Warren Buffett’s letter to investors in Berkshire Hathaway’s annual reports are highly instructive.
They give insight into the minds of one of the greatest investors of all time. How great? Take a look at the phenomenal long-term track record of Berkshire Hathaway versus the S&P 500:
Source: Berkshire Hathaway 2015 Annual Report, page 2
Warren Buffett is pithy and very quotable. This article examines 15 quotes from Warren Buffett’s most recent 2015 chairman letter.
It also discusses how you can apply these quotes to your investing process.
GAAP vs. Normalized Earnings
“Charlie Munger, Berkshire Vice Chairman and my partner, and I expect Berkshire’s normalized earning power to increase every year. (Actual year-to-year earnings, of course, will sometimes decline because of weakness in the U.S. economy or, possibly, because of insurance mega-catastrophes.) In some years the normalized gains will be small; at other times they will be material.”
Warren Buffett and Charlie Munger do not think in terms of current year GAAP earnings. Instead they look at normalized earnings.
They look for ways to allocate capital that will grow normalized earnings every year. This means investing in high quality businesses that are likely to see underlying business growth every year (unless something unusual happens).
Normalized earnings show the underlying earnings power of a business. GAAP earnings can fluctuate wildly from year to year for a variety of reasons. Buffett and Munger focus on the financial metrics that matter.
How to Apply to Your Portfolio: Don’t be fooled by GAAP earnings. When great businesses experience temporary downturns (like this one), look at normalized earnings instead of GAAP earnings when calculating the price-to-earnings ratio of a business. This process is likely behind Warren Buffett’s recent purchase of Deere & Company (DE).
Todd Combs and Ted Weschler
“Todd (Combs) and Ted Weschler are primarily investment managers – they each handle about $9 billion for us – both of them cheerfully and ably add major value to Berkshire in other ways as well. Hiring these two was one of my best moves.”
Buffett has thought a great deal about his successor. There is no question that Berkshire Hathaway will far outlive both Buffett and Munger.
As a forward looking owner, Buffett does not invest all of Berkshire’s portfolio. Todd Combs and Ted Weschler each invest around 7% of Berkshire Hathaway’s portfolio.
Both Weschler and Combs were hedge fund managers before joining Berkshire Hathaway.
Weschler is in his mid 50’s. His hedge fund Peninsula Capital generated annual returns of around 25% per year from 2000 through 2011.
Combs is 45. He ran hedge fund Capital Point from 2005 to 2010 and is said to have generated annual returns of 34% per year during that time.
How to Apply to Your Portfolio: If you expect your investment portfolio to outlive you (perhaps it is in a trust), be sure to lay out intelligent rules for the management of your assets into the future. Alternatively, find an asset manager that is decades younger than you who will be able to manage your account in a style you feel comfortable with far into the future.
For investors who don’t have this ‘problem’, you can still benefit from outside opinions by looking at the holdings of great investors – like Warren Buffett himself.
The Magic of Insurance Float
“Berkshire’s huge and growing insurance operation again operated at an underwriting profit in 2015 – that makes 13 years in a row – and increased its float. During those years, our float – money that doesn’t belong to us but that we can invest for Berkshire’s benefit – grew from $41 billion to $88 billion. Though neither that gain nor the size of our float is reflected in Berkshire’s earnings, float generates significant investment income because of the assets it allows us to hold.”
Insurance float is ‘magic’ because it is in effect free money to invest. If you got an $88 billion interest free loan, you could make tremendous sums of money every year just from dividend and interest income. That is the magic of insurance float.
“If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability. Owing $1 that in effect will never leave the premises – because new business is almost certain to deliver a substitute – is worlds different from owing $1 that will go out the door tomorrow and not be replaced. The two types of liabilities, however, are treated as equals under GAAP.”
This quote shows how GAAP does not always function properly to value a business. While insurance float is technically a liability because it has to be paid back, it also produces income from investing the float. Float only has to technically be paid back. As Buffett says in the quote above, if the float is long enduring – meaning it is being reliably replaced, it really is a giant pool of money which can be invested by the company controlling the float.
How to Apply to Your Portfolio: You can apply Buffett’s use of float to your own portfolio by investing in proven insurance companies with a history of profitable underwriting and growth. Cincinnati Financial (CINF) and Aflac (AFL) are two Dividend Aristocrat insurers with long growth histories. Aflac also has a long history of profitable underwriting operations.
“We follow an approach emphasizing avoidance of bloat, buying businesses such as PCC that have long been run by cost-conscious and efficient managers.
After the purchase, our role is simply to create an environment in which these CEOs – and their eventual successors, who typically are like-minded – can maximize both their managerial effectiveness and the pleasure they derive from their jobs.
(With this hands-off style, I am heeding a well-known Mungerism: “If you want to guarantee yourself a lifetime of misery, be sure to marry someone with the intent of changing their behavior.”)”
Warren Buffett makes it very clear that he looks for businesses run by “cost-conscious and efficient managers”.
