Thursday, 2 March 2017

Favourite quotes from the recent Berkshire annual letter

A bit belated but below are a selection of quotes, grouped by topic, that I liked from Warren Buffett's recent letter. There was no big change in my mind but I enjoyed reading his section on buybacks (on this topic Joe from Value Investing World has a great collection of quotes). He also really went to town on fees this time around - 5 pages, must have had a lot on his chest.

No discussion around the Kraft/Unilever process (probably too early), but in a recent FT article he hinted at a possible misunderstanding between Kraft's chairman and Unilever's CEO. It's very rare for him to single out someone by name (unless he praises), so I think there probably was some tension between Berkshire/3G given the way the deal ended up (Unilever played a great defense though). As I said in a recent post, one of the most important things I learnt last year was that business is not just about numbers and most public investors tend to completely ignore boards/managements when they are analysing a company. Here is a clear example why understanding their skills and abilities, personalities, motives, incentives and so on are hugely important. I think the single best change most investors can make is that they stop reading the "risk" section in annual reports (as a side note, actually the majority of risk factors are common sense and included by the insistence of lawyers for "backside" covering) and put more effort into understanding the people running the company, what kind of CEO is in place (a dealmaker, a numbers guy, a sales/story guy etc), what's the relationship with the board or controlling shareholder(s) (if any), what skills board members bring and so on. Sometimes you can discover fascinating information.

And now for the quotes. Enjoy. Oh and the letter is available here.

  • On Berkshire’s business model: “(1) continuing to build our insurance operation; (2) energetically acquiring large and diversified non-insurance businesses and (3) largely making our deals from internally-generated cash”
  • On retained earnings vs capital return: “It’s our job, though, to over time deliver significant growth, bumpy or not. After all, as stewards of your capital, Berkshire directors have opted to retain all earnings. Indeed, in both 2015 and 2016 Berkshire ranked first among American businesses in the dollar volume of earnings retained, in each year reinvesting many billions of dollars more than did the runner-up. Those reinvested dollars must earn their keep”
  • On market volatility: “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 businesses will almost certainly do well”
  • On buybacks: “From the standpoint of exiting shareholders, repurchases are always a plus. Though the day-to-day impact of these purchases is usually minuscule, it’s always better for a seller to have an additional buyer in the market. For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. 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. 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. When CEOs or boards are buying a small part of their own company, though, they all too often seem oblivious to price. Would they behave similarly if they were managing a private company with just a few owners and were evaluating the wisdom of buying out one of them? Of course not”
  • On adjusted earnings: “Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses. Charlie and I want managements, in their commentary, to describe unusual items – good or bad – that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings” makes us nervous. That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well. Goals like that can lead, for example, to insurers underestimating their loss reserves, a practice that has destroyed many industry participants. Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers”
  • Banker fees (there is a whole section about investment management fees from page 20 onwards): “And, finally, let me offer an olive branch to Wall Streeters, many of them good friends of mine. Berkshire loves to pay fees – even outrageous fees – to investment bankers who bring us acquisitions. Moreover, we have paid substantial sums for over-performance to our two in-house investment managers – and we hope to make even larger payments to them in the future. To get biblical (Ephesians 3:18), I know the height and the depth and the length and the breadth of the energy flowing from that simple four-letter word – fees – when it is spoken to Wall Street. And when that energy delivers value to Berkshire, I will cheerfully write a big check”
  • On the current cash balance: “It’s important for you to understand that 95% of the $86 billion of “cash and equivalents” (which in my mind includes U.S. Treasury Bills) shown on our balance sheet are held by entities in the United States and, consequently, is not subject to any repatriation tax”
  • On mistakes: “I earlier described our gradual shift from a company obtaining most of its gains from investment activities to one that grows in value by owning businesses. Launching that transition, we took baby steps – making small acquisitions whose impact on Berkshire’s profits was dwarfed by our gains from marketable securities. 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”
  • On his two investment managers: “Todd Combs or Ted Weschler, who work with me in managing Berkshire’s investments. Each, independently, manages more than $10 billion; I usually learn about decisions they have made by looking at monthly trade sheets. Included in the $21 billion that the two manage is about $7.6 billion of pension trust assets of certain Berkshire subsidiaries.” See page 18 for public investment breakdown
  • On insurance operations: “At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained. Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance”