Published February 28th, 2017 by Nicholas McCullum
On February 25, 2017, Berkshire Hathaway (BRK.A) (BRK.B) published their 2016 Annual Report. This comes shortly after their February 14th filing of their Form 13F with the Securities Exchange Commission.
Many value investors have earmarked some time to read over Berkshire’s Annual Report – or more specifically, the Chairman’s Letter, written by the company’s Chairman and CEO Warren Buffett.
Buffett is one of the most successful – and most iconic – investors of all time. From 1965 to 2016, Buffett led Berkshire Hathaway through a period that saw their book value per common share grow at an incredible 19.0% per year. These returns are notable for both their magnitude and the length of time over which they occurred.
Buffett is also a remarkably skilled communicator. His Chairman’s Letters are often cited as must-reads and condense an incredible amount of knowledge into folksy colloquialisms that are easily understood by novice investors.
This year is no different. This article will discuss in detail the valuable investment lessons contained in Berkshire Hathaway’s 2016 Annual Report.
Lesson #1: Book Value is an Imperfect Measure of Intrinsic Value
For decades, Berkshire Hathaway’s annual reports have begun with a table that depicts the growth in the company’s book value per common share versus the total return of the S&P 500 Index.
This was changed in Berkshire’s 2014 Annual Report, when an additional column was included to include the performance of Berkshire Hathaway’s Class A common stock.
You can view the table from the 2016 Annual Report below.
Source: Berkshire Hathaway 2016 Annual Report, page 2
Buffett made in very clear why he decided to add the column of market price. You can see his reasoning below.
“Today, our emphasis has shifted in a major way to owning and operating large businesses. Many of these are worth far more than their cost-based carrying value. But that amount is never revalued upward no matter how much the value of these companies has increased. Consequently, the gap between Berkshire’s intrinsic value and its book value has materially widened.
With that in mind, we have added a new set of data – the historical record of Berkshire’s stock price – to the performance table on the facing page.”
Source: Berkshire Hathaway 2014 Annual Report, page 3
Buffett again discussed the divergence between Berkshire Hathaway’s book value and intrinsic value in his 2016 letter.
“Over time, stock prices gravitate toward intrinsic value. That’s what has happened at Berkshire, a fact explaining why the company’s 52-year market-price gain – shown on the facing page – materially exceeds its book-value gain.”
Source: Berkshire Hathaway 2016 Annual Report, page 3
For investor focused on valuation metrics, this is important. It will be very rare for Berkshire Hathaway to trade at prices near its book value at any point in the near future.
This is not because the company is becoming more overpriced as time passes. Rather, it’s because book value is becoming an increasingly poor measure by which to estimate Berkshire’s intrinsic value.
This principle exists among other companies as well, and can especially be used when analyzing other businesses that commonly perform transactions to gain new wholly-owned subsidiaries.
Lesson #2 – Dilution Destroys Shareholder Value
After discussing book value, Buffett writes about the value-destroying capability of stock issuances have.
More specifically, Buffett discusses how some of his company’s previous acquisitions, while valuable as subsidiaries of Berkshire, have actually harmed Berkshire’s shareholders because the transactions were made in stock rather than in cash.
Buffett begins his explain in the 1990s, a period that saw Berkshire transition from a company that primarily invested in marketable securities to one that purchased businesses in whole.
Though Berkshire began this transition very carefully, Buffett’s first large mistake inevitably came in the form of Dexter Shoe, of which he writes:
“Despite that cautious approach, I made one particularly egregious error, acquiring Dexter Shoe for $434 million in 1993. Dexter’s value promptly went to zero. The story gets worse: I used stock for the purchase, giving the sellers 25,203 shares of Berkshire that at yearend 2016 were worth more than $6 billion.”
Buffett then goes on to describe his strategy for financing some of Berkshire’s other notable acquisitions.
First, he happily describes how Berkshire paid cash for the half of GEICO it did not already own in 1996, a transaction that made the insurer a ‘centerpiece’ for Berkshire.
Next, the Oracle of Omaha laments about the issuance of stock for General Re, which raised Berkshire’s float by 21.8%.
“My error caused Berkshire shareholders to give far more than they received (a practice that – despite the Biblical endorsement – is far from blessed when you are buying businesses).”
– Warren Buffett on issuing stock to purchase General Re in late 1998
Buffett describes in his last example how his cash purchase of MidAmerican Energy allowed his shareholders to benefit from the acquisition without reducing their ownership stake.
For investors, the main take-home message here is to invest in companies who avoid issuing shares unless absolutely necessary.
While share issuance can sometimes be value enhancing (Berkshire’s acquisition of BNSF being one example, according to Buffett), they typically have the opposite effect.
Lesson #3 – Buffett is Bullish on the American Economy
Buffett is known for being vocally bullish on the American economy, particularly over long enough periods of time.
When asked his opinion on the stock market after the election of President Trump in November, Buffett said “The stock market will be higher 10, 20, 30 years from now, and it would have been with Hillary, and it … will be with Trump.”
Buffett’s bullishness was reiterated in his 2016 annual report.
“This economic creation will deliver increasing wealth to our progeny far into the future. Yes, the build-up of wealth will be interrupted for short periods from time to time. 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.”
I think it’s safe to say that Buffett has more insight into the economic future or American than most individual investors. As such, it is encouraging to see him being so optimistic about the future of the country’s economy.
Lesson #4 – Bargain Hunting Combined with Long Holding Periods Create Substantial Value
Buffett has been investing on some level for the better part of seventy years. He has been through numerous market cycles and the bear markets associated with them.
