On Saturday Feb. 22nd Berkshire Hathaway Inc. (BRK.A, BRK.B) released its annual earnings report. As per tradition, Chairman Warren Buffet also included his shareholder letter where he and his partner, Charlie Munger, discuss their view on the state of the market.
This overview includes the earnings as well as a detailed look at the shareholders letter section by section.
BERKSHIRE HATHAWAY 2019 PERFORMANCE
Berkshire Hathaway vs. S&P 500
Berkshire’s performance vs. the S&P 500, according to the report, were as followed:
Annual Percentage Change in 2019:
- Per-Share Market Value of Berkshire Hathaway: 11.0%
- S&P 500 including Dividends: 31.5%
Berkshire Hathaway Earnings
In the opening of the letter, it states:
“Berkshire earned $81.4 billion according to general accepted accounting principles (GAAP)” […] “$24 billion of operating earnings, $3.7 billion of realized capital gains and a $53.7 billion gain from an increase in the amount of net unrealised capital gains that exist in stocks we hold.”Berkshire Hathaway 2019 Shareholder Letter, page 3
This is stated on an after-tax basis.
The letter briefly addresses the $53.7 billion saying it was due to a new GAAP rule implemented in 2018. This rule requires a company holding equity securities to include in their earnings the net change in the unrealized gains and losses of said securities.
In last year’s letter, Buffet stated that neither him nor Charlie Munger agree with this rule, illustrating an example saying:
“In 2018, a down year for the stock market, our net unrealized gains decreased by $20.6 billion, and we therefore reported GAAP earnings of only $4 billion. In 2019, rising stock prices increased net unrealized gains by the aforementioned $53.7 billion, pushing GAAP earnings to the $81.4 billion reported at the beginning of this letter. Those market gyrations led to a crazy 1,900% increase in GAAP earnings! […] Berkshire’s equity holdings averaged about $200 billion during the two years, and the intrinsic value of the stocks we own grew steadily and substantially throughout the period.Berkshire Hathaway 2019 Shareholder Letter, page 3
Overview of Buffet’s Shareholder Letter
After showing Berkshire’s earnings and talking about the accounting rule imposed in 2019, Buffet continued the letter starting with retained earnings.
“The Power of Retained Earnings”
At first a reference to the “obscure economist and financial advisor” Edgar Lawrence Smith was made regarding a “thin” (yet impactful) book he wrote from 1924 titled “Common Stocks as Long Term Investments”.
Smith confesses about the book “These studies are the record of a failure – the failure of facts to sustain a preconceived theory” after planning to argue that during inflationary periods, stocks would perform better than bonds, while during deflationary periods bonds would yield better returns.
Furthermore, Buffet quotes Economist John Maynard Keynes referencing Smith:
“I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest (Keynes’ italics) operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”John Maynard Keynes (1883-1946)
Considering “titans” such as Rockefeller, Carnegie, and Ford amassed substantial amounts of wealth by retaining large portions of their business earnings to fund growth and earn even bigger profits, Buffet says he finds it difficult to understand why retained earnings were so “unappreciated” by investors prior to Smith’s book.
Buffet continues and elaborates on what they [Berkshire] do with retained funds.
“In our deployment of the funds we retain, we first seek to invest in the many and diverse businesses we already own. During the past decade, Berkshire’s depreciation charges have aggregated $65 billion whereas the company’s internal investments in property, plant and equipment have totaled $121 billion. Reinvestment in productive operational assets will forever remain our top priority.”Berkshire Hathaway 2019 Shareholder Letter, page 4
It is mentioned too that additionally, Berkshire is always looking to acquire companies that satisfy the following 3 criteria:
- Earn good returns on net tangible capital required in their operation
- Must be run by able and honest managers
- Must be available at a sensible price
Because the opportunities to make such business acquisitions according to these criteria is rare, Buffet claims their preference would be to buy 100% of those they come across. However, far more often Buffet says opportunities to purchase large but non-controlling positions in public companies arise instead.
Next, a look at Berkshire Hathaway’s 10 largest stock market holdings of businesses is given in the letter.
“It is certain that Berkshire’s rewards from these 10 companies, as well as those from our many other equity holdings, will manifest themselves in a highly irregular manner. Periodically, there will be losses, sometimes company-specific, sometimes linked to stock-market swoons. At other times – last year was one of those – our gain will be outsized. Overall, the retained earnings of our investees are certain to be of major importance in the growth of Berkshire’s value.”Berkshire Hathaway 2019 Shareholder Letter, page 5
Buffet finishes talking about retained earnings by simply saying: “Mr. Smith got it right.”
