In its latest annual letter, released at 8am on Saturday, Warren Buffett’s Berkshire Hathaway said Q4 profit rose 15% as net income increased to $6.29 billion, or $3,823 a share, from $5.48 billion, or $3,333 the previous year, while operating earnings, which exclude some investment results, were $2,665 a share, a slight miss to the $2,717 consensus estimate.
In 2016, the 86-year-old billionaire added new companies to his assorted conglomerate portfolio, and completed the purchases of battery giant Duracell and aerospace supplier Precision Castparts, which helped to boost profit in his company’s manufacturing segment.
For the full year, Berkshire earned $24.07 billion, unchanged from the previous year, despite a 6% increase in total revenue to $223.6 billion. Unlike 2015, which saw a bumper rebound in the amount of revenues from investment and derivative gains which rose by more than 150% to $10.3 billion, in 2016 this number was more modest at $8.3 billion.
Among other notable operational highlights, Berkshire said it had booked a $1.2 billion gain from converting its preferred stake in Dow Chemical to common stock, and that it had sold all of the Dow common it converted by Dec. 31. Berkshire also revealed that its massive holdings of Apple stock, which as of December 31, had risen to 61.2 million shares making Berkshire one of the Top 10 holders of Apple, was acquired last year for $6.747 billion, or an average of roughly $110 per share. The stake was valued at more than $8.3 billion as of Friday’s $136.66 closing price, leading to a $1.6 billion unbooked gain. In addition to apple, Berkshire's other Top 15 investments are laid out below:
Ironically, even though Berkshire - along with Goldman and JPM - has been among the biggest beneficiaries of the "Trump rally", with Berkshire Class A shares climibg 15% since Nov. 8, bringing the company’s market capitalization above $400 billion for the first time, beating the S&P's 11% increase, there were no explicit mentions of Donald Trump's name anywhere in the letter. There were, however, various veiled references to the new president.
Speaking of performance, Buffett has advised investors to focus on the earnings from his operating businesses, rather than one-time gains or losses on Berkshire’s securities portfolio as these can fluctuate widely on investments and derivatives contracts that he entered years ago. Furthermore, whereas the Berkshire chairman used to compare Berkshire’s book value to the return on the S&P 500, in the past few years he’s also added Berkshire’s stock price. Buffett argues here that book value–a measure of assets minus liabilities–now lags so significantly behind Berkshire's stock because Berkshire has shifted its business model over the past few decades away from largely investing in just insurance companies and publicly traded stocks. Book value doesn't rise when the value of a wholly-owned company does in the same way it rises when a stock goes up.
Now, Buffett writes, “the company’s 52-year market-price gain – shown on the facing page – materially exceeds its book-value gain," and lays out his case for why book value is a less important metric than it used to be using language similar to last year's letter. As the WSJ chart below show, in the past year, Berkshire book value rose 10.7%, while its shares rose 23.4%. The S&P 500 returned 12% with dividends. That’s why Berkshire in recent years has said it would buy back shares if the stock ever fell as low as 120% of book value.
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Berkshire's performance and operations aside, it is the actual contents of the letter that is of fascination to the millions of "value investing" Buffett faithful every year. Here, while Buffett does not engage Trump directly, he almost immediately touches on one of the key policies of the new White House namely immigration, as part of his big picture political comments.
On immigration and the future of the US economy:
On page five Buffett writes that "Americans have combined human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law to deliver abundance beyond any dreams of our forefathers."
As the WSJ notes, "that's about as political as he appears to get in his annual section on what makes America great" although he does make the case that immigrants are a core explanation of how "America’s economic dynamism" has played a role in boosting Berkshire over the years. As such, you can count Buffett among those whose faith in America remains unshaken. As he writes: "Early Americans, we should emphasize, were neither smarter nor more hard working than those people who toiled century after century before them. But those venturesome pioneers crafted a system that unleashed human potential, and their successors built upon it. This economic creation will deliver increasing wealth to our progeny far into the future."
"Early Americans, we should emphasize, were neither smarter nor more hard working than those people who toiled century after century before them. But those venturesome pioneers crafted a system that unleashed human potential, and their successors built upon it."
