"We Need Shed No Tears For The Capitalists" - Key Highlights From Buffett's 2015 Annual Letter

Earlier today Berkshire Hathaway released its 2015 annual report, which among other things includes Buffett's traditional annual observations and insights. Buffett brushes past last year’s disappointing stock performance, muses on the future of America while taking a swipe at Donald Trump, dwells on Berkshire’s ties to Brazilian PE firm 3G, talks about Berkshire’s big 2015 deal, defends manufactured-housing unit Clayton Homes, bashes inequality and capitalists (just not the crony kind), and concludes with a summary of the biggest risks facing America. 

Before we get into the meat, a quick summary of the company's operational results.

In 2015 Berkshire earned $24.08 billion, up from $19.9 billion a year ago, driven by an 8% increase in total revenue to $210.8 billion; however as shown below is notable that in 2015 the amount of revenues from investment and derivative gains rose by more than 150% to $10.3 billion, resulting in $6.7 billion in after tax gains.

 

In the fourth quarter Berkshire generated $51.8 billion in revenue, translating to $5.5 billion in net earnings or $3,333 in EPS,

 

Some other key operational results: Berkshire’s gain in net worth during 2015 was $15.4 billion, which increased the per-share book value of both our Class A and Class B stock by 6.4%. The company's per-share book value was $155,501, up from $146,186 the previous year. 

Perhaps most notable about 2015 is that this was a year in which BRK's stock posted not only its worst return since 2008, hurt by investments in companies like American Express, Wal-Mart and IBM while cheaper oil prices was a growing problem for key holdings including BNSF and Geico...

 

... and the first time since 2011 in which BRK notably underperformed the S&P.

 

Buffett provides a defense of this underperformance, by falling back to his preferred indicators of performance during down years: book and "intrinsic" value:

Today, the large – and growing – unrecorded gains at our “winners” make it clear that Berkshire’s intrinsic value far exceeds its book value. That’s why we would be delighted to repurchase our shares should they sell as low as 120% of book value. At that level, purchases would instantly and meaningfully increase per-share intrinsic value for Berkshire’s continuing shareholders.

 

The unrecorded increase in the value of our owned businesses explains why Berkshire’s aggregate marketvalue gain – tabulated on the facing page – materially exceeds our book-value gain. The two indicators vary erratically over short periods. Last year, for example, book-value performance was superior. Over time, however, market-value gains should continue their historical tendency to exceed gains in book value.

Just not this year.

In terms of the most important development for Berkshire in 2015, Buffett says it was not a financial one, but one related to improvements and increased capex spending for Buffett's railroad, BNSF:

The most important development at Berkshire during 2015 was not financial, though it led to better earnings. After a poor performance in 2014, our BNSF railroad dramatically improved its service to customers last year. To attain that result, we invested about $5.8 billion during the year in capital expenditures, a sum far and away the record for any American railroad and nearly three times our annual depreciation charge. It was money well spent.

 

BNSF moves about 17% of America’s intercity freight (measured by revenue ton-miles), whether transported by rail, truck, air, water or pipeline. In that respect, we are a strong number one among the seven large American railroads (two of which are Canadian-based), carrying 45% more ton-miles of freight than our closest competitor. Consequently, our maintaining first-class service is not only vital to our shippers’ welfare but also important to the smooth functioning of the U.S. economy.

He notes that despite declines in the railroad industry, mostly due to the collapse of coal and oil shipments, "BNSF maintained volume, and pre-tax income rose to a record $6.8 billion (a gain of $606 million from 2014)." He does, however, warn that the pain for BNSF is only just starting and expects "lower earnings at BNSF" in 2016.

The letter then covers Berkshire's relationship with Brazilian PE company 3G, its recent acquisition of Precision Castparts, and focuses on its disappointing "Big Four" investments: American Express, Coca-Cola, IBM and Wells Fargo. This is what he said:

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 8.4% versus 7.8% at yearend 2014) and Wells Fargo (going to 9.8% from 9.4%). At the other two companies, Coca-Cola and American Express, stock repurchases raised our percentage ownership. Our equity in Coca-Cola grew from 9.2% to 9.3%, and our interest in American Express increased from 14.8% to 15.6%.... If Berkshire’s yearend holdings are used as the marker, our portion of the “Big Four’s” 2015 earnings amounted to $4.7 billion. In the earnings we report to you, however, we include only the dividends they pay us – about $1.8 billion last year. But make no mistake: The nearly $3 billion of these companies’ earnings we don’t report are every bit as valuable to us as the portion Berkshire records.

Of course, their dramatic underperformance in 2015 is also a main reason why BRK stock has seen its worst performance in 7 years.

