Each year at around this time, I summarise Warren Buffett’s annual
shareholder letter. The 2015 letter just came out 12 hours or so ago. Below are
the key points I found interesting:
Berkshire’s Gain in Net
Worth in 2015: “Berkshire’s gain in net worth
during 2015 was $15.4 billion, which increased the per-share book value of both
our Class A and Class B stock by 6.4%. Over the last 51 years (that is, since
present management took over), per-share book value has grown from $19 to
$155,501, a rate of 19.2% compounded annually.”
Berkshire Share Buyback
Strategy: “Today, the large – and growing –
unrecorded gains at our “winners” make it clear that Berkshire’s intrinsic
value far exceeds its book value.
That’s why we would be delighted to repurchase our shares should they sell as
low as 120% of book value. At that level, purchases would instantly and
meaningfully increase per-share intrinsic value for Berkshire’s continuing
shareholders.”
Highlights on Performance:
·
Burlington Northern and
Santa Fe (BNSF): “For most American railroads, 2015
was a disappointing year. Aggregate ton-miles fell, and earnings weakened as
well. BNSF, however, maintained volume, and pre-tax income rose to a record
$6.8 billion (a gain of $606 million from 2014). Matt Rose and Carl Ice, the
managers of BNSF, have my thanks and deserve yours.”
·
Precision Castparts Corp
(PCC) – new acquisition: “… a business that we
purchased a month ago for more than $32 billion of cash. PCC fits perfectly into
the Berkshire model and will substantially increase our normalized per-share earning power… Under CEO Mark Donegan, PCC has become the
world’s premier supplier of aerospace components (most of them destined to be
original equipment, though spares are important to the company as well)… PCC’s
products, often delivered under multi-year contracts, are key components in
most large aircraft. Other industries are served as well by the company’s
30,466 employees, who work out of 162 plants in 13 countries. In building his
business, Mark has made many acquisitions and will make more. We look forward
to having him deploy Berkshire’s capital.”
·
Insurance Operations: “Berkshire’s huge and growing insurance operation again operated
at an underwriting profit in 2015 – that makes 13 years in a row – and
increased its float. During those years, our float – money that doesn’t belong to
us but that we can invest for Berkshire’s benefit – grew from $41 billion to
$88 billion.” And “…Meanwhile, our underwriting profit totaled $26 billion
during the 13-year period, including $1.8 billion earned in 2015. Without a
doubt, Berkshire’s largest unrecorded wealth lies in its insurance business. We’ve
spent 48 years building this multi-faceted operation, and it can’t be
replicated.” And “…The property-casualty (“P/C”) branch of that industry has
been the engine that has propelled our expansion since 1967, when we acquired
National Indemnity and its sister company, National Fire & Marine, for $8.6
million.”
·
Bolt-On Acquisitions by
Subsidiaries: “While Charlie and I search for new
businesses to buy, our many subsidiaries are regularly making bolt-on acquisitions.
Last year we contracted for 29 bolt-ons, scheduled to cost $634 million in
aggregate. The cost of these purchases ranged from $300,000 to $143 million.”
·
Heinz Partnership with 3G
Capital: “Our Heinz partnership with Jorge Paulo
Lemann, Alex Behring and Bernardo Hees more than doubled its size last year by
merging with Kraft. Before this transaction, we owned about 53% of Heinz at a
cost of $4.25 billion. Now we own 325.4 million shares of Kraft Heinz (about
27%) that cost us $9.8 billion. The new company has annual sales of $27 billion”
and “…Berkshire also owns Kraft Heinz preferred shares that pay us $720 million
annually and are carried at $7.7 billion on our balance sheet. That holding
will almost certainly be redeemed for $8.32 billion in June (the earliest date
allowed under the preferred’s terms). That will be good news for Kraft Heinz
and bad news for Berkshire.” “… Jorge Paulo and his associates could not be
better partners. We share with them a passion to buy, build and hold large businesses that satisfy basic
needs and desires… Their method, at
which they have been extraordinarily successful, is to buy companies that offer
an opportunity for eliminating many unnecessary costs and then – very promptly – to make the moves that
will get the job done. Their actions significantly boost productivity, the
all-important factor in America’s economic growth over the past 240 years.
Without more output of desired goods and services per working hour – that’s the
measure of productivity gains – an economy inevitably stagnates. At much of
corporate America, truly major gains in productivity are possible, a fact
offering opportunities to Jorge Paulo and his associates.”
