The publication of the annual letter of Warren Buffett, Berkshire Hathaway’s legendary Chairman, to the company’s shareholders is a much-anticipated event. Investors and observers value the letter for its comments about investing, the economy, and Buffet’s own outlook for the future, as well as for his occasional doses of humor and worldly wisdom. The 2017 letter, published on the company’s website on Saturday morning, does not disappoint. This year’s version has much to justify a full reading. The letter also has a long real-life parable for the benefit of ordinary investors hoping to maximize their investment gains. The February 24, 2018 letter can be found here. Full disclosure: I own BRK-B shares, although not nearly as many as I wish I did.
The Company’s Performance
As has been the case for many years, the unmistakable message from this year’s letter is that Berkshire Hathaway is an extraordinary company. Not only did the company generate 2017 revenues of over $242 billion but it generated a gain from operations of $36 billion (plus an additional $29 billion as a result of the impact of the tax reform legislation for a total gain of $65.3 billion). Perhaps even more extraordinarily, the company finished 2017 with $116 billion in cash and U.S. Treasury Bills on its balance sheet, up from $86.4 billion at the end of 2016 – representing a single year increase in cash and cash equivalents of over 33%.
The Company’s Results from Insurance Operations
The company’s insurance operations experienced significant insurance-related losses during 2017. In fact, one of the main reasons I was particularly interested to read Buffet’s letter this year was to see what he had to say about the impact on the company from the extraordinary catastrophe losses that took place during calendar year 2017. The three hurricanes that made landfall during 2017 as well as the significant losses from the California wildfires affected all P&C insurers active in North America, and Berkshire was no exception.
Prior to 2017, Berkshire had experienced 14 straight years of underwriting profits; over that time, Buffett took pains in his annual shareholder letter to emphasize that despite the consistent gains, the company was exposed in ways that in some years would produce losses, perhaps significant losses. 2017 proved to be the year that proved Buffett’s longstanding point. In 2017, the company experienced insurance underwriting losses of about $3 billion, or about $2.2 billion after taxes.
The company’s $2.2 billion in after taxes losses are significant. But it is always important to keep these things in perspective. The company’s $2.2 billion in insurance underwriting losses were offset by insurance investment income of $3.9 billion. Moreover, as Buffet emphasized, the insurance underwriting losses decreased Berkshire’s GAAP net worth by less than 1%, while elsewhere in the reinsurance industry there were companies that suffered losses to their net worth ranging from 7% to over 15%. As Buffett also noted, the 2017 experience could have been far worse if, for example. Hurricane Irma had followed a path through Florida.
The point about how much worse 2017 easily could have been worse underscores the fact that Berkshire and the rest of the insurance industry face the possibility of a “mega-catastrophe,” which Buffett measured as an event that produces insured losses of $400 billion (compared to the losses in 2017 from the three hurricanes of roughly $100 billion). Buffett pursued this line of analysis to highlight the fact that a $400 billion event would produce a loss for Berkshire of approximately $12 billion, “an amount that is far below the annual earnings we expect from our non-insurance activities” – whereas much (“indeed, perhaps most”) of the rest of the P&C world “would be out of business.” As Buffett put it, “no company comes close to Berkshire in being financially prepared for a $400 billion mega-cat.” The company’s strength, Buffett says, explains why other P&C insurers come to Berkshire (“and only Berkshire”) when they need to purchase huge insurance overages for large payments they may have to make far in the future.
Buffett’s Bet and the Lessons for Investors
A large part of this year’s annual report is devoted to describing the final outcome of a wager that Buffett made ten years ago. Basically, Buffett bet ten years ago that the returns on a conservative investment in a low cost S&P 500 index fund would beat the returns on an actively managed fund over the following ten years, after costs and fees. The bettor on the opposite side of the wager invested in five funds that in turn invested in a variety of hedge funds. The ultimate goal of the wager was to produce a benefit to be paid to a charity Buffett selected, but the real purpose of the wager “was to publicize my conviction that my pick – a virtually cost-free investment in an unmanaged S&P 500 index fund – would, over time, deliver better results than those achieved by most investment professionals, however well-regarded and incentivized those ‘helpers’ may be.”
The final ten-year scorecard comparing Buffett’s index-fund results with the results of the five funds of funds’ results makes for some extraordinary reading (you can find it on page 12 of the letter to shareholders). Over the ten-year period, Buffett’s index fund investment produced a final gain of 125.8% for an average annual gain of 8.5%. The five funds’ aggregate gains ranged from a high of 87.7% to a low of 2.8%. The average annual returns ranged from a high of 6.5% to a low of 0.3%. In other words, none of the actively managed funds came even close to the returns on Buffet’s passive index fund investment and the aggregate investment on the five funds was dramatically below Buffet’s investment.
It is important to note that though Buffet’s investment clearly produced better results over the ten-year period, the index fund investment didn’t produce better results in each of the years within the ten-year period. Indeed, in 2008, the first year of the wager period, and an extraordinary year in the long history of investing in the U.S., all five of the funds of funds performed better (actually, it would be more accurate to say, the five funds lost less money) than the S&P index fund. But in the next nine years, the S&P fund consistently beat the managed funds.
