The day the Buffet "value-investing" fanatics have been looking forward to all year, almost as much as the annual pilgrimage to Omaha, has finally arrived - hours ago Warren Buffett released his historic, 50th annual letter to shareholders, which is extra special because as the Oracle notes in the foreword, "Fifty years ago, today’s management took charge at Berkshire. For this Golden Anniversary, Warren Buffett and Charlie Munger each wrote his views of what has happened at Berkshire during the past 50 years and what each expects during the next 50."
The foreword continues: "Neither changed a word of his commentary after reading what the other had written. Warren’s thoughts begin on page 24 and Charlie’s on page 39. Shareholders, particularly new ones, may find it useful to read those letters before reading the report on 2014, which begins below." The result is the magnum opus of Berskshire letter, one which weighs in at 43 pages and a massive 25,100 words compared to "only" 24 pages and about 14,700 words last year, and 15,300 the year before. Almost as if Buffett is telegraphing that this may be his last letter and savoring the moment...
But first, some of the details of Berkshire's performance, which was not quite the magnum opus Buffett may have expected, after Berkshire Hathaway posted lower earnings for the fourth quarter amid investment derivative gains of $192 million.
As summarized by the WSJ [10], Berkshire reported a net profit of $4.16 billion, or $2,529 a Class A share, compared with $4.99 billion, or $2,297 a share, a year earlier. Operating earnings, which exclude some investment results, were $2,412 a Class A share, versus $2,297 a share, thus missing Wall Street expectations of per-share operating earnings of $2,701. Book value per Class A share increased by 8.3% to $146,186 at Dec. 31.
So back to the letter: here are some preliminary observations and excerpts from the letter:
- Berkshire increased its ownership interest last year in each of its “Big Four” investments – American Express, Coca-Cola, IBM and Wells Fargo. We purchased additional shares of IBM (increasing our ownership to 7.8% versus 6.3% at yearend 2013). Meanwhile, stock repurchases at Coca-Cola, American Express and Wells Fargo raised our percentage ownership of each. Our equity in Coca-Cola grew from 9.1% to 9.2%, our interest in American Express increased from 14.2% to 14.8% and our ownership of Wells Fargo grew from 9.2% to 9.4%. And, if you think tenths of a percent aren’t important, ponder this math: For the four companies in aggregate, each increase of one-tenth of a percent in our ownership raises Berkshire’s portion of their annual earnings by $50 million.
- [W]ho has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita U.S. output has sextupled. My parents could not have dreamed in 1930 of the world their son would see. Though the preachers of pessimism prattle endlessly about America’s problems, I’ve never seen one who wishes to emigrate (though I can think of a few for whom I would happily buy a one-way ticket).
Of course there is the fact that global wealth inequality has never been greater and as a result the entire globe has approached - or crossed - its own "let them eat cake" moment, but let's forget all about that. After all, for Buffett the "long enough timeline" has almost dropped to zero.
Munger explains economies of scale and quasi-monopoly:
- in the early decades of the Buffett era, common stocks within Berkshire’s insurance subsidiaries greatly outperformed the index, exactly as Buffett expected. And, later, when both the large size of Berkshire’s stockholdings and income tax considerations caused the index-beating part of returns to fade to insignificance (perhaps not forever), other and better advantage came. Ajit Jain created out of nothing an immense reinsurance business that produced both a huge “float” and a large underwriting gain. And all of GEICO came into Berkshire, followed by a quadrupling of GEICO’s market share. And the rest of Berkshire’s insurance operations hugely improved, largely by dint of reputational advantage, underwriting discipline, finding and staying within good niches, and recruiting and holding outstanding people. Then, later, as Berkshire’s nearly unique and quite dependable corporate personality and large size became well known, its insurance subsidiaries got and seized many attractive opportunities, not available to others, to buy privately issued securities. Most of these securities had fixed maturities and produced outstanding results.
Buffett's take on the future:
- The bad news is that Berkshire’s long-term gains – measured by percentages, not by dollars – cannot be dramatic and will not come close to those achieved in the past 50 years. The numbers have become too big. I think Berkshire will outperform the average American company, but our advantage, if any, won’t be great. Eventually – probably between ten and twenty years from now – Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings. At that time our directors will need to determine whether the best method to distribute the excess earnings is through dividends, share repurchases or both. If Berkshire shares are selling below intrinsic business value, massive repurchases will almost certainly be the best choice. You can be comfortable that your directors will make the right decision.
And Munger's:
- The next to last task on my list was: Predict whether abnormally good results would continue at Berkshire if Buffett were soon to depart. The answer is yes. Berkshire has in place in its subsidiaries much business momentum grounded in much durable competitive advantage. Provided that most of the Berkshire system remains in place, the combined momentum and opportunity now present is so great that Berkshire would almost surely remain a better-than-normal company for a very long time even if (1) Buffett left tomorrow, (2) his successors were persons of only moderate ability, and (3) Berkshire never again purchased a large business.