Buffett looks for businesses that have intelligent and competent managerial teams. Established large businesses with strong competitive advantages can see their competitive position erode from poor management.
Many brands have decades of good will built up. It can take just one (severe) mistake to ruin this brand equity forever.
How to Apply to Your Portfolio: Look for businesses that focus on efficiency and cost-cutting. Businesses with a history of rising margins show a focus on efficiency. Margins do not rise on their own. It takes careful strategy and diligent execution from management to improve efficiency.
On The Value of Retained Earnings
“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. The earnings our investees retain are often used for repurchases of their own stock – a move that increases Berkshire’s share of future earnings without requiring us to lay out a dime.
The retained earnings of these companies also fund business opportunities that usually turn out to be advantageous. All that leads us to expect that the per-share earnings of these four investees, in aggregate, will grow substantially over time. If gains do indeed materialize, dividends to Berkshire will increase and so, too, will our unrealized capital gains.”
The ideal management team would invest only in projects with market beating returns, and return the rest of money to shareholders in the form of dividends (or share repurchases).
Earnings not paid out as dividends are called retained earnings.
When a company’s management is focused on maximizing shareholder value, every dollar of retained earnings is just as valuable as a dividend.
That’s because the money is being reinvested into the business to make it larger (more dividends later) in the future.
Of course this is only true when earnings are invested intelligently. Businesses that squander profits on ‘long shot’ investments or ideas outside their circle of competence would be better paid out as dividends.
How to Apply to Your Portfolio: Invest in businesses that generate per-share earnings growth over time. The better a management is at reinvesting its capital, the quicker earnings-per-share will grow over time.
Businesses that can grow reasonably quickly and have a high payout ratio – Philip Morris (PM) is an example – are able to generate high total returns for shareholders because they invest in only their best ideas and distribute the rest of money to shareholders.
On American Greatness & Growth
“American GDP per capita is now about $56,000. As I mentioned last year that – in real terms – is a staggering six times the amount in 1930, the year I was born, a leap far beyond the wildest dreams of my parents or their contemporaries. U.S. citizens are not intrinsically more intelligent today, nor do they work harder than did Americans in 1930. Rather, they work far more efficiently and thereby produce far more. This all-powerful trend is certain to continue: America’s economic magic remains alive and well.”
Buffett talked about the importance of having efficient management teams in his investments in an earlier quote in this article.
The word efficiency shows up again in this quote.
Innovation has led to efficiency gains in every industry since 1930. As a result, Americans are 6x better off on average than they were in 1930.
Americans on average are 3.8x better off than they were in 1947 (adjusted for inflation) as the image below shows.
Unfortunately America’s real GDP per capita growth is slowing…
“America’s population is growing about .8% per year (.5% from births minus deaths and .3% from net migration). Thus 2% of overall growth produces about 1.2% of per capita growth.
That may not sound impressive. But in a single generation of, say, 25 years, that rate of growth leads to a gain of 34.4% in real GDP per capita. (Compounding’s effects produce the excess over the percentage that would result by simply multiplying 25 x 1.2%.)
In turn, that 34.4% gain will produce a staggering $19,000 increase in real GDP per capita for the next generation. Were that to be distributed equally, the gain would be $76,000 annually for a family of four. Today’s politicians need not shed tears for tomorrow’s children.”
From 1947 through 2015 (a 68 year period) real GDP per capita increased to 3.8x what it used to be in the United States.
The next 68 year period will only see 2.3x gains. While it’s true the United States is still growing, the next generation cannot expect to realize the same growth that previous generations have.
Warren Buffett’s right – that’s nothing to shed a tear over, but it also shows there is much room for improvement.
“The good news, however, is that even members of the “losing” sides will almost certainly enjoy – as they should – far more goods and services in the future than they have in the past. The quality of their increased bounty will also dramatically improve. Nothing rivals the market system in producing what people want – nor, even more so, in delivering what people don’t yet know they want. My parents, when young, could not envision a television set, nor did I, in my 50s, think I needed a personal computer.”
The losing side Buffett is referring to is whoever gains less ground (the rich or the poor) as incomes continue to grow.
Free markets work because they allocate capital to its most efficient use. This does not happen instantly, but over long periods of time it is extremely effective at maximizing the value of society.
Free markets don’t slice the economic pie evenly, but they do greatly expand the pie so everyone society is better off in the long run.
“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.”
Warren Buffett again deviates from investing and discusses politics in this quote.
There is no doubt that American businesses and continued innovation will result in growth over time.
It isn’t clear what will happen with America’s socialized safety net. Nor is it clear that the next generation will truly live better than their parents did…
How can this be if GDP per capita is increasing? Because the next generation will have to contend with more debt than ever before.
The United States national debt sits at $19 trillion. That’s $59,000 of debt for every man, woman, and child in the United States.
Debt represents money that has already been spent by the government. Debt cannot increase indefinitely.
