BERKSHIRE HATHAWAY INC.
I have put together a few snippets of information that was released to Shareholders of Berkshire Hathaway Inc. Reflecting Berkshire’s Performance vs. the S&P 500, in Feb 2020. Some things to ponder and perhaps expand your knowledge through the eyes of a long time successful investor.
One aspect of their vision for investing is buying with the intent of holding for the long term. Read more about his approach to investing here.
This is a quote highlighting Warren Buffett’s approach on long term investing. “Charlie and I urge you to focus on operating earnings and to ignore both quarterly and annual gains or losses from investments. Whether these are realized or unrealized.”
The Power of Retained Earnings
In 1924, Edgar Lawrence Smith, an obscure economist and financial advisor, wrote Common Stocks as Long Term Investments. A slim book that changed the investment world. Indeed, writing the book changed Smith himself, forcing him to reassess his own investment beliefs.
It’s difficult to understand why retained earnings were unappreciated by investors before Smith’s book was published. After all, it was no secret that mind-boggling wealth had earlier been amassed by such titans as Carnegie, Rockefeller and Ford. All of whom had retained a huge portion of their business earnings to fund growth and produce ever-greater profits. Throughout America, also, there had long been small-time capitalists who became rich following the same playbook.
Nevertheless, when business ownership was sliced into small pieces – “stocks”. Buyers in the pre-Smith years usually thought of their shares as a short-term gamble on market movements. Even at their best, stocks were considered speculations. Gentlemen preferred bonds.
Though investors were slow to wise up, the math of retaining and reinvesting earnings is now well understood. Today, school children learn what Keynes termed “novel”: combining savings with compound interest works wonders.
Berkshire’s Performance vs. the S&P 500
At Berkshire, Charlie and I have long focused on using retained earnings advantageously. Sometimes this job has been easy – at other times, more than difficult. Particularly when we began working with huge and ever- growing sums of money.
In our deployment of the funds we retain, we first seek to invest in the many and diverse businesses we already own. During the past decade, reinvestment in productive operational assets will forever remain our top priority.
In addition, we constantly seek to buy new businesses that meet three criteria. First, they must earn good returns on the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price.
When we spot such businesses, our preference would be to buy 100% of them. But the opportunities to make major acquisitions possessing our required attributes are rare. Far more often, a fickle stock market serves up opportunities for us to buy large, but non-controlling, positions in publicly-traded companies that meet our standards.
Whichever way we go – controlled companies or only a major stake by way of the stock market, Berkshire’s financial results from the commitment, will in large part be determined by the future earnings of the business we have purchased. Nonetheless, there is between the two investment approaches a hugely important accounting difference, essential for you to understand.
In our controlled companies, (defined as those in which Berkshire owns more than 50% of the shares). The earnings of each business flow directly into the operating earnings that we report to you. What you see is what you get.
In the non-controlled companies, in which we own marketable stocks, only the dividends that Berkshire receives are recorded in the operating earnings we report. The retained earnings? They’re working hard and creating much added value, but not in a way that deposits those gains directly into Berkshire’s reported earnings.
At almost all major companies other than Berkshire, investors would not find what we’ll call this “non- recognition of earnings” important. For us, however, it is a standout omission, of a magnitude that we lay out for you below.
Here, we list our 10 largest stock-market holdings of businesses and our share, so to speak, of the earnings the investees retain and put to work. Normally, those companies use retained earnings to expand their business and increase its efficiency. Or sometimes they use those funds to repurchase significant portions of their own stock. An act that enlarges Berkshire’s share of the company’s future earnings.
(1) Based on current annual rate.
(2) Based on 2019 earnings minus common and preferred dividends paid.
Obviously, the realized gains we will eventually record from partially owning each of these companies will not neatly correspond to “our” share of their retained earnings. Sometimes, retentions produce nothing. But both logic and our past experience indicate that from the group we will realize capital gains at least equal to and probably better than – the earnings of ours that they retained. (When we sell shares and realize gains, we will pay income tax on the gain at whatever rate then prevails. Currently, the U.S. federal rate is 21%.)