The letter begins with a piece of advice from Tom Murphy, a “valued director of Berkshire”: “To achieve a reputation as a good manager, just be sure you buy good businesses.”
After reviewing his “un-even” record, Buffet describes marriage as an analogy to acquisitions:
“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. 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.”Berkshire Hathaway 2019 Shareholder Letter, page 6
Buffet continues saying that for those acquisitions over the years that did not go as planned, losses were minimized due to “poor” businesses stagnating and “good” businesses growing and providing more investment opportunities. Therefore, the “winners” at Berkshire become an expanding portion of their total capital, while stagnating businesses increasingly require less percentage of Berkshire Hathaway’s capital.
Today, Buffet says investor’s funds are deployed in “controlled businesses” that yield “good-to excellent” returns on net tangible assets required for each operation.
BNSF railroad and Berkshire Hathaway Energy (BHE), the two “lead dogs” of the non-insurance group, collectively earned $8.3 billion in 2019. Including only their 91% share in BHE, this is a 6% increase from last year.
Berkshire’s next five non-insurance subsidiaries, according to earnings, is presented alphabetically as Clayton Homes, International Metalworking, Lubrizol, Marmon and Precision Castparts. These five have earned a combined $4.8 billion, with little change comparing to the previous year.
The next five, being Berkshire Hathaway Automotive, Johns Manville, NetJets, Shaw and TTI, earned an aggregate $1.9 billion – with this tier up from $1.7 from the previous year.
The rest of the non-insurance businesses owned by Berkshire had a total of $2.7 billion in 2019. This is down from last years $2.8 billion.
Total Net Income from Non-Insurance Businesses in 2019: $17.7 billion
This is a 3% increase from 2018’s $17.2 billion earned by this group of businesses.
Buffet finishes off “Non-Insurance Operations” with a story about one of Berkshire’s companies, owned since 2011. Lubrizol, an Ohio-based company producing and marketing oil additives globally, had a fire break out on Sep. 26th 2019. Originating from a small next-door operation, the fire spread to a “large French plant” owned by Lubrizol.
“The result was significant property damage and a major disruption in Lubrizol’s business. Even so, both the company’s property loss and business-interruption loss will be mitigated by substantial insurance recoveries that Lubrizol will receive. […] One of the largest insurers of Lubrizol was a company owned by . . . uh, Berkshire.”Berkshire Hathaway 2019 Shareholder Letter, page 7
“Property / Casualty Insurance”
Buffet mentions earlier (on page 6), “Our insurance business has been the superstar. That operation has special characteristics that give it a unique metric for calibrating success, one unfamiliar to many investors.” He continues to start this section of the letter off by saying “Our property/casualty (“P/C”) insurance business has been the engine propelling Berkshire’s growth since 1967”, the year Berkshire acquired National Indemnity and National Fire & Marine (its sister company) for $8.6 million.
Today, National Indemnity is the world’s largest P/C business in terms of net worth.
The reason why Berkshire has been attracted to P/C is due to the industry’s business model being: “P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, or severe workplace accidents, payments can stretch over many decades.”
This model leaves these P/C businesses holding large sums (referred to as “float” in the letter). Insurers get to invest this “float” for their own benefit, with the amount remaining fairly stable in relation to premium volume. In short: as the business grows, so does it’s float. Below is a table showing the growth of this float starting in 1970.
While Buffet notes there may at some point be a decline in float, it will be a very gradual decline and “no more than 3% in a given year”. This is due to the fact that Berkshire’s insurance contracts are structured in a way that it is protected from being subject to immediate or near-term demands for amounts that are significant to their cash resources.
The Chairman reassures investors that this structure is by design a key component to the financial strength of Berkshires insurance companies.
“That strength will never be compromised.” Buffet says, before elaborating further.
“If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it.”Berkshire Hathaway 2019 Shareholder Letter, page 8
For the P/C industry as a whole, float has become less valuable financially. Buffet claims this is because P/C investment strategies consist “heavily” and “properly” of high-grade bonds. This makes interest rates paramount. However, rates have been “pathetically low” recently.
Insurers were thus forced into “recycling old investments” into lower-yielding ones by “maturities or issue-call provisions”. Previously, insurers could earn 5 or 6 cents for each dollar of float, while now only 2 to 3 cents is taken (even lower for operations located in countries with negative interest rates).
Dangerous games may be played by some insurers where they mitigate losses by purchasing lower-quality bonds or non-liquid “alternative investments”, with Buffet calling this a game most institutions are “ill-equipped to play”.