·
On Extreme Decentralization
and Future Partnerships (like that with 3G Capital):
“We will continue to operate with extreme – indeed, almost unheard of –
decentralization at Berkshire. But we will also look for opportunities to
partner with Jorge Paulo, either as a financing partner, as was the case when
his group purchased Tim Horton’s, or as a combined equity-and-financing
partner, as at Heinz. We also may occasionally partner with others, as we have
successfully done at Berkadia.”
·
Large Stock Holdings and the
Flexibility They Bring: “Berkshire increased its
ownership interest last year in each of its “Big Four” investments – American Express,
Coca-Cola, IBM and Wells Fargo. We purchased additional shares of IBM
(increasing our ownership to 8.4% versus 7.8% at yearend 2014) and Wells Fargo
(going to 9.8% from 9.4%). At the other two companies, Coca-Cola and American
Express, stock repurchases raised our percentage ownership. Our equity in Coca-Cola
grew from 9.2% to 9.3%, and our interest in American Express increased from
14.8% to 15.6%... These four investees
possess excellent businesses and are run by managers who are both talented and shareholder-oriented.
Their returns on tangible equity range from excellent to staggering.” And “…Our
flexibility in capital allocation – our willingness to invest large sums
passively in non-controlled businesses – gives us a significant edge over
companies that limit themselves to acquisitions they will operate. Woody Allen
once explained that the advantage of being bi-sexual is that it doubles your
chance of finding a date on Saturday night. In like manner – well, not exactly
like manner – our appetite for either operating businesses or passive
investments doubles our chances of
finding sensible uses for Berkshire’s endless gusher of cash. Beyond that,
having a huge portfolio of marketable securities gives us a stockpile of funds
that can be tapped when an elephant-sized acquisition is offered to us.”
On America and Capitalism:
“The babies being born in America today are the
luckiest crop in history.
“…Nothing rivals the market system in producing what people want –
nor, even more so, in delivering what people don’t yet know they want.
“…For 240 years it’s been a terrible mistake to bet against America,
and now is no time to start. America’s golden goose of commerce and innovation
will continue to lay more and larger eggs. America’s social security promises
will be honored and perhaps made more generous. And, yes, America’s kids will
live far better than their parents did.”
Berkshire’s Insurance
Float (recorded as Liability in Balance Sheet) is in fact a Costless and
Long-Enduring Revolving Fund (Tri’s comment: With no covenants!): “So how does our float affect intrinsic value? When Berkshire’s book value is calculated, the full amount
of our float is deducted as a liability,
just as if we had to pay it out tomorrow and could not replenish it. But to
think of float as strictly a liability is incorrect. It should instead be
viewed as a revolving fund. Daily, we pay old claims and related expenses – a
huge $24.5 billion to more than six million claimants in 2015 – and that
reduces float. Just as surely, we each day write new business that will soon
generate its own claims, adding to float.
“If our revolving float is both costless and long-enduring, which I
believe it will be, the true value of this liability is dramatically less than the accounting liability. Owing $1 that in
effect will never leave the premises – because new business is almost certain
to deliver a substitute – is worlds different from owing $1 that will go out
the door tomorrow and not be replaced. The two types of liabilities, however,
are treated as equals under GAAP.
“…Its value [value of costless and growing float] today is one
reason – a huge reason – why we [Munger and Buffett] believe Berkshire’s
intrinsic business value substantially exceeds its book value.”
Disciplined Insurance
Operators need to do the following: “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.”
“Disciplined risk evaluation is the daily focus of all of our
insurance managers, who know that while float is valuable, its benefits can be
drowned by poor underwriting results. All insurers give that message lip
service. At Berkshire it is a religion, Old Testament style.”
Keeping Prices Low
(Competitive) in Berkshire’s Regulated, Capital-Intensive Businesses: “In Iowa, [Berkshire Hathaway Energy] BHE’s average retail rate is 6.8¢
per kWh. Alliant, the other major electric utility in the state, averages 9.5¢.
Here are the comparable industry figures for adjacent states: Nebraska 9.0¢,
Missouri 9.3¢, Illinois 9.3¢, Minnesota 9.7¢. The national average is 10.4¢.
Our rock-bottom prices add up to real money for paycheck-strapped customers.
