As always, the investment media have sliced and diced the 13-page letter handcrafted by the Oracle of Omaha himself. As is usually the case, there are lots of little gems from the long-time investor.
When it comes to Berkshire’s performance in 2019, it didn’t deliver the goods. It generated an 11% return over the past year, about one-third the 31.5% annual return for the S&P 500, including dividends.
It’s not an entirely accurate reflection of how Berkshire did relative to the index because the 11% return doesn’t include any of the dividends the company receives from its massive equity portfolio. That alone is worth several percentage points of performance, I would think.
There’s a lot to like from this year’s annual letter. Here are 10 things that stand out for me.
Warren Buffett Doesn’t Like the New GAAP Rule
Of course, that net margin is inflated by a significant amount due to the 2018 rule that requires Berkshire Hathaway and every other holding company in America to include in net earnings the net change in the company’s unrealized gains and losses from the stocks it owns. That includes Apple, its most significant position.
Berkshire had a $53.7 billion increase in unrealized gains over the past 12 months. Exclude these gains and the company’s net margin goes from 32% to 10.9%, well below Apple’s net margin.
Buffett advises investors to focus on the company’s operating earnings and not its unrealized gains and losses.
Warren Buffett Says Retained Earnings Are a Good Thing
Buffett and his partner, Charlie Munger, believe wholeheartedly in the idea of retained earnings. They think that to keep growing the businesses you own, you have to invest capital in those businesses to keep them modern and up to date. You can’t do that without retained earnings.
An amazing statistic: Berkshire has invested $121 billion over the past decade on property, plant and equipment to keep the company from grinding to a halt. That’s a massive amount of money, but that’s money that can’t be provided for without retained earnings.
One need look no further than the past 17 years since Eddie Lampert took control of Kmart in 2003 and then Sears a year later. At every turn, Lampert looked to take money out of the business, most notably the special dividends Sears received from Sears Canada over the years.
In years past, as Buffett has done again in this year’s letter, he points out that although Berkshire’s share of Apple dividends is $773 million, the company’s share of Apple’s retained earnings is $2.5 billion. While it doesn’t get any of these retained earnings, they will help increase the value of Apple’s stock for years to come.
And Berkshire benefits once more.
Warren Buffett Loves Dividends
On the same page that Buffett discusses retained earnings, he also discussed dividends. In 2019, Berkshire’s top 10 holdings paid the company $3.8 billion in dividends. Of those 10, Apple, Bank of America (NYSE:BAC), Coca-Cola (NYSE:KO) and Wells Fargo (NYSE:WFC) accounted for three-quarters of the $3.8 billion in dividends.
I know a financial advisor in Victoria, British Columbia, who refers to dividends as rent checks. While it’s not an original term, it illustrates their compounding effect, just like retained earnings. Interestingly, Buffett continues to eschew paying out dividends to Berkshire shareholders.
At some point, he might decide as he has with share repurchases, that it’s time for this leopard to change its spots.
In 2019, Berkshire received a total of $15.6 billion in dividends and distributions, which accounts for 65% of its operating earnings. It repurchased $4.9 billion of its stock, all paid for from the dividends it receives.
Thanks to dividends, unlike many companies, it will never have to borrow money to repurchase its shares.
Warren Buffett Likens Acquisitions to Marriage
I’ve never been a fan of large acquisitions, primarily because CEOs generally overpay. Therefore, it was nice to see Buffett compare acquisitions to marriage in this year’s letter.
“In reviewing my uneven record, I’ve concluded that acquisitions are similar to marriage: They start, of course, with a joyful wedding — but then reality tends to diverge from pre-nuptial expectations. Sometimes, wonderfully, the new union delivers bliss beyond either party’s hopes,” Buffett wrote. “In other cases, disillusionment is swift. Applying those images to corporate acquisitions, I’d have to say it is usually the buyer who encounters unpleasant surprises. It’s easy to get dreamy-eyed during corporate courtships.”
He goes on to state the company’s record on acquisitions has generally been acceptable. But a number of them have caused him to question his initial intent.
While Buffett doesn’t say in this year’s report whether BNSF was one of his best acquisitions — I believe he said so in the past — he does point out that the railroad it acquired in 2009 for $26 billion in cash and stock is a vital part of the company’s non-insurance operations, along with Berkshire Hathaway Energy. Together, the two earned $8.3 billion in 2019.
Failing to bag the elephant has probably saved the company more money than it’s lost.
Warren Buffett Loves the Property and Casualty Industry
It’s not hard to understand why both Warren Buffett and Charlie Munger are high on the property and casualty business. It is what’s propelled Berkshire into the company it is today. Paying $8.6 million for National Indemnity in 1967, according to the annual shareholder letter, it is the largest P&C company in the world measured by net worth.
Buffett goes on to explain the concept of float.
“One reason we were attracted to the P/C business was the industry’s business model: P/C insurers receive premiums upfront and pay claims later,” stated the 2019 annual shareholder letter. “In extreme cases, such as claims arising from exposure to asbestos, or severe workplace accidents, 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.”
In 1970, the company’s float was $39 million. Today, it’s $129.4 billion, leaving the company with additional financial flexibility.
As the company likes to point out, Berkshire’s P&C companies have generated an underwriting profit in 16 out of 17 of the last years. While it’s great to have investment profits, it is the focus on underwriting profits that will keep the company at the top of the heap when it comes to the insurance industry.
Warren Buffett Explains the Beauty of Utilities
Berkshire Hathaway entered the utility business in 2000, buying 76% of Mid-American Energy for $9 billion in cash and debt. Other investors, including Warren Buffett’s long-time friend and board member, Walter Scott, put up the remaining equity.
