when we agreed to purchase two companies that, though smaller than we would normally acquire, have excellent economic characteristics. Combined, the two earn $100 million annually on about $125 million of net tangible assets. I’ve asked Todd and Ted to each take on one as Chairman, in which role they will function in the very limited way that I do with our larger subsidiaries. This arrangement will save me a minor amount of work and, more important, make the two of them even better investors than they already are (which is to say among the best)."

• Common Stock Investments Doing Well, except for a $444 million Mistake: "Attentive readers will notice that Tesco, which last year appeared in the list of our largest common stock investments, is now absent. An attentive investor, I’m embarrassed to report, would have sold Tesco shares earlier. I made a big mistake with this investment by dawdling. At the end of 2012 we owned 415 million shares of Tesco, then and now the leading food retailer in the U.K. and an important grocer in other countries as well. Our cost for this investment was $2.3 billion, and the market value was a similar amount. In 2013, I soured somewhat on the company’s then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior “thumb-sucking.” (Considering what my delay cost us, he is being kind.) During 2014, Tesco’s problems worsened by the month. The company’s market share fell, its margins contracted and accounting problems surfaced. In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives. We sold Tesco shares throughout the year and are now out of the position. (The company, we should mention, has hired new management, and we wish them well.) Our after-tax loss from this investment was $444 million..."

Until next year!

Regards

Tri I. Suseno