The reasons why Berkshire’s position in general is far better than other insurers is primarily due to it’s “unrivalled mountain of capital”, “abundance of cash”, and a “huge and diverse stream of non-insurance earnings” that allow for far more investment flexibility, as quoted from the letter.
“Disciplined risk evaluation is the daily focus of our insurance managers, who know that the rewards of float can be drowned by poor underwriting results”Berkshire Hathaway 2019 Shareholder Letter, page 8
“Berkshire Hathaway Energy” (BHE)
Berkshire Hathaway purchased 76% of BHE back in 2000. At this point in time, residential customers in Iowa paid an average of 8.8 cents / kilowatt-hour (kWh). Prices for these customers have since risen less than 1%, with the promise of no base-rate price increase through 2028.
As for other investor-owned Iowa utility, residential customers were charged 61% higher than that of BHE. “Recently, that utility received a rate increase that will widen the gap to 70%.” said Buffet.
BHE’s generation of wind energy into electricity is cited as the reason for the extraordinary differences in rates. In 2021, 25.2 million mega-watt hours (mWh) is expected to be generated in Iowa by turbines owned and operated by BHE.
Annual needs of residential customers in Iowa are around 24.6 million mWh, marking Berkshire’s utility reaching self-sufficiency in the state. In comparison, “that other Iowa utility” generates less than 10% of it’s power from wind energy.
“We know of no other investor-owned utility, wherever located, that by 2021 will have achieved a position of wind self-sufficiency”Berkshire Hathaway 2019 Shareholder Letter, page 9
Of course, wind turbines do not always turn, thus resulting in BHE resorting to other non-wind generating capacity to secure the electricity needed. On the flip-side, during times of energy surplus from wind, excess power is sold to other utilities via “the grid”. This offers a supplement to carbon resources such as coal and natural gas.
Unlike other utilities companies, of who pay dividends sometimes reaching over 80% of earnings, BHE has never paid Berkshire Hathaway a dividend since purchase, with $28 billion in earnings retained over the years.
The fifteen common stock investments that had the largest market value at year end for Berkshire is shown below.
However, it is noted that the Kraft Heinz holding (325,442,152 shares) is not included. This is because Berkshire is a part of “a control group and therefore must account for this investment on the “equity” method”.
“Charlie and I do not view the $248 billion detailed above as a collection of stock market wagers […] What we see in our holdings, rather, is an assembly of companies that we partly own and that, on a weighted basis, are earning more than 20% on the net tangible equity capital required to run their businesses. These companies, also, earn their profits without employing excessive levels of debt.Berkshire Hathaway 2019 Shareholder Letter, page 10
Under any circumstance, returns of this order by large, established, and understandable businesses are “remarkable”.
The letter further says if interest rates continue at the current level and corporate tax rates stay at the low level businesses have been enjoying, equities will “almost certainly” over time yield better results than “long-term, fixed-rate debt instruments”.
However an important note is made: ANYTHING can happen to stock prices tomorrow.
“Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater. But the combination of The American Tailwind, about which I wrote last year, and the compounding wonders described by Mr. Smith, will make equities the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions. Others? Beware!”Berkshire Hathaway 2019 Shareholder Letter, page 11
“The Road Ahead”
In this part of the letter, Buffet begins to talk about the future of Berkshire Hathaway – one where Charlie Munger nor himself will be around to manage.
“Charlie and I long ago entered the urgent zone. That’s not exactly great news for us. But Berkshire shareholders need not worry: Your company is 100% prepared for our departure.”Berkshire Hathaway 2019 Shareholder Letter, page 11
According to Buffet, Munger and himself are confident in the succession of Berkshire Hathaway for five key reasons:
- “First, Berkshire’s assets are deployed in an extraordinary variety of wholly or partly-owned businesses that, averaged out, earn attractive returns on the capital they use.”
- “Second, Berkshire’s positioning of its “controlled” businesses within a single entity endows it with some important and enduring economic advantages.”
- “Third, Berkshire’s financial affairs will unfailingly be managed in a manner allowing the company to withstand external shocks of an extreme nature.”
- “Fourth, we possess skilled and devoted top managers for whom running Berkshire is far more than simply having a high-paying and/or prestigious job.”
- “Finally, Berkshire’s directors – your guardians – are constantly focused on both the welfare of owners and the nurturing of a culture that is rare among giant corporations.”