“…At BNSF (Burlington Northern and Santa Fe), … To supply a very crude measure, … our revenue per
ton-mile was just under 3¢ last year, while shipping costs for customers of the
other four major U.S.-based railroads were at least 40% higher, ranging from
4.2¢ to 5.3¢.”
Some Lessons in
Accounting:
·
On Amortisation of Intangibles: “serious
investors should understand the disparate nature of intangible assets. Some
truly deplete in value over time, while others in no way lose value. For software, as a big example, amortization
charges are very real expenses. Conversely, the concept of recording charges
against other intangibles, such as customer relationships, arises from
purchase-accounting rules and clearly does not reflect economic reality. GAAP
accounting draws no distinction between the two types of charges. Both, that
is, are recorded as expenses when earnings are calculated – even though, from
an investor’s viewpoint, they could not differ more.” And “…We now have $6.8
billion left of amortizable intangibles, of which $4.1 billion will be expensed
over the next five years. Eventually, of course, every dollar of these “assets”
will be charged off. When that happens, reported earnings increase even if true
earnings are flat. (My gift to my successor.) I suggest that you ignore a
portion of GAAP amortization costs.”
·
On Depreciation: “Depreciation charges
are a more complicated subject but are almost always true costs. Certainly they
are at Berkshire. I wish we could keep our businesses competitive while
spending less than our depreciation charge, but in 51 years I’ve yet to figure
out how to do so. Indeed, the depreciation charge we record in our railroad
business falls far short of the capital outlays needed to merely keep the
railroad running properly, a mismatch that leads to GAAP earnings that are
higher than true economic earnings.”
·
“…Our public reports of
earnings will, of course, continue to conform to GAAP. To embrace reality,
however, you should remember to add back most of the amortization charges we
report. You should also subtract something to reflect BNSF’s inadequate
depreciation charge.”
Focus on High Return on
Net Tangible Assets Business: “Some of this
sector’s businesses [manufacturing, service and retailing operations], measured
by earnings on unleveraged net tangible
assets, enjoy terrific economics, producing profits that run from 25% after-tax
to far more than 100%. Others generate good returns in the area of 12% to 20%.
“… Viewed as a single entity, the companies in this group are an
excellent business. They employed an average of $25.6 billion of net tangible
assets during 2015 and, despite their holding large quantities of excess cash
and using only token amounts of leverage, earned 18.4% after-tax on that
capital.”
On Clayton Homes (Pre-tax
Earnings: $416M (2013), $558M (2014), $706M (2015)): “Kevin Clayton has again delivered an industry-leading performance
at Clayton Homes, the second-largest home builder in America. Last year, the
company sold 34,397 homes, about 45% of the manufactured homes bought by
Americans. In contrast, the company was number three in the field, with a 14%
share, when Berkshire purchased it in 2003.
“Manufactured homes allow the American dream of home ownership to be
achieved by lower-income citizens: Around 70% of new homes costing $150,000 or
less come from our industry.
“…Key to Clayton’s operation is its $12.8 billion mortgage
portfolio. We originate about 35% of all mortgages on manufactured homes. About
37% of our mortgage portfolio emanates from our retail operation, with the
balance primarily originated by independent retailers,
“…Lenders other than Clayton have come and gone. With Berkshire’s
backing, however, Clayton steadfastly financed home buyers throughout the panic
days of 2008-2009.”
Top 15 Common Stocks
Position (excluding Kraft Heinz which was ‘control’ à i.e., accounted for on the “equity” method): See screenshot attached [Tri’s
comment: Note $4.4 billion investment Phillips 66 -> Buffett calling oil’s bottoming price?]
Buffett’s Use of
Long-Dated Derivative (combined with Preferred): “Berkshire
has one major equity position that is not included in the [stock investments]
table: We can buy 700 million shares of Bank of America at any time prior to
September 2021 for $5 billion. At yearend these shares were worth $11.8 billion.
We are likely to purchase them just before expiration of our option and, if we
wish, we can use our $5 billion of Bank of America 6% preferred to fund the
purchase. In the meantime, it is important for you to realize that Bank of
America is, in effect, our fourth largest equity investment – and one we value
highly.”
Prosperity comes from
Increasing Productivity: “Earlier, I told you how
our partners at Kraft Heinz [3G Capital] root out inefficiencies, thereby
increasing output per hour of employment. That kind of improvement has been the
secret sauce of America’s remarkable gains in living standards since the
nation’s founding in 1776. Unfortunately, the label of “secret” is appropriate:
Too few Americans fully grasp the linkage between productivity and prosperity.”
