Reviewing the 2018 Berkshire Hathaway Chairman’s Letter

by Evan

It has been more than a few years since I have read The Snowball: Warren Buffett and the Business of Life, and it still stands as one of my favorite books.  It may be the only book I have read more than twice (in fact I may put that on my audio book list this year for a refresher).  Whether you are a Buffett fan-boy or not, most people who I have urged to read the book enjoyed it.  It takes an honest look at the life of a self made billionaire which includes some pretty big character flaws (absentee husband first time around for one).

After finishing the book for the first time I was inspired to read all of Buffett’s Berkshire Hathaway’s annual letters.  Every year since 1977 Buffett has written his fellow shareholders of Berkshire Hathaway (who he commonly refers to as “partners”).  For the most part the letters can be read as an addendum to the annual report he is forced to write every year for compliance purposes.  The addendum often tells a story and or tidbit into his thoughts on a certain subject – and that’s where it gets interesting.

For example in the past Buffett has discussed, his views on stock splits and why they aren’t appropriate for Berkshire Hathawaywhy shareholder’s should be treated like his fellow owners more like partners rather than faceless shareholders, the ridiculousness that are stock compensation plans, and just last year, he discussed reducing leverage and the holding cash.

Sometimes I read the ltter and get an overall message which I outline, and sometimes there are just interesting quotes/tangents that catch my attention.  This year it is the latter which I will highlight below in the order they are found within the letter.  These are items, I found interesting; you could read the 15 page letter and pull out a completely different message. 

Items of Interest from Buffett’s 2018 Annual Letter

For nearly three decades, the initial paragraph featured the percentage change in Berkshire’s per share book value. It is now time to abandon that practice

For those of us that have read these letters annually, this was a massive change. For everyone else, it is merely a waste of a paragraph  Buffett gave three reasons, but I think they can be summed up with the fact that the company has changed from largely marketable securities to wholly owned subsidiaries.  While I could make either side of the argument (keep it for continuity purposes vs. it doesn’t give an insight to the company so why bother comparing it annually) it just doesn’t matter all that much.

When we say “earned,” moreover, we are descirving remains after all income taxes, interest payments, managerial compensation (whether cash or stock-based), restructuring expenses, depreciation, amortization and home-office overhead.

That brand of earnings is a far cry from that frequently touted by Wall Street bankers and corporate CEOs.  Too often, their presentations feature “adjusted EBITDA,” a measure that redefines “earnings” to exclude a variety of all-too-real costs.

For example, managements sometimes assert that their company’s stock-based compensation shouldn’t be counted as an expense. (What else could it be – a gift from shareholders?) And restructuring expenses? Well, maybe last year’s exact rearrangement won’t recur. But restructurings of one sort or another are common in business – Berkshire has gone down that road dozens of times, and our shareholders have always borne the costs of doing so.

I thought the brief discussion was interesting because all anyone sees quoted out there is EBITDA.  He is not wrong (obviously), since your bottom line is your bottom line.  I guess it would come down to whether Company XYZ always had those rare, non-recurring expenses.

Berkshire held $112 billion at year end in U.S. Treasury bills and other cash equivalents,and another $20 billion in miscellaneous fixed-income instruments. We consider a portion of that stash to be untouchable, having pledged to always hold at least $20 billion in cash equivalents to guard against external calamities.

We have also promised to avoid any activities that could threaten our maintaining that buffer.Berkshire will forever remain a financial fortress. In managing, I will make expensive mistakes of commission and will also miss many opportunities, some of which should have been obvious to me. At times, our stock will tumble as investors flee from equities. But I will never risk getting caught short of cash.

I always find his commitment to cash equivalents reassuring.  He has said it many times over the years that he would forgo gains if it would compromise his cash reserves.  Feels like a lesson that can easily be applied to personal finances!

Earlier I mentioned that Berkshire will from time to time be repurchasing its own stock. Assuming that we buy at a discount to Berkshire’s intrinsic value – which certainly will be our intention – repurchases will benefit both those shareholders leaving the company and those who stay.

True, the upside from repurchases is very slight for those who are leaving. That’s because careful buying by us will minimize any impact on Berkshire’s stock price. Nevertheless, there is some benefit to sellers in having an extra buyer in the market.