* * *

An interesting discussion takes place on page 16 where Buffett discusses a topic near and dear to our heart: ridiculous non-GAAP adjustments which put lipstick on ugly GAAP earnings:

... it has become common for managers to tell their owners to ignore certain expense items that are all too real. “Stock-based compensation” is the most egregious example. The very name says it all: “compensation.” If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?

 

Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring “earnings” figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing “access” to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.

Buffett goes into an extended tirade about how politicians (being a very vocal supporter of Hillary Clinton, it quite clear just which GOP candidate he is referring to) are wrong that America's future is bleak and instead says that "the babies being born in America today are the luckiest crop in history." Here are excerpts from the section:

It’s an election year, and candidates can’t stop speaking about our country’s problems (which, of course, only they can solve). As a result of this negative drumbeat, many Americans now believe that their children will not live as well as they themselves do.

That view is dead wrong: The babies being born in America today are the luckiest crop in history.

 

* * * 

 

Indeed, most of today’s children are doing well. All families in my upper middle-class neighborhood regularly enjoy a living standard better than that achieved by John D. Rockefeller Sr. at the time of my birth. His unparalleled fortune couldn’t buy what we now take for granted, whether the field is – to name just a few – transportation, entertainment, communication or medical services. Rockefeller certainly had power and fame; he could not, however, live as well as my neighbors now do.

 

Though the pie to be shared by the next generation will be far larger than today’s, how it will be divided will remain fiercely contentious. Just as is now the case, there will be struggles for the increased output of goods and services between those people in their productive years and retirees, between the healthy and the infirm, between the inheritors and the Horatio Algers, between investors and workers and, in particular, between those with talents that are valued highly by the marketplace and the equally decent hard-working Americans who lack the skills the market prizes. Clashes of that sort have forever been with us – and will forever continue. Congress will be the battlefield; money and votes will be the weapons. Lobbying will remain a growth industry.

To be sure, Buffett knows all about those, and since corporations remain the true owners of America, one can understand Buffett's optimism:

"For 240 years it’s been a terrible mistake to bet against America, and now is no time to start. America’s golden goose of commerce and innovation will continue to lay more and larger eggs. America’s social security promises will be honored and perhaps made more generous. And, yes, America’s kids will live far better than their parents did."

The ones born to crony capitalists who get bailed out any time there is a major risk dislocation, absolutely.

One thing is certain: his skepticism toward Tinder will be enjoyed by Becky Quick:  "My parents, when young, could not envision a television set, nor did I, in my 50s, think I needed a personal computer. Both products, once people saw what they could do, quickly revolutionized their lives. I now spend ten hours a week playing bridge  online. And, as I write this letter, “search” is invaluable to me. (I’m not ready for Tinder, however.)"

* * *

Buffett also provides a curious discussion on climate change, because he has "a proxy proposal regarding climate change to consider at this year’s annual meeting. The sponsor would like us to provide a report on the dangers that this change might present to our insurance operation and explain how we are responding to these threats."

This is what he says:

It seems highly likely to me that climate change poses a major problem for the planet. I say “highly likely” rather than “certain” because I have no scientific aptitude and remember well the dire predictions of most “experts” about Y2K. It would be foolish, however, for me or anyone to demand 100% proof of huge forthcoming damage to the world if that outcome seemed at all possible and if prompt action had even a small chance of thwarting the danger.

 

This issue bears a similarity to Pascal’s Wager on the Existence of God. Pascal, it may be recalled, argued that if there were only a tiny probability that God truly existed, it made sense to behave as if He did because the rewards could be infinite whereas the lack of belief risked eternal misery. Likewise, if there is only a 1% chance the planet is heading toward a truly major disaster and delay means passing a point of no return, inaction now is foolhardy. Call this Noah’s Law: If an ark may be essential for survival, begin building it today, no matter how cloudless the skies appear.

Or, in a worst case scenario, the insurer can just hope for another government bailout. After all Berkshire employs some 361,270 workers.

* * *

In an surprising twist, following his spirited defense of the bright future facing America's children, Buffett then says that "gains achieved in recent years have largely benefitted the wealthy" making one wonder just whose children's future will be so bright.

... the productivity gains achieved in recent years have largely benefitted the wealthy. Second, productivity gains frequently cause upheaval: Both capital and labor can pay a terrible price when innovation or new efficiencies upend their worlds.

But it is not until the next sentence that we hit peak crony cynicism:

We need shed no tears for the capitalists (whether they be private owners or an army of public shareholders). It’s their job to take care of themselves. When large rewards can flow to investors from good decisions, these parties should not be spared the losses produced by wrong choices.

Unless of course you happen to be Warren Buffett and having made huge investments in insolvent US banks, you too need a taxpayer funded bailout to save you...

 

...  or risk having your "investing Oracle" halo crashing into the dustbin of history.

