Warren Buffett just released his annual (2016) Berkshire Hathaway shareholder letter over the weekend. You can find it here along with all of his annual shareholder letters dating back to 1977. I have read all of them. I recommend reading each of them because in addition to learning something about accounting, economics, finance, or tax, you can gain wisdom about life from each of his letters.
My thoughts and what I gathered from the 2016 letter:
- Berkshire Hathaway is my largest holding as shown in my Stock Holdings page. The stock was up 23.4% in 2016 while the S&P 500 was up 12%. Since 1964, the shares of Berkshire Hathaway have produced an overall gain of 1,972,595% while the S&P 500 has delivered an overall gain of 12,717%. A substantial difference in ending wealth if you held Berkshire Hathaway shares during this period instead of the S&P 500.
- Buffet believes Berkshire’s intrinsic value far outweighs its book value today. Book value is around $172,000/share while the A shares trade at $255,000/share. Usually each year, Whitney Tilson does an update of what he believes Berkshire’s intrinsic value to be. I would think that Berkshire’s intrinsic value is close to $255,000/share (probably higher) then $172,000/share.
- Buffett is candid in pointing out his failures. This highlights Buffett’s high emotional intelligence as he knows that he is not perfect – even being one of the richest men on earth. This is something that I have always admired about him. In this passage, he is talking about bad purchases in terms of accounting treatment but he is nonetheless stating that he has made mistakes when buying businesses: “As is the case in marriage, business acquisitions often deliver surprises after the “I do’s.” I’ve made some dumb purchases, paying far too much for the economic goodwill of companies we acquired. That later led to goodwill write-offs and to consequent reductions in Berkshire’s book value. We’ve also had some winners among the businesses we’ve purchased – a few of the winners very big – but have not written those up by a penny.” He recognizes his errors at other points in the letter as well, “Despite that cautious approach, I made one particularly egregious error, acquiring Dexter Shoe for $434 million in 1993. Dexter’s value promptly went to zero.” He does not stop there, “It was, nevertheless, a terrible mistake on my part to issue 272,200 shares of Berkshire in buying General Re, an act that increased our outstanding shares by a whopping 21.8%. My error caused Berkshire shareholders to give far more than they received (a practice that – despite the Biblical endorsement – is far from blessed when you are buying businesses).”
- As I have mentioned here before, one should be prepared to act in full when investment opportunities present themselves. For example, consider the buying opportunities that arose in late 2008 and early 2009 when the world was in an economic crisis. Buffett alludes to being prepared to act when bargains are numerous. I think this means being patient and having cash on hand to invest when opportunties slap you in the face: “Some years, the gains in underlying earning power we achieve will be minor; very occasionally, the cash register will ring loud. Charlie and I have no magic plan to add earnings except to dream big and to be prepared mentally and financially to act fast when opportunities present themselves. Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”
- Buffett continues to show his optimism for American economic progress over the long-term. I agree with him. While there are likely to be short-term dips in the economy here and there, over the long-term standard of living should continue to increase: “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.” He touches on this point again. One should be contrarian when it comes to fear and large stock market declines. Buy when everyone else is selling: “Many companies, of course, will fall behind, and some will fail. Winnowing of that sort is a product of market dynamism. Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.” He goes on: “During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.”
- Berkshire’s insurance business is still its most important. The float (accumulated premiums before insurance payouts are made) is almost $100B! This float is used to make investments and can derive significant investment income before insurance payouts have to be made. The float is reported as a liability on the balance sheet but it acts more like an asset because it continues to grow each year allowing Buffett to invest. Thus, using leverage. Berkshire has operated at an underwriting profit for 14 consecutive years, accumulating before tax profits of $28B!
- Berkshire’s railway (BNSF) and energy (Berkshire Hathaway Energy) division continued to make significant capital investments as it positions itself for growth, particularly in renewables. Despite low oil prices, BNSF’s profits held up well while earnings within Berkshire Hathaway Energy were up year over year.
- Earnings for the manufacturing, services, and retailing division were up significantly year over year. This includes Berkshire’s automotive group, Duracell, Precision Castparts, and See’s Candies.
- Buffett shows his disdain for earnings “adjusted” from GAAP numbers. Particularly those earnings adjusted to remove restructuring and stock-based compensation expenses. His position is that restructuring costs are very much part of the business so they should not be adjusted away when reporting earnings. In addition, stock-based compensation expense is a very real cost because it will hit your earnings per share and reduce the piece of the pie for all of the other shareholders. I agree with him.
- Berkshire’s marketable securities had a significant unrealized capital gain at year-end (nearly $60B). Its largest holdings by value include Kraft Heinz, Coca-Cola, American Express, IBM, Wells Fargo, and Apple. This large gain is not surprising though since the stock market has risen significantly recently and many of Berkshire’s marketable securities have been held for more than a decade.
- The most interesting part of the letter I found was Buffett’s discussion of a bet he made in the 2005 annual report where his position was that active management by professionals would underperform the returns of an amateur who simply bought a low-cost S&P 500 index fund. The bet was that no investment professional could select at a least a minimum of five hedge funds that would over a long period of time (10 years) match the performance of an S&P 500 index fund. What happened through 9 years (the bet started on January 1, 2008)? The S&P 500 compounded at an annual rate of 7.1% and the five funds-of-funds (active management) delivered 2.2% compounded annually. On $1M invested, that is over $600,000 in more wealth created by the S&P 500 index fund compared to active management! Buffett concludes: “The 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. Both large and small investors should stick with low-cost index funds.”