For continuing shareholders, the advantage is obvious: If the market prices a departing partner’s interest at,say, 90¢ on the dollar, continuing shareholders reap an increase in per-share intrinsic value with every repurchase by the company. Obviously, repurchases should be price-sensitive: Blindly buying an overpriced stock is value-destructive, a fact lost on many promotional or ever-optimistic CEOs. (emphasis added)

It isn’t hard to find a recent article about buy backs going wrong.  I often wonder if it the CEO/CFO being over optimistic or if it is really just blind buying to get earnings per share to move in the right direction?

…Consequently, Charlie and I have never focused on current-quarter results.

***

Over the years, Charlie and I have seen all sorts of bad corporate behavior, both accounting and operational,induced by the desire of management to meet Wall Street expectations. What starts as an “innocent” fudge in order to not disappoint “the Street” – say, trade-loading at quarter-end, turning a blind eye to rising insurance losses, or drawing down a “cookie-jar” reserve – can become the first step toward full-fledged fraud. Playing with the numbers “just this once” may well be the CEO’s intent; it’s seldom the end result. And if it’s okay for the boss to cheat a little, it’s easy for subordinates to rationalize similar behavior.

At Berkshire, our audience is neither analysts nor commentators: Charlie and I are working for our shareholder-partners. The numbers that flow up to us will be the ones we send on to you.

It feels like CEOs of publicly traded companies would be better to just largely ignore Wall Street.  If the company is not loved by The Street then isn’t it just an opportunity to buy back shares until earnings/revenue are strong enough that the company can’t continue to go unloved?

Begin with an economic reality: Like it or not, the U.S. Government “owns” an interest in Berkshire’s earnings of a size determined by Congress. In effect, our country’s Treasury Department holds a special class of our stock – call this holding the AA shares – that receives large “dividends” (that is, tax payments) from Berkshire. In 2017, as in many years before, the corporate tax rate was 35%, which meant that the Treasury was doing very well with its AA shares. Indeed, the Treasury’s “stock,” which was paying nothing when we took over in 1965, had evolved into a holding that delivered billions of dollars annually to the federal government.

Last year, however, 40% of the government’s “ownership” (14/35ths) was returned to Berkshire – free of charge – when the corporate tax rate was reduced to 21%. Consequently, our “A” and “B” shareholders received a major boost in the earnings attributable to their shares.This happening materially increased the intrinsic value of the Berkshire shares you and I own. The same dynamic, moreover, enhanced the intrinsic value of almost all of the stocks Berkshire holds.

Hopefully the wealth effect reverberates through the economy!

In most cases, the funding of a business comes from two sources – debt and equity. At Berkshire, we have two additional arrows in the quiver to talk about, but let’s first address the conventional components.

We use debt sparingly. Many managers, it should be noted, will disagree with this policy, arguing that significant debt juices the returns for equity owners. And these more venturesome CEOs will be right most of the time.At rare and unpredictable intervals, however, credit vanishes and debt becomes financially fatal. A Russian-roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company’s upside but does not share in its downside. But that strategy would be madness for Berkshire. Rational people don’t risk what they have and need for what they don’t have and don’t need.

The rare case where I disagree with Buffett.  I think rational people risk everything they have worked for shit they don’t need every single day, and they do it with debt no less.  I know he isn’t talking about the idea in terms of personal finance, however, I don’t think it is far fetched to think about a business owner trying to expand whether he or his family needs it.

Let’s put numbers to that claim: If my $114.75 had been invested in a no-fee S&P 500 index fund, and all dividends had been reinvested, my stake would have grown to be worth (pre-taxes) $606,811 on January 31, 2019 (the latest data available before the printing of this letter). That is a gain of 5,288 for 1.

Meanwhile, a $1 million investment by a tax-free institution of that time – say, a pension fund or college endowment – would have grown to about $5.3billion.

Let me add one additional calculation that I believe will shock you: If that hypothetical institution had paidonly1%of assets annually to various “helpers,” such as investment managers and consultants, its gain would have been cut in half, to $2.65 billion. That’s what happens over 77 years when the 11.8% annual return actually achieved by the S&P 500 is recalculated at a 10.8% rate.

Mind blowing! Taxes and investment fees should be on everyone’s mind.

 

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2 comments

Dividend Diplomats March 5, 2019 - 12:12 pm

Thanks for the synopsis MJTM. Those were some interesting tidbits, especially the piece about stock-based comp and Wall Street. Overall, the message I take is that companies will always benefit from taking a long-term approach to their decisions, rather than the short-term/short-cited approach that Wall Street prefers.

Bert

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Evan March 7, 2019 - 10:25 am

Exactly, but 75% of the companies don’t operate that way

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