Government debt is the current generation borrowing from the future generation.
The next generation will simply not be able to borrow as much money as the previous has in order to give itself benefits in the present. Extreme debt levels are why it is far from guaranteed that the next generation will be as well off as the current generations.
We cannot pass the buck indefinitely. One generation will be stuck paying down debt instead of borrowing its way to more benefits. That is not political conjecture. It is economic certainty.
“Earlier, I told you how our partners at Kraft Heinz root out inefficiencies, thereby increasing output per hour of employment. That kind of improvement has been the secret sauce of America’s remarkable gains in living standards since the nation’s founding in 1776. Unfortunately, the label of “secret” is appropriate: Too few Americans fully grasp the linkage between productivity and prosperity.”
The way toward improvement in the United States is increasing efficiency (Buffett uses this word yet again! – it is important).
Increased automation and connectedness will make American workers far more efficient on a per capita basis than ever before – resulting in GDP growth.
How to Apply to Your Portfolio: Don’t be scared off from investing in American businesses because GDP growth is sluggish or the country’s debt burden is too high. US businesses are not the US government. Great businesses will continue to improve their efficiency and deliver rising earnings-per-share over time.
Maximizing Per Share Intrinsic Business Value
“The managers who succeed Charlie and me will build Berkshire’s per-share intrinsic value by following our simple blueprint of:
(1) constantly improving the basic earning power of our many subsidiaries;
(2) further increasing their earnings through bolt-on acquisitions;
(3) benefiting from the growth of our investees;
(4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value;
(5) making an occasional large acquisition. Management will also try to maximize results for you by rarely, if ever, issuing Berkshire shares.”
Maximizing per share intrinsic business value is exactly what a management should focus on. It is a fancy way of saying ‘make sure each share has more earnings power next year than last year’.
The 5 point blueprint above discusses exactly how Warren Buffett and Charlie Munger have increased intrinsic business value per share.
“As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). It is possible, however, to make a sensible estimate.”
It is impossible to know the real intrinsic value of a business. To know, one would have to know the exact amount of cash flows the business will generate over its useful life. This is unknowable for all of us non-fortune tellers.
As Buffett says, knowing exact intrinsic value is impossible, but making a reasonable estimate is not. Calculating the fair value of a business is more art than science. All things being equal, businesses with more durable competitive advantages and faster growth rates are more valuable because their earnings are likely to be greater (and last longer) in the future.
How to Apply to Your Portfolio: Invest in businesses that are focused on maximizing intrinsic value per share. Businesses that repurchase shares when the stock has fallen are very likely focused on maximizing shareholder value rather than empire building.
It is also important to invest in businesses you feel are trading under their fair intrinsic value. Low price-to-earnings ratios are the first (but certainly not the last or only) place to look for potentially undervalued businesses.
Cost Based Competitive Advantage
“GEICO’s cost advantage is the factor that has enabled the company to gobble up market share year after year. (We ended 2015 with 11.4% of the market compared to 2.5% in 1995, when Berkshire acquired control of GEICO.) The company’s low costs create a moat – an enduring one – that competitors are unable to cross.”
Cost based competitive advantages in slow-changing industries are among the most lucrative positions a business can have.
GEICO’s low costs allow it to charge what its competitors do and make more profits – which it can spend on advertising to grow faster. Alternatively, the company can undercut its competitors to grow market share.
Cost-based competitive advantages can either be based on business organization (such as GEICO’s) or due to economies of scale (like Wal-Mart). Scale based competitive advantages are especially difficult to combat because they prevent new entrants from being able to ‘catch up’.
How to Apply to Your Portfolio: Invest in highly efficient, low cost leaders in industries that are likely to exist far into the future.
“Of course, a business with terrific economics can be a bad investment if it is bought at too high a price.”
This is best thought of by looking at the earnings yield of a business. If a company is growing at 25% a year but has an earnings yield (earnings divided by price) of just 2%, it will take around 6 years for the business to have an earnings yield on cost of 8%.
You could get the same 8% earnings yield today by investing in a business with a price-to-earnings of 12.5 – and not have to wait 6 years and risk the growth not being as high as expected.
Great businesses are only great when they trade at fair or better prices.
How to Apply to Your Portfolio: Don’t invest in businesses trading significantly above their historical average price-to-earnings ratio, or the price-to-earnings ratio of the overall market. The 8 Rules of Dividend Investing takes valuation into account to find high quality businesses trading at fair or better prices.
Warren Buffett’s quotes illuminate his investing style.
Boiled down to its core, Buffett looks for the following in an investment:
- Strong and durable competitive advantage
- Efficiency focused management
- Fair or better price
If a business fits the 3 criteria above he will hold it for the long run – often for decades.
Warren Buffett has used this relatively simple approach (applied extremely intelligently) to become one of the richest men in the world.
His take on the economy, investing, and politics is well-reasoned and well thought out. This makes his annual reports important reading for investors serious about investing in great businesses.