It is certain that Berkshire’s rewards from these 10 companies, as well as those from our many other equity holdings, will manifest themselves in a highly irregular manner. Periodically, there will be losses, sometimes company-specific, sometimes linked to stock-market swoons. At other times – last year was one of those – our gain will be outsized. Overall, the retained earnings of our investees are certain to be of major importance in the growth of Berkshire’s value.
Mr. Smith got it right.
Our property/casualty (“P/C”) insurance business has been the engine propelling Berkshire’s growth since 1967. The year we acquired National Indemnity and its sister company, National Fire & Marine, for $8.6 million. Today, National Indemnity is the largest P/C company in the world as measured by net worth. Insurance is a business of promises, and Berkshire’s ability to honor its commitments is unmatched.
One reason we were attracted to the P/C business was the industry’s business model. P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, or severe workplace accidents, payments can stretch over many decades.
This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go. The amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float. And how it has grown, as the following table shows:
We may in time experience a decline in float. If so, the decline will be very gradual – at the outside no more than 3% in any year. The nature of our insurance contracts is such that we can never be subject to immediate or near- term demands for sums that are of significance to our cash resources. That structure is by design and is a key component in the unequaled financial strength of our insurance companies. That strength will never be compromised.
If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it.
Some insurers may try to mitigate their loss of revenue by buying lower-quality bonds or non-liquid “alternative” investments promising higher yields. But those are dangerous games and activities that most institutions are ill-equipped to play.
Berkshire’s Performance vs. the S&P 500
Berkshire’s situation is more favorable than that of insurers in general. Most important, our unrivaled mountain of capital, abundance of cash and a huge and diverse stream of non-insurance earnings allow us far more investment flexibility than is generally available to other companies in the industry. The many choices open to us are always advantageous. And sometimes have presented us with major opportunities.
Our P/C companies have meanwhile had an excellent underwriting record. Berkshire has now operated at an underwriting profit for 16 of the last 17 years. The exception being 2017, when our pre-tax loss was a whopping $3.2 billion. For the entire 17-year span, our pre-tax gain totaled $27.5 billion, of which $400 million was recorded in 2019.
That record is no accident: Disciplined risk evaluation is the daily focus of our insurance managers, who know that the rewards of float can be drowned by poor underwriting results. All insurers give that message lip service. At Berkshire it is a religion, Old Testament style.
As I have repeatedly done in the past, I will emphasize now that happy outcomes in insurance are far from a sure thing: We will most certainly not have an underwriting profit in 16 of the next 17 years. Danger always lurks.
Mistakes in assessing insurance risks can be huge and can take many years. Even decades to surface and ripen. (Think asbestos.) A major catastrophe that will dwarf hurricanes Katrina and Michael will occur. Perhaps tomorrow, perhaps many decades from now. “The Big One” may come from a traditional source, such as wind or earthquake. Or it may be a total surprise involving, say, a cyber attack. Having disastrous consequences beyond anything insurers now contemplate. When such a mega-catastrophe strikes, Berkshire will get its share of the losses and they will be big – very big. Unlike many other insurers, however, handling the loss will not come close to straining our resources, and we will be eager to add to our business the next day.
Berkshire Hathaway Energy
Berkshire Hathaway Energy is now celebrating its 20th year under our ownership. That anniversary suggests that we should be catching up with the company’s accomplishments.
We’ll start with the topic of electricity rates. When Berkshire entered the utility business in 2000, purchasing 76% of BHE, the company’s residential customers in Iowa paid an average of 8.8 cents per kilowatt-hour (kWh). Prices for residential customers have since risen less than 1% a year, and we have promised that there will be no base rate price increases through 2028. In contrast, here’s what is happening at the other large investor-owned Iowa utility: Last year, the rates it charged its residential customers were 61% higher than BHE’s. Recently, that utility received a rate increase that will widen the gap to 70%.