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On the US market:
Buffett said the market system that has propelled U.S. economic growth for more than two centuries will continue unabated, echoing his optimism about the country where he amassed a fortune. “The build-up of wealth will be interrupted for short periods from time to time,” Buffett, 86, wrote in his annual letter to Berkshire Hathaway Inc. shareholders, which was posted online Saturday. “It will not, however, be stopped. I’ll repeat what I’ve both said in the past and expect to say in future years: Babies born in America today are the luckiest crop in history.”
"American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that. Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle."
Of course, the noted naysayers may respond quite simply to Buffett by saying "heaven help you" if the government does not bail out your flailing investments during a financial crash, as happened in 2008.
Buffett has a favorable perspective on entitlements, writing that "America has, for example, decided that those citizens in their productive years should help both the old and the young. Such forms of aid – sometimes enshrined as “entitlements” – are generally thought of as applying to the aged. But don’t forget that four million American babies are born each year with an entitlement to a public education. That societal commitment, largely financed at the local level, costs about $150,000 per baby. The annual cost totals more than $600 billion, which is about 31?2% of GDP."
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On fear as an investor's friend:
Having covered his optimism in the future of the country, and his faith in the average American, Buffett then quickly moves on to discuss why "widespread fear" is an investor's friend: "Every decade or so, dark
clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do." However, shortly after, he offers more general investment advice, saying that it's important to "never forget two things."
"First, widespread fear is your friend as an investor, because it serves up bargain purchases," he writes. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well."
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On Passive vs Active investing, and why Buffett is not a fan of Hedge Funds
Buffett writes that "in Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund. "
Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?
What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides –stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds. I hadn’t known Ted before our wager, but I like him and admire his willingness to put his money where his mouth was. He has been both straight-forward with me and meticulous in supplying all the data that both he and I have needed to monitor the bet.
Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. The five he selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager. Each fund-of-funds, of course, operated with a layer of fees that sat above the fees charged by the hedge funds in which it had invested. In this doubling-up arrangement, the larger fees were levied by the underlying hedge funds; each of the fund-of-funds imposed an additional fee for its presumed skills in selecting hedge-fund managers.
The results aren't pretty for active managers. The S&P 500 index fund has climbed 85.4% to date. Only one hedge fund of hedge funds came remotely close with a 62.8% return. The others are well below with gains of 8.7% 28.3% 2.9% 7.5%. In annualized returns, the S&P 500 index fund returned 7.1%, while the five hedge fund of funds delivered through 2016 an average of just 2.2%.
Just to hammer the point in, Buffett also says "in my opinion, the disappointing results for hedge-fund investors that this bet exposed are almost certain to recur in the future."
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On others' buyback strategies
Continuing his surprising cognitive dissonance demonstrated in recent years, Buffett, a champion of "investing for the long term" has once again ridden to the defence of a corporate practice that is sometimes condemned as the height of short-termism: share buybacks. In his latest annual letter, the chief executive of Berkshire Hathaway, urged everyone in what he called the “heated” debate over buybacks to “take a deep breath”.
“Some people have come close to calling them un-American - characterizing them as corporate misdeeds that divert funds needed for productive endeavors. That simply isn’t the case.”
Buffett looks at the lesser-discussed question of what price the company is buying its shares back at, noting that repurchases only make sense for long-term shareholders if they're done at a level below the company's intrinsic value. In that sense, Mr. Buffett says more companies should disclose the maximum price at which they would buy back shares, noting:
"It is puzzling, therefore, that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed. That certainly wouldn’t be the case if a management was buying an outside business. There, price would always factor into a buy-or-pass decision."
Buffett also dismisses arguments that buybacks are diverting funds from more worthwhile expenditures. Some have argued that the money spent to repurchase shares in recent years could be spent on expanding operations, but "that simply isn't the case," he writes. "Both American corporations and private investors are today awash in funds looking to be sensibly deployed. I’m not aware of any enticing project that in recent years has died for lack of capital."
Which, of course, is the whole point: its not the lack of capital, it's the lack of IRR-worthy projects presented to corporate CFOs and Treasurers, who instead of investing in long-term growth focus on the immediate gratification for shareholders and management at the expense of newly incurred debt.