In 2004 Mid-American Energy became Berkshire Hathaway Energy (BHE). Buffett’s Berkshire owns 91% of the company. Walter Scott and BHE CEO Greg Abel hold the rest.
“BHE has never paid Berkshire Hathaway a dividend since our purchase and has, as the years have passed, retained $28 billion of earnings. That pattern is an outlier in the world of utilities, whose companies customarily pay big dividends — sometimes reaching, or even exceeding, 80% of earnings. Our view: The more we can invest, the more we like it,” Buffett writes.
It’s interesting to see how Berkshire allocates capital.
On the one hand, it receives more than $15 billion annually in dividends from its various operations and equity holdings. Yet, when it comes to BHE, it chooses to reinvest those potential dividends in the business, forsaking short-term gains for more substantial increases in the future.
Remember, the utility business, especially the regulated component, is all about building a rate base. However, because it’s been able to invest significant sums in wind-generated electricity, the rate customers pay in many cases is much lower than its competitors.
That’s a win-win situation.
Warren Buffett Reflects on Equity Holdings
It’s unlikely that any section of the annual shareholder letter gets a more thorough examination than the investments section, which outlines the company’s equity holdings. The letter itself lists the top 15 Berkshire holdings.
As I said earlier, its top 10 holdings paid the company $3.8 billion in dividends in 2019. Of the top 15, the difference between the market value and its tax-basis cost as of the end of December was $137.7 billion. Of the 15 stocks, the biggest cumulative return would be Coca-Cola, where a $1.3 billion investment has turned into $22.1 billion. American Express (NYSE:AXP) and Wells Fargo would be the next largest gains.
Buffett’s most important comment about the equity investments, as it relates to individual investors like you or me, ought to provide some confidence at times like the present.
“What we can say is that if something close to current rates should prevail over the coming decades and if corporate tax rates also remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term, fixed-rate debt instruments.”
So, if you think you’re going to live as long as Buffett has, you might want to keep your equity weighting relatively high, despite the current coronavirus-led correction.
Warren Buffett Discusses Berkshire After He’s Gone
The succession issue is one of Berkshire Hathaway’s biggest negatives.
While Buffett and Munger maintain they’ve prepared the company for the eventuality of their mutual demise, they’ve yet to crown the CEO successor, and that troubles some.
However, this year’s letter makes it clear that the machinations for change are firmly in place. To go beyond that explanation would be like cheering for your demise. It isn’t going to happen.
“Charlie and I long ago entered the urgent zone,” Buffett writes. “That’s not exactly great news for us. But Berkshire shareholders need not worry: Your company is 100% prepared for our departure.”
The letter goes on to highlight five reasons why Munger and Buffett are optimistic about the company’s future long after they’re gone. One of the primary reasons, as I see it, is that it has top-notch talent running its various operations.
As for the $248 billion equity portfolio, Buffett, Ted Weschler and Todd Combs currently share their oversight.
Buffett recently appointed Combs as CEO of its Geico insurance subsidiary. Combs replaced Bill Roberts, who turned 70 in the past year and wanted to retire. Combs, who is only 48, will continue to manage $14 billion of Berkshire’s equities while running Geico.
While some might consider this too much work for Combs, the lessons he learns running Geico will be far more valuable to Berkshire shareholders than the time he puts into finding more stocks to buy.
If Buffett weren’t thinking about succession, Combs’ appointment wouldn’t have happened.
Warren Buffett Talks Corporate Governance
Interestingly, Buffett states that over the last 62 years, he’s served as a director on the board of 21 public companies. Relative to you or I, that’s a tremendous number. However, for the fourth-wealthiest person in the world, it seems kind of low. But in a good way.
I guess that Buffett’s service on public company boards happened more often in Berkshire’s earlier years. At some point, he must have come to the realization it wasn’t worth his time to make the required board meetings. After all, it’s not as if Tim Cook wouldn’t take his call unless Buffett were a board member.
One positive today is that companies must gather board members to discuss the CEO’s performance.
However, on the downside, he points out that director compensation, much like CEO compensation, has risen to levels far higher than the average income in America.
“Think, for a moment, of the director earning $250,000-300,000 for board meetings consuming a pleasant couple of days six or so times a year. Frequently, the possession of one such directorship bestows on its holder three to four times the annual median income of the U.S. households.”
It’s pretty hard to say no to a CEO’s crazy acquisition idea when you’re getting that kind of money. He goes on to say he once looked at the proxy of a large corporation and found that eight directors had never paid for a single share with their own money. Not a one.
In the 1960s, my grandfather was the president of Famous Players, a Canadian theater chain now owned by Cineplex (OTCMKTS:CPXGF). He got a weekly paycheck and a small percentage of the profits (maybe 1.5%-2.5%). He had to buy stock with his own money. There were no freebies like today.
Warren Buffett Wants to Pay More Taxes
Buffett brags that Berkshire sent $3.6 billion to the U.S. Treasury to pay for its yearly income tax. That represents 1.5% of the entire $243 billion collected in 2019 for corporate income tax payments.
“Fifty-five years ago, when Berkshire entered its current incarnation, the company paid nothing in federal income tax. (For good reason, too: Over the previous decade, the struggling business had recorded a net loss.) Since then, as Berkshire retained nearly all of its earnings, the beneficiaries of that policy became not only the company’s shareholders but also the federal government. In most future years, we both hope and expect to send far larger sums to the Treasury.”
Buffett’s on record as saying he’d gladly pay more taxes. The only problem is that he’s also on the record before President Donald Trump’s tax cut, saying he’d like to see the corporate tax rate lowered from 35% to 21%. That tax cut favored the wealthy who own most of the public company stock in the U.S.
The Oracle of Omaha does have a penchant for speaking out of both sides of his mouth. Other than that, there’s a lot to be learned from this year’s annual letter.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.