The extraordinary differential between our rates and theirs is largely the result of our huge accomplishments in converting wind into electricity. In 2021, we expect BHE’s operation to generate about 25.2 million megawatt-hours of electricity (MWh) in Iowa from wind turbines that it both owns and operates. That output will totally cover the annual needs of its Iowa customers, which run to about 24.6 million MWh. In other words, our utility will have attained wind self-sufficiency in the state of Iowa.
In still another contrast, that other Iowa utility generates less than 10% of its power from wind. Furthermore, we know of no other investor-owned utility, wherever located, that by 2021 will have achieved a position of wind self-sufficiency. In 2000, BHE was serving an agricultural-based economy; today, three of its five largest customers are high-tech giants. I believe their decisions to site plants in Iowa were in part based upon BHE’s ability to deliver renewable, low-cost energy.
Of course, wind is intermittent, and our blades in Iowa turn only part of the time. In certain periods, when the air is still, we look to our non-wind generating capacity to secure the electricity we need. At opposite times, we sell the excess power that wind provides us to other utilities, serving them through what’s called “the grid.” The power we sell them supplants their need for a carbon resource – coal, say, or natural gas.
Berkshire Hathaway now owns 91% of BHE in partnership with Walter Scott, Jr. and Greg Abel. BHE has never paid Berkshire Hathaway a dividend since our purchase and has, as the years have passed, retained $28 billion of earnings. That pattern is an outlier in the world of utilities, whose companies customarily pay big dividends – sometimes reaching, or even exceeding, 80% of earnings. Our view: The more we can invest, the more we like it.
Today, BHE has the operating talent and experience to manage truly huge utility projects – requiring investments of $100 billion or more – that could support infrastructure benefitting our country, our communities and our shareholders. We stand ready, willing and able to take on such opportunities.
Investments – Berkshire’s Performance vs. the S&P 500
Below as part of Berkshire’s Performance vs. the S&P 500, we list our fifteen common stock investments that at year end had the largest market value. We exclude our Kraft Heinz holding – 325,442,152 shares – because Berkshire is part of a control group and therefore must account for this investment on the “equity” method. On its balance sheet, Berkshire carries the Kraft Heinz holding at a GAAP figure of $13.8 billion, an amount that represents Berkshire’s share of the audited net worth of Kraft Heinz at December 31, 2019. Please note, though, that the market value of our shares on that date was only $10.5 billion.
* Excludes shares held by pension funds of Berkshire subsidiaries.
** This is our actual purchase price and also our tax basis.
*** Includes $10 billion investment in Occidental Petroleum Corporation consisting of preferred stock and warrants to buy common stock.
A Rosy Prediction Comes With a Warning
What we see in our holdings, rather, is an assembly of companies that we partly own and that, on a weighted basis, are earning more than 20% on the net tangible equity capital required to run their businesses. These companies, also, earn their profits without employing excessive levels of debt.
Forecasting interest rates has never been our game, and Charlie and I have no idea what rates will average over the next year, or ten or thirty years. Our perhaps jaundiced view is that the pundits who opine on these subjects reveal, by that very behavior, far more about themselves than they reveal about the future.
What we can say is that if something close to current rates should prevail over the coming decades and if corporate tax rates also remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term, fixed-rate debt instruments.
That rosy prediction comes with a warning: Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater. But the combination of The American Tailwind, about which I wrote last year, and the compounding wonders described by Mr. Smith, will make equities the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions. Others? Beware!
The Road Ahead
Three decades ago, my Midwestern friend, Joe Rosenfield, then in his 80s, received an irritating letter from his local newspaper. In blunt words, the paper asked for biographical data it planned to use in Joe’s obituary. Joe didn’t respond. So? A month later, he got a second letter from the paper, this one labeled “URGENT.”