Buffet continues with outlining “pragmatic” reasons for why Charlie and himself want to assure Berkshire’s continued success and future prosperity following their exit. Firstly, The Munger’s Berkshire holdings “dwarf” any of the other investments held by the family. Additionally, Buffet has 99% of his net worth “lodged” in Berkshire stock.
“I have never sold any shares and have no plans to do so,” said Buffet. “My only disposal of Berkshire shares, aside from charitable donations and minor personal gifts, took place in 1980, when I, along with other Berkshire stockholders who elected to participate, exchanged some of our Berkshire shares for the shares of an Illinois bank that Berkshire had purchased in 1969 and that, in 1980, needed to be offloaded because of changes in the bank holding company law.”
Furthermore, the letter begins talking about Buffet’s plans regarding his will, and how certain actions will be executed.
The will instructs the executors and trustees of Buffets estate not to sell any of Berkshire shares.
Each year a portion of Buffet’s BRK.A shares will be converted into BRK.B shares, with the BRK.B shares then distributed to various foundations. Said foundations will be required to “deploy their grants promptly”. Buffet estimates that it will take 12-15 years for the entirety of his Berkshire shares held at death to move into the market.
“I myself feel comfortable that Berkshire shares will provide a safe and rewarding investment during the disposal period. There is always a chance – unlikely, but not negligible – that events will prove me wrong. I believe, however, that there is a high probability that my directive will deliver substantially greater resources to society than would result from a conventional course of action.”Berkshire Hathaway 2019 Shareholder Letter, page 12
Board of Directors
Buffet starts this section out by reflecting on the composition of corporate boards. He mentions that at a certain time, the responsibilities of boards was for the most part limited to lawyers. However, today institutional investors and politicians have “weighed in as well”.
Over the last 62 years Buffet has served as a director of 21 publicly-owned companies. With the exception of two, he has held a significant amount of shares. “In a few cases, I have tried to implement important change”.
“During the first 30 or so years of my services, it was rare to find a woman in the room unless she represented a family controlling the enterprise. This year, it should be noted, marks the 100th anniversary of the 19th Amendment, which guaranteed American women the right to have their voices heard in a voting booth. Their attaining similar status in a board room remains a work in progress.”Berkshire Hathaway 2019 Shareholder Letter, page 12
Despite the many changes in rules and regulations regarding board composition, Buffet states the bedrock challenge is still the same: “Find and retain a talented CEO […] possessing integrity […] who will be devoted to the company for his/her business lifetime.”
Speaking on integrity, Buffet mentions that his “[thankfully] limited” experience with CEO’s “playing with a company’s numbers” indicates they were prompted more so by ego opposed to financial gain.
A note on a very important improvement in corporate governance is made, being a regularly scheduled “executive session” of directors where the CEO is barred. Before this change was implemented, Buffet notes that “truly frank” discussions of a CEO’s skills, acquisition decisions, and compensations were “rare”.
The letter continues with the role of board members being discussed along with factors, such as compensation, concerning them.
“Director compensation has now soared to a level that inevitably makes pay a subconscious factor affecting the behavior of many non-wealthy members. Think […] 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 U.S. households.”Berkshire Hathaway 2019 Shareholder Letter, page 13
It is also noted that the job security is “fabulous”, with board members maybe getting politely ignored but rarely fired. “Generous” age limits typically act as the “genteel ejection” of directors.
“At Berkshire, we will continue to look for business-savvy directors who are owner-oriented and arrive with a strong specific interest in our company. Thought and principles, not robot-like “process,” will guide their actions. In representing your interests, they will, of course, seek managers whose goals include delighting their customers, cherishing their associates and acting as good citizens of both their communities and our country.”Berkshire Hathaway 2019 Shareholder Letter, page 13
Buffets ends the letter with brief mention of a variety of short subjects.
Repurchasing of Berkshire Stocks
Buffet states that repurchasing of Berkshire stock happens given the following two criteria is true:
- Charlier or Warren believe the stock is selling for less than it should
- the company (upon completing the repurchase) is left with ample cash
2019 Income Tax Paid by Berkshire Hathaway to U.S. Treasurey: $3.6 billion
Given the U.S. government collected around $243 billion in corporate tax around this time, Berkshire paid approximately 1.5% of the “federal income taxes paid by all of corporate America”.
The Berkshire Hathaway 2019 annual letter to shareholders closes with Warren saying:
On May 2nd, come to Omaha. Meet your fellow capitalists. Buy some Berkshire products. Have fun. Charlie and I – along with the entire Berkshire gang – are looking forward to seeing you.Berkshire Hathaway 2019 Shareholder Letter, page 14