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On Berkshire's buyback strategy
Giving a thumbs up to others' buybacks, Buffett then reminds readers about Berkshire's own buyback policy. Berkshire has said publicly, and repeatedly, that it will buy back shares if they ever fall to within 120% of book value. "Our Board has concluded that purchases at that level clearly bring an instant and material benefit to continuing shareholders," he writes. "By our estimate, a 120%-of-book price is a significant discount to Berkshire’s intrinsic value."
But even then, Mr. Buffett doesn't promise to rush in and buy up every available share. "If that level is reached," he writes, "we will instead attempt to blend a desire to make meaningful purchases at a value-creating price with a related goal of not over-influencing the market." Berkshire has rarely actually repurchased its stock, in part because Mr. Buffett has signaled so clearly that 120% of book value is a level where he considers the stock to be a screaming buy.
And that, he writes, is fine by him: "Charlie and I prefer to see Berkshire shares sell in a fairly narrow range around intrinsic value, neither wishing them to sell at an unwarranted high price – it’s no fun having owners who are disappointed with their purchases – nor one too low."
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Buffett again slams of hedge funds
And the hits just keep on coming for the "two and twenty" industry which Buffett is clearly not a fan on. He writes that management fees invariably eat into returns, and especially the famous "two and twenty" fee structure. "Under this lopsided arrangement, a hedge-fund operator’s ability to simply pile up assets under management has made many of these managers extraordinarily rich, even as their investments have performed poorly.
"I estimate that over the nine-year period roughly 60% – gulp! – of all gains achieved by the five funds-of-funds were diverted to the two levels of managers. That was their misbegotten reward for accomplishing something far short of what their many hundreds of limited partners could have effortlessly – and with virtually no cost – achieved on their own."
He then generalizes his observation as follows:
So that was my argument – and now let me put it into a simple equation. If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win. (The academic in me requires me to mention that there is a very minor point – not worth detailing – that slightly modifies this formulation.) And if Group A has exorbitant costs, its shortfall will be substantial.
Not everyone is a terrible manager: "There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified – early on – only ten or so professionals that I expected would accomplish this feat. There are no doubt many hundreds of people – perhaps thousands – whom I have never met and whose abilities would equal those of the people I’ve identified. The job, after all, is not impossible. The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: “In investment management, the progression is from the innovators to the imitators to the swarming incompetents.”
That said, perhaps Buffett can ask Sequoia, which the late Bill Ruane founded via Euane, Cuniniff and Goldfarb, how its investment in Valeant has done in the past few years. A fund that was until recently the best-performing large-cap growth mutual fund tracked by Morningstar over the previous 15 years, Sequoia was recently slammed by the spectacular tumble of Valeant shares: Valeant was Sequoia's largest position by far at the time of its fall. There's more irony in the story: Sequoia used profits made by selling shares of Berkshire Hathaway to first buy Valeant in 2010.
Buffett continues, comparing hedge fund managers to lucky monkeys:
Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him.
Finally, Buffett writes, "there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!). Third, most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees."
He is not wrong in that observation, and continues: "these three points are hardly new ground for me: In January 1966, when I was managing $44 million, I wrote my limited partners: “I feel substantially greater size is more likely to harm future results than to help them. This might not be true for my own personal results, but it is likely to be true for your results. Therefore, . . . I intend to admit no additional partners to BPL. I have notified Susie that if we have any more children, it is up to her to find some other partnership for them.”
His bottom line: "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds."
Judging by the collapse in the hedge fund industry, this observation is starting to take hold.
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On his "hero", passive investing's patron saint, Vanguard's Jack Bogle
If Buffett hates hedge funds, and active investing, it is only logical that he would praise passive investors and their god, Vanguard's Jack Bogle. And sure enough, after four pages blasting what he believes to be overcompensated hedge fund managers, Buffett sets aside space to honor indexing champion and Vanguard Group founder, Jack Bogle:
"If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value. In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.
And as for Bogle's hero? Activist Central Banks, who now intervene directly in capital markets any time there is even a tiny dip in the S&P, making hedging unnecessary, and shorting suicidal.