Given Buffett’s investment longevity, he certainly possesses an above-average ability to withstand market downturns. More novice investors may have trouble staying invested and making decisions with a long-term point of view when bear markets inevitably arise.
For these investors, Buffett offers the following advice:
“During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. 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.”
With the S&P 500 trading at a historically elevated price-to-earnings ratio and the stock market continuing a remarkably long bull market, many investors are expecting some sort of downturn in the near future.
Predicting the timing of market cycles is impossible. One thing remains certain – the advice listed above will help investors whenever the next downturn arrives.
Lesson #5 – Share Repurchases Build Value, Regardless of What the Skeptics Say
The concept of share repurchases often divides investors into two camps.
The first camp cites the shareholder benefits of a stock repurchase plan. When a company retires stock in this way, investors benefit from owning a higher proportion of the overall company. This translates to higher earnings-per-share and more voting power. The business also benefits from savings in the form of reduced future dividend payments (unless they pay no dividend like Berkshire).
The second camp believes that while share repurchases might be beneficial for the shareholders of the company in question, they divert funds from more economically useful endeavors. In Buffett’s letter, he notes how some have even stated that share repurchases are “un-American” and describing them as “corporate misdeeds”.
Buffett disagrees with this second view, and appears to be a supporter of share repurchase plans so long as they occur at the right price. In a very Buffett-esque manner, he boils down the concept of share repurchases in a way that nearly anyone can understand:
“Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.”
Lesson #6 – Cheap Leverage is an Incredible Advantage
Much of Berkshire’s total wealth has been created with the use of insurance float.
Float is money that is collected as insurance premiums and expected to be paid in the future as insurance claims. In the interim, the insurance company is free to invest this money to gain a profit.
Buffett has long invested Berkshire’s insurance float in equity securities to Berkshire’s (and its investors’) benefit. It is safe to say that Buffett’s success in investing his insurance float has been a huge contributor to Berkshire’s strong long-term financial performance.
Unfortunately, individual investors do not have the same leverage capabilities that Buffett has. Other than the magnitude of Berkshire’s float (currently in excess of $100 billion), there are two other major differences between Buffett’s leverage and leverage available to the individual investor.
First, most investment margin available to individual investors is callable. This means that a certain amount of maintenance margin (or actual investor capital) is required to stay in an the account, and if falling security prices make the account fall below this level, securities will automatically be sold to meet this requirement.
This is undesirable because it does not allow leveraged investors to hold on to their securities during periods of significant market decline. Being forced to sell at a loss due to over-leverage can seriously inhibit investor returns.
Buffett’s leverage is not callable in the same sense. While small portions of Berkshire’s insurance float are consistently being paid out as claims while also being replenished by new premiums, the net effect is positive. Berkshire Hathaway’s insurance float has consistently grown over the years thanks to conservative underwriting and strong investment performance.
Source: Berkshire Hathaway 2016 Annual Report, page
The second major difference between Buffett’s leverage and the leverage available to you and I is the interest rate. Buffett pays a 0% interest rate on his insurance float, since it is not a loan in the technical sense. The margin interest rates from the retail brokers available to you & I is much higher than this – the cheapest I have seen is 2%.
So while investors may be able to borrow money to fund their investing, they will not be capable of doing it at the rates available to the Oracle of Omaha.
Lesson #7 – Berkshire Has an Invisible Stake in Bank of America
Many investors (this website included) follow Berkshire Hathaway’s investment activities. While it is not wise to blindly follow Buffett into trades, Buffett’s seal of approval can certainly cement an investment thesis.
A large part of this is because the Oracle of Omaha places a great degree of emphasis on investing in high-quality companies. This focus on quality is evident in Buffett’s portfolio of high quality dividend growth stocks.
Many significant positions in Berkshire Hathaway’s portfolio can be seen below.
Source: Berkshire Hathaway 2016 Annual Report, page 19
What might not be evident from looking at the table above of the company’s 13F filings is that Berkshire Hathaway has a large, invisible stake in Bank of America (BAC). The mechanics of this investment lie in preferred shares and stock warrants, and were described in detail in Buffett’s letter:
“Excluded from the table – but important – is our ownership of $5 billion of preferred stock issued by Bank of America. This stock, which pays us $300 million per year, also carries with it a valuable warrant allowing Berkshire to purchase 700 million common shares of Bank of America for $5 billion at any time before September 2, 2021. At yearend, that privilege would have delivered us a profit of $10.5 billion. If it wishes, Berkshire can use its preferred shares to satisfy the $5 billion cost of exercising the warrant.”
Buffett also elaborates on his plan to eventually exercise the warrants. He states that if Bank of America’s dividend rises to $0.44 before 2021, he would aim to make a cashless exchange of preferred stock into common stock. Bank of America’s current dividend is $0.30 per year.
Investors who follow Buffett’s investment activities should keep in mind his meaningful – though not straightforward – position in Bank of America.
Final Thoughts and Additional Resources
As investors, we have a great deal to learn from successful investors who communicate their strategies openly to the public. Warren Buffett certainly fits this description and is also generally accepted as one of the most renowned investors of all time.
If you’re interested in learning more about the investment style of Warren Buffett, the following articles on Sure Dividend may be of interest to you:
- 15 Actionable Quotes from Warren Buffett’s 2015 Annual Report
- Warren Buffett’s Top 20 Dividend Stocks (recently updated to reflect 12/31/2016 holdings)
- 107 Profound Warren Buffett Quotes: Learn to Build Wealth
- Warren Buffett’s 3 Cornerstones of Sound Investing
- Warren Buffett’s Billion Dollar Apple Investment
- The 15 Owner-Related Business Principles of Warren Buffett