What we read in Warren Buffett’s Letter to Shareholders

27 Feb 2023 , 10:39 AM

It is not often that company founders become larger than life personalities. It is also rare that an annual general meeting almost becomes like a pilgrimage for every aspiring and veteran investor the world over. It is a lot more surprising that young professionals and wannabe investment experts are captivated by 2 founders aged 92 and 99 respectively. Yes, we are talking about Warren Buffett, the oracle of Omaha, and his long time associate and co-founder, Charlie Munger. Over the last many years, the one thing about Berkshire Hathaway that has become almost part of investment folklore is the annual letter to shareholders, which is personally penned by Warren Buffett.

First, the proof of the pudding

Over the last few years, there have been several critics who have questioned whether the age old Buffett wisdom is still relevant in a rapidly changing world. However, despite the pressures of short-termism, Buffett and Munger have stuck to some of the core principles (which we shall look at towards the end). There are some who protest that Buffett missed out the greatest stories in the technology space, but that was a conscious decision. However, let us not forget, that today nearly 40% of the holdings of Berkshire Hathaway are Apple and it has accounted for most of the value accretion in the last 6 years.

But, that is not the real point. Investing longevity is about how true an investor can stay to the core principles in an intelligent, yet flexible, way. It is not that Buffett has not changed. He did buy Apple, IBM and TSMC among technology stocks, although he exited IBM and substantially cut down on TSMC. Berkshire also bought pharma stocks around COVID but exited most of them by 2022. But the real proof of the pudding lies in their compounded returns (CAGR) over the last 57 years. While the S&P 500 yielded 9.9% CAGR in these 57 years, Berkshire portfolio has given 19.8%. Remember, this is at a time when majority of fund manages even struggle to beat the index on a consistent basis.

The Berkshire Hathaway model

As Buffett explains in his now famous letter to shareholders for year 2022, the Berkshire model is broadly classified into two parts.

1. Businesses that Berkshire own nearly 100% and fully control include their interests in the insurance, reinsurance, utility and the railroads business. Here, Berkshire is actively involved in capital allocation, strategy and in selecting the CEO to manage operations.

    

2. The second is the passively owned portfolio of publicly traded stocks, where Berkshire has no say in the management, although it is now making its voice heard. Stocks like Apple, Amex, Coca Cola, Bank of America and Chevron fall in this category.

On the owned business front, Berkshire largely delegates full powers to the CEO, albeit with monitoring. Berkshire gives a long rope to the CEOs in such cases. On the second part of the portfolio, the focus continues to be on digging out value. However, as Buffett puts it, it is much easier to get bargains in passive investments than in buying businesses. That, probably, explains why Buffett continues to be interested in portfolio investing. Even in the portfolio part, Berkshire has generally been a long term investor where they sense sustained value. Two classic examples of this approach is Coca Cola and Amex in the portfolio.

Year 2022 performance and the unique buyback story

For the full year 2022, Berkshire Hathaway earned $30.8 billion as operating earnings with the earnings largely spread across the four quarters. However, as per the GAAP model that Berkshire is required to report, their operating earnings were negative at $-22.8 billion. However, as Buffett sums it up, this GAAP reporting for statutory purposes also factors in the capital gains and capital losses; both of which are misleading when viewed in terms of short term gyrations. 

Contrary to the divided opinion about the efficacy of buybacks, Berkshire Hathaway has consistently been a big believer in repurchasing stocks. According to Buffett, when there are not enough good opportunities in the market, the best way to add value is to buyback the stock of the company so that the company funds can be used to enhance the holding of the existing shareholders. In the fourth quarter of 2022 alone, as per the letter to shareholders, Berkshire directly increased the holdings of investors by 1.2% in Berkshire Hathaway through repurchase of stock. As Buffett put it, this impact was compounded by the stock repurchase programs of Amex and Apple too.

Buffett’s interesting take on taxes

In an investment world, where fund manages and financial advisors are obsessed with post tax returns, Buffett has a slightly different take. He strongly feels that paying taxes is not necessarily value depleting and Berkshire is a classic example of that. Let us look at some interesting numbers. For the decade to 2021, the US government had collected $32.3 trillion by way of income tax. Out of this personal income taxes accounted for a bulk of 48% and social security receipts were 34.5%. Corporate income tax accounted for 8.5% of these collections, or $2,746 billion. During the previous decade, Berkshire Hathaway had paid $32 billion in taxes, which his about 1.2% of all corporate taxes collected by the US government in the last decade.

As Buffett puts it succinctly, if there were just 1,000 companies in the US paying taxes like Berkshire, then no American would need to pay any tax. That sounds rather far-fetched, but that is not the point. At a more fundamental level, Buffett has believed that paying dividends and taxes are two very unmistakeable signals that the company actually has cash flows. It is not about eyeballs or book profits. Taxes and dividends can only be paid by companies with genuine free cash flows in their books and hence there can never be a better test of corporate solvency. That is surely an interesting point.

Finally, some Buffettian words of wisdom

Of course, what is a Berkshire Letter to Shareholders without the generous share of Buffettian wisdom. Here are our key picks.

• Patience pays in investing, since this world is full of foolish gamblers. The good thing is that patience can be learned. A good attention span and the ability to focus on one thing for long enough can be a huge edge in investing.

   

• Rationality is the key to investing. If you are not rational or you don’t work on it, you are likely to remain irrational in your decision making and hence get lousy results. Irrationality does not help much, at least not in investing.

   

• The stock markets can be an expensive university course to learn by making mistakes again and again. To be successful in the stock markets, learn from the mistakes of others. That is easier and also cheaper.

   

• Investing is about making choices. You either choose the option that is better or that is less evil. It is OK to abandon a sinking boat and swim in the rough seas towards a more seaworthy boat. It is the lesser of the two evils.

   

• There is no 100% sure shot thing in investing, so avoid leverage like the plague. Borrowing and investing is a bad idea. Learn and invest in a few stocks. Berkshire has nearly 75% of its corpus in just five stocks.

The last word on succession. In 2021, Berkshire confirmed Greg Abel as the successor to Buffett and Ajith Jain his deputy. But, Berkshire must be the only company in the world where the two co-founders are 92 and 99 years of age and shareholders are just not complaining!