What we read from the Warren Buffett letter to shareholders

26 Mar 2024 , 03:17 PM

A TRIBUTE TO CHARLIE MUNGER

Over the years, the Berkshire Hathaway annual letter to shareholders was meticulously crafted by Warren Buffett and Charlie Munger. As Buffett loved to say, “The job of the newsletter is to lay out the good with the bad and not try to deluge the shareholders with feel-good news.” This year, the one difference was that Charlie Munger was not present. Munger had passed away just a few months ago, at the age of 99. In fact, Buffett puts it more precisely that Munger was just 33 day short of 100. For Buffett, it marked the natural end to a 50 year long partnership; and that is the only way it could be really ended.

In the words of Buffett, Charlie Munger was the architect of the Berkshire Hathaway that we get to see today. Munger was the man who laid out the broad vision of Berkshire Hathaway and Buffett was merely the contractor who was getting things. Of course, here Buffett me be a little more modest than required, but the message is fairly clear about how they divided their roles and ensured that each was required to critically approve the other. There is one thing about Charlie Munger that Buffett acknowledges readily. Munger helped Buffett bridge the gap between the theoretical sophistication of Ben Graham and the more hard-nosed pragmatism that the investment business required. After all, Ben Graham’s ideas did work beautifully on a small scale; but on a larger scale, it was Munger’s hard-nosed pragmatism that really made the difference. 

OPERATING INCOME VERSUS NET INCOME

This has been one of the favourite topics of Warren Buffett and over the years he has spent a lot of time postulating on the difference between the two. Let us look at net earnings first. Berkshire Hathaway reported net earnings of $90 Billion in 2021; $(23) Billion in 2022 and $96 Billion in 2023. Remember, year 2022 was a loss and so the gyrations are huge. These are not gyrations in the business but the capital gains and losses caused by the fluctuations in the valuation of the portfolio of Berkshire Hathaway. Remember, Berkshire has an investment portfolio of nearly $380 Billion, so fluctuations are par for the course. As Buffett himself admits, the net earnings reporting is more for statutory compliance purposes.

Net earnings may have little analytical value; because what really has analytical value is the operating earnings. Operating earnings are the earnings of Berkshire Hathaway, shorn of the capital gains and capital losses. Operating earnings for the last 3 years were $27.6 Billion in 2021, $30.9 Billion in 2022 and $37.4 Billion in 2023. That is a more secular trend since it excludes the unrealized capital gains of the portfolio. According to Warren Buffett, capital gains or capital losses are significant from a business perspective, when they are booked. In a sense this philosophy of Buffett also stems from his strong belief that no investors should ever bet against the United States of America, so long term is always going to be fruitful. Of course, that is assuming that you are in the right stocks and at the right price.

HOW DOES BERKSHIRE HATHAWAY DO STOCK SELECTION

There are enough models in the world that would tell you how to select stocks, but most of them fall short of practical utility. Buffett believes that a simple approach to stock selection, combined with rigor and monitoring works best. As they say, you investment idea should be so simple that you can illustrate it on a blackboard with a piece of chalk. Here is how the investment process at Berkshire Hathaway works; and these are amazing insights.

• Buffett believes that the nature of capitalism is such that there will be great success stories and great failures in the stock market. However, one thing that separates the performers is sustained and enduring growth in earnings. Hence the first portfolio approach of Berkshire Hathaway is to own large chunks of good businesses and hold them for an awfully long period, or as long as the economics are still favourable.

   

• Secondly, Buffett also requires that such good businesses are run by able and trustworthy managers. Here there is a focus on two words. To buttress is point, Buffett quotes Hugh McCulloch, the first Comptroller of the US, “Never deal with a rascal, under the expectation that you can prevent him from cheating you.” In short, management is not just about ability, but a lot more about integrity. Even the best of business models if it is run by managers whose aspirations do not sync with that of the company. 

Of course, these are just two points that Buffett loves to underline and behind these philosophies, there is a lot of number crunching that does happen. But these two are what Buffett calls the red flags. Without that, the investment is to be strictly avoided.

BERKSHIRE HATHAWAY’S NOT SO SECRET WEAPON

As of the close of December 2023, Berkshire Hathaway sits on an enviable stash of $168 Billion in cash. Most fund managers may guffaw at so much of funds sitting in US treasuries. However, as  Buffett puts it, they would rather wait for the right opportunity to present itself, than jump into whatever is available. As Buffett puts it, the markets have the ability to display amazing wisdom but also displays amazing levels of myopia at times. For Buffett and company, this is the opportunity for which they are holding the cash stash. In recent years, Buffett has raised stakes in oil companies and in Japanese conglomerates. 

However, he still prefers that the first priority should be to return cash to shareholders through buyback of shares. But primarily, the cash stash of $168 Billion allows Berkshire Hathaway to move in quickly and commit large sums of money, should there be a market disruption. As Buffett sums up his argument, “Never risk permanent loss of Capital.” The core of the Berkshire secret weapon is to be prepared for opportunities, make a couple of very good decisions and avoiding making serious mistakes. It is not clear when they will put the $168 Billion to use, but clearly Berkshire Hathaway is in no hurry to pile on to equities.

NON-CONTROLLED BUSINESS – PAST AND THE FUTURE

When you talk of the history of Berkshire Hathaway, two company names automatically pop up, viz. Coca Cola and American Express. Berkshire has held on to both companies for decades for the sheer difference to the lives of people and the impact they have had on their specific markets. Buffett had been sceptical about some of the diversifications of both the companies, but now is a lot more comfortable as the company business model is more on target. For now, both Amex and Coca Cola are more like cash cows for Berkshire Hathaway. Both are not as big as Apple in terms of percentage holdings; but they are fairly meaningful at 4% to 5% of the non-controlled portfolio. In recent years, Coke and Amex have been consistently growing earnings and dividends, so Buffett has little to complain about. After, that is all that is expected of these business with a pedigree of 150 years.

But, for Buffett, the focus is more on the future and one such company that fits into Berkshire’s long term future plans is Occidental Petroleum. Berkshire already owns 27.8% of Occidental Petroleum, so it is substantial, to say the least. Berkshire also owns warrants of Occidental Petroleum, so the eventual stake should be much higher on conversion. For Buffett, Occidental Petroleum is synonymous with the shift in the US economy from being a net oil importer to self sufficiency in oil. Thanks to shale, where Occidental Petroleum is very active, chunk of the US needs is met internally and there are very few concerns about how the global geopolitical situation pans out or what the OPEC does. The other such stake is the holding that Buffett has in 5 major Japanese conglomerates. Berkshire has hiked its stake in these Japanese conglomerates in each of the last 5 years. The 5 Japanese conglomerates (Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo) has also been reducing capital on a consistent basis, something that appeals to Buffett.

INSURANCE CONTINUES TO BE BUFFETT’S FAVOURITE BUSINESS

Over the years, Buffett’s dalliance with insurance began as early as 1951 when he bought GEICO. He has always believed that originating insurance with finesse is an amazing business as long as you are collecting more premiums than you are paying out in claims. In the latest year 2023, insurance continued to surprise on the positive. It was all the more relevant since in the year,  its railroads business (BNSF) and its electrical utility business (BHE) put up a rather disappointing show. Insurance at Berkshire Hathaway is today a $83 Billion business, a 5,000-fold growth since it first started off. But, what about the insurance model?

According to Buffett, the success of Berkshire in the Insurance business stems from the way they have built grassroot expertise in the insurance business. It basically amounts to knowing what types of insurance businesses to avoid and what sort of customers to avoid. Remember, Berkshire Hathaway is predominantly into the property casualty (P/C) insurance business. The business is inherently risky since estimates can be awfully wrong and there are enough of fake claims putting your business at risk. As Buffett puts it, the last thing we want is an underwriter who is an optimist since that can be the death knell of P/C insurance.

FINALLY, PROOF OF THE PUDDING LIES IN THE EATING

The legendary writer, Mark Twain, famously said, “There are 3 kinds of lies in this world; lies, damned lies and statistics.” As much as statistics and numbers have been reviled over the years, there are few parameters that capture a long term story as eloquently as numbers can. Over the years, there have been several opinions about the current efficacy Warren Buffett’s ideas and whether he has been losing his touch. Of course, people are referring to some of the recent investment commitments made by Buffett that backfired; like buying IBM or buying airline stocks. But, to the credit of Buffett, he was also quick to get out of these stocks and stick to his core knitting. But let us get back to the big issue of what is the proof of pudding and why it lies in the eating.

Over the last 58 years, for which data is available, the Berkshire Hathaway stock price performance and the performance of the S&P 500 have been volatile at times and lacklustre at other times. However, one thing that cannot really lie is the CAGR (compounded annual growth rate) returns over the last 58 years for which data is available (between 1965 and 2023). Had an investor invested in the S&P 500 in 1965 and held on till date, he would have earned CAGR returns of 10.2%. However, had the same investment been made in Berkshire Hathaway in 1965, the CAGR return over 58 years would have been an impressive 19.8%.

What does this translate into in value terms. Let us look at the S&P 500 first. Had you invested $10,000 in the S&P 500 in the year 1965, it would be worth $2.80 Million today. However, had the same investor put that $10,000 in the stock of Berkshire Hathaway, the holding would be worth a whopping $355.22 Million today. That is the kind of returns that only dreams are made of. Even the worst critics of Buffett would admit that you just cannot dispute the value of these numbers!