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On his investment in Bank of America
Going back to the topic of buybacks, Buffett applauds Bank of America, which he believes has been undervalued, for buying back its shares. "Many of our investees, including Bank of America, have been repurchasing shares, some quite aggressively," he writes. "We very much like this behavior because we believe the repurchased shares have in most cases been underpriced."
As the WSJ points out, this comment comes after he adds an interesting nugget to his paragraphs on holdings of Bank of America warrants and preferred shares starting on page 19. In short, Berkshire has warrants to buy 700 million shares of Bank of America at $7.14 apiece. The stock closed Friday at $24.23, so Mr. Buffett is looking at a paper gain of about $12 billion. In the past, Berkshire has said it would probably only exercise the warrants just before they expired, in September 2021. But now, Buffett says he would consider doing it if Bank of America raises its dividend, and would exchange its Bank of America preferred shares to fund the transaction. Right now, the bank pays a 30 cent-per-share dividend annually, but it it hits 44 cents, it would make the swap, he writes.
Why 44 cents? He doesn't spell it out here, but that works out to just over $300 million in annual dividend proceeds. The preferred stock Berkshire now owns pays a chunky 6% annual dividend that also works out to $300 million a year. The preferreds have little downside, so long as Bank of America stays solvent, but they have no upside either. Mr. Buffett is saying he'd rather enjoy the upside on the common stock, about as clear a buy signal as you'll get from the famed stockpicker. Bank of America raised its dividend to 30 cents annually from 20 cents last year.
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On the non-GAAP Charade
Having skewered hedge funds, Buffett then turns to another recurring peeve of his: adjusted earnings and begins with an old story: "During the accounting nonsense that flourished during the 1960s, the story was told of a CEO who, as his company revved up to go public, asked prospective auditors, 'What is two plus two?' The answer that won the assignment, of course, was, 'What number do you have in mind?'"
To be sure, Buffett has railed against non-GAAP earnings in the past and this year is no different, as he hones in on two specific items often excluded from adjusted earnings measures.
First, is "restructuring" costs. As he puts it: "Berkshire, I would say, has been restructuring from the first day we took over in 1965," though the firm has never singled out those costs and said to ignore them.
Second, is "stock-based compensation." The top executives at many companies typically get at least 20% of their compensation this way, making it hard to claim it's not an expense. As Mr. Buffett puts it: "CEOs who go down that road are, in effect, saying to shareholders, “If you pay me a bundle in options or restricted stock, don’t worry about its effect on earnings. I’ll ‘adjust’ it away.”
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"Major Slowing" in railcar demand
As the WSJ notes, "Berkshire is such a large conglomerate that other conglomerates are tucked inside it." One is Marmon, acquired from the Pritzker family in 2008. Marmon alone employs more than 18,000 people and recorded pre-tax earnings of more than $750 million last year. It consists of more than 170 manufacturing and servicing businesses that operate withing 15 business sectors, with the main one being a major railcar leasing business called UTLX.
Railcar leasing is cyclical, and Mr. Buffett says the business experience "a major slowdown in demand last year, which will cause earnings to decline in 2017. Fleet utilization was 91% in December, down from 97% a year earlier." Still, Mr. Buffett says he remains a fan of the operation. "Big swings in railcar demand have occurred in the past and they will continue," he writes. "Nevertheless, we very much like this business and expect decent returns on equity capital over the years."
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Declining Coal Use
Linked to the slowdown in railcar demand, the Berkshire annual report notes that BNSF railroad's earnings fell 16% in 2016 to $3.6 billion without an explanation. Since BNSF is one of Berkshire's biggest units, this drop had a notable impact on the company's full-year results. The annual report gives a few more details: "In 2016, we experienced declining demand, especially in our coal and crude oil categories. Coal had the largest decline, driven by structural changes in that business as well as competition from low natural gas prices."
BNSF's freight revenues from coal fell 27% in 2016. But freight revenues also fell in other segments including consumer products and industrial products, suggesting the economic slowdown was much broader than expected. That, as the WSJ notes, might explain why Mr. Buffett didn't mention BNSF's top executives by name, as he has in past letters. Mr. Buffett tends to only name managers when he's praising them.
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There is much more in the full letter below (link)