* * *

Then there is the topic of Berkshire's troubled mortgage lender Clayton Homes which has gotten in hot water recently due to its predatory lending practices. Buffett promptly rushes to defend it:

Lenders other than Clayton have come and gone. With Berkshire’s backing, however, Clayton steadfastly financed home buyers throughout the panic days of 2008-2009. Indeed, during that period, Clayton used precious capital to finance dealers who did not sell our homes. The funds we supplied to Goldman Sachs and General Electric at that time produced headlines; the funds Berkshire quietly delivered to Clayton both made home ownership possible for thousands of families and kept many non-Clayton dealers alive.

 

Our retail outlets, employing simple language and large type, consistently inform home buyers of alternative sources for financing – most of it coming from local banks – and always secure acknowledgments from customers that this information has been received and read.

 

* * *

 

At Clayton, our risk retention was, and is, 100%. When we originate a mortgage we keep it (leaving aside the few that qualify for a government guarantee). When we make mistakes in granting credit, we therefore pay a price – a hefty price that dwarfs any profit we realized upon the original sale of the home. Last year we had to foreclose on 8,444 manufactured-housing mortgages at a cost to us of $157 million.

 

The average loan we made in 2015 was only $59,942, small potatoes for traditional mortgage lenders, but a daunting commitment for our many lower-income borrowers. Our buyer acquires a decent home – take a look at the home we will have on display at our annual meeting – requiring monthly principal-and-interest payments that average $522.

 

Let me talk about one subject of which I am particularly proud, that having to do with regulation. The Great Recession caused mortgage originators, servicers and packagers to come under intense scrutiny and to be assessed many billions of dollars in fines and penalties.

 

The scrutiny has certainly extended to Clayton, whose mortgage practices have been continuously reviewed and examined in respect to such items as originations, servicing, collections, advertising, compliance, and internal controls. At the federal level, we answer to the Federal Trade Commission, the Department of Housing and Urban Development and the Consumer Financial Protection Bureau. Dozens of states regulate us as well. During the past two years, indeed, various federal and state authorities (from 25 states) examined and reviewed Clayton and its mortgages on 65 occasions. The result? Our total fines during this period were $38,200 and our refunds to  customers $704,678. Furthermore, though we had to foreclose on 2.64% of our manufactured-home mortgages last year, 95.4% of our borrowers were current on their payments at yearend, as they moved toward owning a debt-free home.

In other words, Buffett also owns the Federal Trade Commission, the Department of Housing and Urban Development and the Consumer Financial Protection Bureau and dozens of states regulators.

Finally, while there is much more in the full letter, we would like to close with Buffett's summary of risk factors.

Berkshire operates in more industries than any company I know of. Each of our pursuits has its own array of possible problems and opportunities. Those are easy to list but hard to evaluate: Charlie, I and our various CEOs often differ in a very major way in our calculation of the likelihood, the timing and the cost (or benefit) that may result from these possibilities.

 

Let me mention just a few examples. To begin with an obvious threat, BNSF, along with other railroads, is certain to lose significant coal volume over the next decade. At some point in the future – though not, in my view, for a long time – GEICO’s premium volume may shrink because of driverless cars. This development could hurt our auto dealerships as well. Circulation of our print newspapers will continue to fall, a certainty we allowed for when purchasing them. To date, renewables have helped our utility operation but that could change, particularly if storage capabilities for electricity materially improve. Online retailing threatens the business model of our retailers and certain of our consumer brands. These potentialities are just a few of the negative possibilities facing us – but even the most casual follower of business news has long been aware of them.

 

There is, however, one clear, present and enduring danger to Berkshire against which Charlie and I are powerless. That threat to Berkshire is also the major threat our citizenry faces: a “successful” (as defined by the aggressor) cyber, biological, nuclear or chemical attack on the United States. That is a risk Berkshire shares with all of American business.

 

The probability of such mass destruction in any given year is likely very small. It’s been more than 70 years since I delivered a Washington Post newspaper headlining the fact that the United States had dropped the first atomic bomb. Subsequently, we’ve had a few close calls but avoided catastrophic destruction. We can thank our government – and luck! – for this result.

 

Nevertheless, what’s a small probability in a short period approaches certainty in the longer run. (If there is only one chance in thirty of an event occurring in a given year, the likelihood of it occurring at least once in a century is 96.6%.) The added bad news is that there will forever be people and organizations and perhaps even nations that would like to inflict maximum damage on our country. Their means of doing so have increased exponentially during my lifetime. “Innovation” has its dark side.

 

There is no way for American corporations or their investors to shed this risk. If an event occurs in the U.S. that leads to mass devastation, the value of all equity investments will almost certainly be decimated. No one knows what “the day after” will look like.

And then there's this: "U.S. Test Fires Nuclear ICBM, Warns "We Are Prepared To Use Nuclear Weapons." What we do know is that if there is anyone who will profit from said devastation on "the day after", Berkshire will be it.

Full Berkshire annual letter below (pdf)