Charlie and I long ago entered the urgent zone. That’s not exactly great news for us. But Berkshire shareholders need not worry: Your company is 100% prepared for our departure.
The Urgent Zone
The two of us base our optimism upon five factors. First, Berkshire’s assets are deployed in an extraordinary variety of wholly or partly-owned businesses that, averaged out, earn attractive returns on the capital they use.
Second, Berkshire’s positioning of its “controlled” businesses within a single entity endows it with some important and enduring economic advantages.
Third, Berkshire’s financial affairs will unfailingly be managed in a manner allowing the company to withstand external shocks of an extreme nature. Fourth, we possess skilled and devoted top managers for whom running Berkshire is far more than simply having a high-paying and/or prestigious job.
Finally, Berkshire’s directors – your guardians – are constantly focused on both the welfare of owners and the nurturing of a culture that is rare among giant corporations. (The value of this culture is explored in Margin of Trust, a new book by Larry Cunningham and Stephanie Cuba that will be available at our annual meeting.)
Berkshire’s Performance vs. the S&P 500
Charlie and I have very pragmatic reasons for wanting to assure Berkshire’s prosperity in the years following our exit. The Mungers have Berkshire holdings that dwarf any of the family’s other investments. And I have a full 99% of my net worth lodged in Berkshire stock. I have never sold any shares and have no plans to do so.
My only disposal of Berkshire shares, aside from charitable donations and minor personal gifts, took place in 1980. When I, along with other Berkshire stockholders who elected to participate, exchanged some of our Berkshire shares for the shares of an Illinois bank, that Berkshire had purchased in 1969. And that, in 1980, needed to be offloaded because of changes in the bank holding company law.
Today, my will specifically directs its executors – as well as the trustees who will succeed them in administering my estate after the will is closed. Not to sell any Berkshire shares. My will also absolves both the executors and the trustees from liability for maintaining what obviously will be an extreme concentration of assets.
The will goes on to instruct the executors – and, in time, the trustees. To each year convert a portion of my A shares into B shares and then distribute the Bs to various foundations. Those foundations will be required to deploy their grants promptly. In all, I estimate that it will take 12 to 15 years for the entirety of the Berkshire shares I hold at my death to move into the market.
Will And Testament
Absent my will’s directive that all my Berkshire shares should be held until their scheduled distribution dates, the “safe” course for both my executors and trustees would be to sell the Berkshire shares under their temporary control and reinvest the proceeds in U.S. Treasury bonds with maturities matching the scheduled dates for distributions. That strategy would leave the fiduciaries immune from both public criticism and the possibility of personal liability for failure to act in accordance with the “prudent man” standard.
I myself feel comfortable that Berkshire shares will provide a safe and rewarding investment during the disposal period. There is always a chance – unlikely, but not negligible – that events will prove me wrong. I believe, however, that there is a high probability that my directive will deliver substantially greater resources to society than would result from a conventional course of action.
Key to my “Berkshire-only” instructions is my faith in the future judgment and fidelity of Berkshire directors. They will regularly be tested by Wall Streeters bearing fees. At many companies, these super-salesmen might win. I do not, however, expect that to happen at Berkshire.
Fifty-five years ago, when Berkshire entered its current incarnation, the company paid nothing in federal income tax. (For good reason, too: Over the previous decade, the struggling business had recorded a net loss.) Since then, as Berkshire retained nearly all of its earnings, the beneficiaries of that policy became not only the company’s shareholders but also the federal government. In most future years, we both hope and expect to send far larger sums to the Treasury.
Warren E. Buffett
Chairman of the Board
February 22, 2020
Read more about why investing with the intent of holding for the long term is his best approach to investing here
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Disclaimer: This article is factual information only. It is not intended to imply any recommendation about any financial product(s) or to constitute financial or tax advice. The information in the article is reliable at the time of distribution, but may not be complete or accurate in the future.