Every year since 1977, Warren Buffett has released a shareholder letter. In recent years, it’s been a highlight of the financial calendar with investors eagerly poring over his words to glean his thoughts on everything from bond valuations to the dangers of debt. I’m a big fan of Warren Buffett – I like his sensible, easy-to-digest insights into business and investing, and like many retail investors think there’s plenty of learn from his words.
With this in mind, I started a series of articles about Warren Buffett’s Shareholder Letters. The idea is simple. I’m going to read his letters (all available for free on Berkshire Hathaway’s website) and provide an overview of the content and my thoughts on it, year by year, working backwards from 2019. Welcome to Berkshire Hathway in 2018.
Berkshire Hathaway: 2018
In sharp contrast to Berkshire’s 2019 annual shareholder letter, Warren highlights that Berkshire made $4bn in 2018 (compared to the whopping $84bn it would make in 2019). This largely down to the change in ‘Generally Accepted Accounting Principles’ or GAAP which mandated that unrealised gains had to be factored into earnings. This creates an obvious problem for companies with significant investment holdings in that the declared earnings figure will fluctuate wildly based on the paper value of investments held in public markets. Until those investments are sold, no gains or losses would actually be generated but GAAP ignores this.
Ignoring Book Value
Warren goes on to highlight that he is no longer reporting changes in the book value of assets held by Berkshire Hathaway. As a value investor, Warren marks this down to the simple fact that he perceives a tangible difference between the book value (current market price) and intrinsic value (Berkshire’s assessment of the true long-term value of the company).
Both this, and the change in GAAP rules raise interesting points for investors. Accountants and public markets often make fundamentally unsound decisions that force companies to report their finances in unreliable ways. As an investor, we have to rely on the accounts published by a company and audited by their auditors – we have nothing else. But accepting the figures presented as prima facie is somewhat naïve.
For example, if I invest in a company that buys £10m of listed equities and the week after they’ve declined in quoted value to £9m, does that mean the company has lost £1m? Unless they sell them, then in my opinion that isn’t a guaranteed certainty. There are a whole host of different ways of valuing an asset and auditors and accountants have to pick something…but that isn’t to say that their way is the only way…or even the best way. Just one of many.
This, in turn, highlights the importance of reading company accounts carefully and diligently – read the auditor’s report and don’t dismiss everything out of hand, but still ensure that you have you apply your own experience and research to validate the assumptions that have been made.
Our ‘Economic Trees’
The next stage of the letter is dedicated to one of Warren’s inimitable analogies where he compares Berkshire’s holdings to a forest. Each of their companies is a tree in that forest, possessing unique characteristics of size and age. He groups these ‘trees’ into ‘groves’ for ease of analysis – a technique I often use when reviewing my own portfolio. These groves are differentiated clusters of businesses and financial assets and can be categorised as follows;
- Marketable securities with an ownership stake of 5-10% (publicly listed companies)
- Non-listed companies with a controlling stake (private non-insurance companies)
- Companies with a major stake but shared control
- Cash and cash equivalents
- Insurance companies
Each of these groves has very different characteristics; Berkshire held over $100bn in cash and cash equivalents in 2018, and significant, diversified interests in everything from rail to power to consumer staples companies. The common feature of a lot of the development of these groves has been a careful, patient approach to investing. Warren has waited to spot something he liked (an undervalued asset) and then bought big. He hasn’t chased the market but he has very much been a consistent buyer of companies over the last 40+ years. By the time of this shareholder letter in 2018, Warren had assembled a vast treasure trove of a financial empire and he highlights this in his statement on page 6;
Berkshire’s value is maximized by our having assembled the five groves into a single entity. This arrangement allows us to seamlessly and objectively allocate major amounts of capital, eliminate enterprise risk, avoid insularity, fund assets at exceptionally low cost, occasionally take advantage of tax efficiencies, and minimize overhead.
If you flick through the annual report to page 12, you’ll see the fifteen companies with the largest market value held by Berkshire Hathaway. Of the 15, Berkshire holds 8 financial companies (mostly major US banks), Apple, Coke and a couple of airlines. In all honesty, I can’t say that there’s a single business on the list that I was running to try and buy in 2018 – the heavy overweighting to financials seemed imprudent given interest rates, airlines are notoriously value destructive, Coke is suffering from age-related slowdown (return on equity has fallen every decade since the 1990) and Apple…honestly just seemed really expensive (and still does at the time of writing this article in 2020).
Warren and Charlie clearly disagree with my thoughts on this, highlighting that the group earns around 20% return on net tangible equity. His general feeling is that these are exceptional businesses in an exceptional economy. Not bad starting criteria for any investor.
Berkshire’s duty to pay tax
Back on page 7, Warren uses a turn of phrase I really love.
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.
The reason I like this paragraph so much is that it underlines Berkshire’s absolute commitment to paying its societal dues. To Warren and the rest of the Berkshire management team, tax is a commitment no less serious than paying shareholders or employees – referred to as a payment for holders of a ‘special class of stock’.
I hold much the same view of tax – I believe it should be fairly levied and I often feel the money could be more efficiently spent, but I could never view it as anything other than my personal commitment to a civilised society. I’ve never really understood the ‘tax is theft’ argument; small government, I can get behind, but not the complete eradication of it. My taxes go to pay for schools and roads and water and education and healthcare – and like Warren, I’m proud to pay my part so that as a society we can have these things.
Debt vs. Equity
On page 10, Warren highlights the dangers of leverage; another view I often espouse when speaking to fellow investors. As Warren puts it, “debt juices returns for equity holders” but sometimes, “usually at rare and unpredictable intervals”, credit vanishes and debt becomes financially fatal.
This is true for both individuals and companies. It never fails to astound me how easily people with relatively few financial assets will merrily go out and borrow to fund frivolous purchases, essentially dousing their financial house of cards with gasoline and hoping that no one with a match joins the party.
By comparison, in 2018 Berkshire’s $349bn in equity capital was unmatched across the entirety of corporate America. By reinvesting earnings rather than borrowing to fund growth, Warren and Charlie have created a financial juggernaut with significant financial resilience. Remember – no investment ever failed from having too much cash in the bank.
Avoid the permabears
Finally, Warren writes a two-page love letter to the American economy. As saccharine as I found this, he makes an important point. Over time, all economies will have their ups and downs. There will be decades of growth and decades of decline. There will be amazing social and economic achievements and there will be terrible, gut wrenching catastrophes.
Investing is no different. I have months where I’m flying high and months where I just can’t imagine how things are going so wrong. The key to success here, in my opinion, is to just keep going. No disaster was ever averted, no calamity ever repaired, no dark night ever brightened because people sat down and gave up.
At the time of writing this article, this world is in the grips of the worst pandemic in living memory. Huge swathes of the economy have been shut for months, governments are spending billions more than they’re receiving, and hundreds of thousands of jobs have been lost. It’s impossible to know if things are getting better or whether we’re in the early stages of a multi-year depression that will define the 2020s.
The value of reading the Berkshire Hathaway shareholder letters is that we can see a glimpse of what that was like for Warren and Charlie in real time. Since the archive starts in 1977, we’ve seen two invasions of Afghanistan, the emergence of AIDS, the Falklands War, the Yugoslavian crisis, the terrorist attacks of 9/11 and 7/7, the assassination of the Israeli Prime Minister, the Los Angeles riots, Hurricane Catrina, Brexit and so, so much more.
Through it all, Warren and Charlie have been steadily investing, being cautious, patient and steadfast in their resolution to build Berkshire into the giant that it is today. If they can keep going, then so can we.