Berkshire Example of Increased
Productivity - BNSF: “Our own BNSF was formed in
1995 by a merger between Burlington Northern and Santa Fe. In 1996, the merged
company’s first full year of operation, 411 million ton-miles of freight were
transported by 45,000 employees. Last year the comparable figures were 702
million ton-miles (plus 71%) and 47,000 employees (plus only 4%). That dramatic
gain in productivity benefits both owners and shippers.”
Berkshire Example of Increased
Productivity – GEICO: “GEICO employs about 34,000
people to serve its 14 million policyholders. I can only guess at the workforce
it would require to serve a similar number of policyholders under the agency
system [Tri’s Note: GEICO sells direct, without using insurance agents]. I
believe, however, that the number would be at least 60,000, a combination of
what the insurer would need in direct employment and the personnel required at
supporting agencies.”
Berkshire Example of
Increased Productivity – Berkshire Hathaway Energy (“BHE”): “BHE acquired its Iowa utility in 1999. In the year before, that
utility employed 3,700 people and produced 19 million megawatt-hours of
electricity. Now we employ 3,500 people and produce 29 million megawatthours. That
major increase in efficiency allowed us to operate without a rate increase for
16 years, a period during which industry rates increased 44%.
“… In 2006 BHE purchased PacifiCorp, which operated primarily in
Oregon and Utah. The year before our purchase PacifiCorp employed 6,750 people
and produced 52.6 million megawatt-hours. Last year the numbers were 5,700
employees and 56.3 million megawatt-hours.”
On Risk - Reducing Coal
Volume for BNSF: “BNSF, along with other railroads,
is certain to lose significant coal volume over the next decade.”
On Risk - Impact of Driverless
Cars: “At some point in the future – though not, in
my view, for a long time – GEICO’s premium volume may shrink because of
driverless cars. This development could hurt our auto dealerships as well.”
On Risk - Reducing
Circulation of Print Newspapers: “Circulation of
our print newspapers will continue to fall, a certainty we allowed for when purchasing
them.”
On Risk - Climate Change effect
on Insurance Business: “Up to now, climate change
has not produced more frequent nor
more costly hurricanes nor other weather related events covered by insurance.
As a consequence, U.S. super-cat rates have fallen
steadily in recent years, which is why we have backed away from that business. If
super-cats become costlier and more frequent, the likely – though far from
certain – effect on Berkshire’s insurance business would be to make it larger
and more profitable.
As a citizen, you may understandably find climate change keeping you
up nights. As a homeowner in a low-lying area, you may wish to consider moving.
But when you are thinking only as a shareholder of a major insurer, climate
change should not be on your list of worries.”
And
“It’s understandable that the sponsor of the proxy proposal believes
Berkshire is especially threatened by climate change because we are a huge
insurer, covering all sorts of risks. The sponsor may worry that property losses
will skyrocket because of weather changes. And such worries might, in fact, be
warranted if we wrote ten- or twenty-year policies at fixed prices. But insurance
policies are customarily written for one year and repriced annually to reflect
changing exposures. Increased possibilities of loss translate promptly into
increased premiums.”
Annual Meeting Webcast in
the internet this year: “Charlie and I have finally
decided to enter the 21st Century. Our
annual meeting this year will be webcast worldwide in its entirety. To view the
meeting, simply go to https://finance.yahoo.com/brklivestream
at 9 a.m. Central Daylight Time on Saturday, April 30th . The Yahoo!
webcast will begin with a half hour of interviews with managers, directors and
shareholders. Then, at 9:30, Charlie and I will commence answering questions.”
Book Recommendations:
·
Limping on Water, by Phil Beuth. “an
autobiography that chronicles his life at Capital Cities Communications and
tells you a lot about its leaders, Tom Murphy and Dan Burke. These two were the
best managerial duo – both in what
they accomplished and how they did it – that Charlie and I ever
witnessed. Much of what you become in life depends on whom you choose to admire
and copy. Start with Tom Murphy, and you’ll never need a second exemplar.”
·
Warren Buffett’s Ground Rules, by Jeremy
Miller. “Mr. Miller has done a superb job of researching and dissecting the
operation of Buffett Partnership Ltd. and of explaining how Berkshire’s culture
has evolved from its BPL origin. If you are fascinated by investment theory and
practice, you will enjoy this book.”