- But, under this Buffett-soon-leaves assumption, his successors would not be “of only moderate ability.” For instance, Ajit Jain and Greg Abel are proven performers who would probably be under-described as “world-class.” “World-leading” would be the description I would choose. In some important ways, each is a better business executive than Buffett.
- With Berkshire now so large and the age of activism upon us, I think some desirable acquisition opportunities will come and that Berkshire’s $60 billion in cash will constructively decrease.
FInally, some amusing comments by Buffet on the sudden need for liquidity and/or bialouts:
- [W]e will never engage in operating or investment practices that can result in sudden demands for large sums. That means we will not expose Berkshire to short-term debt maturities of size nor enter into derivative contracts or other business arrangements that could require large collateral calls. Some years ago, we became a party to certain derivative contracts that we believed were significantly mispriced and that had only minor collateral requirements. These have proved to be quite profitable. Recently, however, newly-written derivative contracts have required full collateralization. And that ended our interest in derivatives, regardless of what profit potential they might offer. We have not, for some years, written these contracts, except for a few needed for operational purposes at our utility businesses.
To be sure, when it comes to "major demands for large sums" in his investments, Buffett seems to forget that it was the US taxpayers themselves who ended up funding said collateral demands as recently as 2008, but that's what crony capitalism is all about: knowing that when the hammer hits, the US government is there to bail you out. As for Buffett phasing out derivatives, this makes sense: with available leverage declining (due to full collateralization), Buffett, who personally decried derivatives as financial weapons of mass destruction, can avoid being a hypocrite as he himself has no use for such massively leveraging instruments any longer.
Some other notes from the WSJ [11]which has been diligently parsing the letter since its release:
- No successor named, as we expected. But on pages 36 and 37, Mr. Buffett discusses the qualities the CEO would need: “My successor will need one other particular strength: the ability to fight off the ABCs of business decay, which are arrogance, bureaucracy and complacency.” Munger notes: "under this Buffett-soon-leaves assumption, his successors would not be “of only moderate ability.” For instance, Ajit Jain and Greg Abel are proven performers who would probably be under-described as “world-class.” “World-leading” would be the description I would choose. In some important ways, each is a better business executive than Buffett."
- Warren Buffett adds his name to the list of those commenting on the effects of a strong U.S. dollar. In the letter Mr. Buffett says: “[We] expect that the per-share earnings of these four investees [American Express, Coca-Cola, IBM and Wells Fargo], in aggregate, will grow substantially over time (though 2015 will be a tough year for the group, in part because of the strong dollar).”
- Mr. Buffett reiterates the importance of preserving the firm’s culture and believes his son Howard is best suited to succeed him as non-executive Chairman:
- “To further ensure continuation of our culture, I have suggested that my son, Howard, succeed me as a nonexecutive Chairman. My only reason for this wish is to make change easier if the wrong CEO should ever be employed and there occurs a need for the Chairman to move forcefully.”
- Buffett says a dividend, share repurchase or both are possible as Berkshire’s earnings and capital resources will reach a level in the next 10 to 20 years that “will not allow management to intelligently reinvest all of the company’s earnings.” How the company will use its capital has been a hot topic of late. Mr. Buffett has previously said it’s unlikely he will pay a dividend in his lifetime, arguing that money can be spent to grow the company instead. However, a small group of investors have long been pushing for one.
- Mr. Buffett said massive repurchases will almost certainly be a better choice than distributing a dividend if Berkshire shares are selling below intrinsic business value.
- Buffett has more to say on page 31 on potentially spinning off certain businesses. That makes “no sense,” he said. “Our companies are worth more as part of Berkshire than as separate entities.” He explains again that Berkshire can move funds between its parts without incurring taxes, but also talks about things like the cost of a board of directors and other administrative expenses that would jump if these companies were split off. This dis-synergy defense sounds a lot like what J.P. Morgan’s executives had to say this week about why it shouldn’t break up.
- Buffett is never one to shy from calling out his mistakes in the letter, and this year he’s got a new one: an investment in U.K. grocery store giant Tesco. Buffett lost $444 million on the company when he sold out of it last year, he writes today, lamenting that he moved slowly as the company faced a barrage of issues and accounting problems. He says in 2013 he “soured somewhat” on the management team and had cut the position by a bit more than 25% but now wishes he had sold more. “My leisurely pace in making sales would prove expensive,” he writes. “Charlie calls this sort of behavior ‘thumb-sucking.’ (Considering what my delay cost us, he is being kind.)” Tesco really ran into trouble in 2014, losing market share, struggling with margins and the accounting issues. As Buffett put it: “You see a cockroach in your kitchen; as the days go by, you meet his relatives.”
Full letter below (pdf link [12])