Buffett took pains took rebut any suggestion that there was something unusual about the particular ten year period during which the wager took place. He said “Let me emphasize that there was nothing aberrational about stock-market behavior over the ten-year period.” If he had polled investment advisors in 2007 about what the average annual return would be for the S&P 500, “their guesses actually would have likely averaged pretty close to the 8.5% actually delivered by the S&P 500.” Making money during this period in that environment “should have been easy.” But while the hedge fund managers on the other side of the bet prospered – “earned staggering sums” – their investors experienced “a lost decade.” As Buffett noted, “Performance comes, performance goes. Fees never falter.”
For Buffett, the lessons from this real world experiment (in fact, the very lessons he expected the experiment to show) are that investing in the stock market does not require extraordinary intelligence or insight. “What investors need,” Buffet says, “is an ability to both disregard mob fears or enthusiasms and focus on a few simple fundamentals.” Investors should “stick with big ‘easy’ decisions and eschew activity.” The point Buffett makes elsewhere in the letter is that the company itself makes more of its investments in America because “overall – and over time – we should get decent results. In America, equity investors have the wind at their back.” Over time, the S&P 500 “which mirrors a huge cross-section of American business … has earned far more that 10% annually on shareholders’ equity.”
As Buffett notes, there are of course a very few investors that beat the S&P 500 over time. But in Buffett’s lifetime, he says, he has only identified ten or so professionals who could accomplish this feat. Meaning that for the vast majority of investors, the likelihood is “very high” that the person soliciting their funds will not be the exception that does well — the most likely best outcome for almost all investors is that your investment manager will produce average results. But if there are two groups of investors, one that pursues a passive strategy and one that pursues an active strategy, “whichever group has the lower costs will win.” And if the group following the active strategy has exorbitant costs, “the shortfall will be substantial.”
The bottom line, according to Buffett? “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
Berkshire’s Investments
All of the theory about investing is interesting, but the fact is that Berkshire itself is not investing just in index funds. At least with respect to its investment activities, Berkshire is in fact a kind of a very large actively managed investment fund. Which makes the information in the annual report about the company’s equity investments interesting in its own way.
By far the most interesting thing in the table of the company’s 15 largest investments is how significant the company’s investment in Apple Inc. has become. Its investment in Apple is now the second largest company investment on the company’s list of top equity holdings. The company increased its holdings in Apple at the same time the company moved out of its holdings in IBM. During the year, Berkshire increased its position in Apple by as much as 35 million shares, while at the same time decreasing its investment in IBM by about 34 million shares.
The market value of its Apple investments is now almost as large as its holdings in long time Berkshire investment target, Wells Fargo. Wells has of course had its issues in the past couple of years, but that does not seem to have soured Berkshire on investing in banks. During the past year, the company increased its investments in two banks, U.S. Bancorp and The Bank of New York Mellon. Buffett’s letter doesn’t say anything about why Berkshire is maintaining its position in Wells. (The scuttlebutt on why the company is moving out of its IBM position was to capture favorable tax loss set off effects that were available in 2017 but that will now not be available going forward.)
About that Cash on Berkshire’s Balance Sheet
In partial explanation of why the company has accumulated such an extraordinary amount of cash on its balance sheet, Buffet explained that he had a particularly difficult time during the year in finding acquisition targets that met his criteria – including in particular “a sensible purchase price.” This requirement, Buffett said, “proved to be a barrier to virtually all deals we reviewed in 2017.” Instead, what he saw in 2017 was the price has seemed “almost irrelevant” to an army of optimistic purchasers.”
What has led to this “purchasing frenzy,” Buffett says, is that both analysts and corporate boards have encourage CEOs to consider acquisitions – which, Buffett says, is “a bit like telling your ripening teenager to be sure to have a normal sex life.”
Another thing that has fueled the purchase activity is “the ample availability of extraordinarily cheap debt.” While other purchasers evaluate possible transactions by taking into account the possibility of debt-financed acquisitions, at Berkshire, Buffett says, the company evaluates acquisitions “on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual basis would generally be fallacious.” The aversion to leverage, Buffett acknowledges “has dampened our returns over the years.” But, Buffett adds, “it is insane to risk what you have and need in order to obtain what you don’t need.” The less the prudence with which others conduct their affairs, “the greater will be the prudence with which we must conduct our own.”
One final note in a different context about Berkshire’s outsize cash position; Buffett observed, with respect to the company’s massive position in Treasury Bills, that “we have intentionally constructed Berkshire in a manner that will allow it to comfortably withstand economic discontinuities, including extremes such as market closures.” Berkshire’s extraordinary position in T-Bills was the subject of a front page Wall Street Journal article on Saturday, February 24, 2018 (here).
Succession Planning
Buffett is truly legendary in the worlds of business and investing both because of the degree of his success and the length of his track record. However, everyone knows Buffett is not getting any younger. With each passing year, the question of Buffett’s succession at Berkshire takes on increasing urgency. Buffett addresses this issue directly in the letter albeit briefly. At the letter’s end, he notes that during the year, the company added as Agit Jain and Greg Abel as Vice Chairmen of Berkshire. Jain will run Berkshire’s insurance operations, while Abel will run the non-insurance operations. (Uncharacteristically, Buffett failed to mine some humor out of the rather obvious pun about Jain and Abel). Buffet will continue, along with Charlie Munger, to run investments and capital allocation. These moves were widely viewed at the time as clarifying the succession plan for Berkshire and as cementing Jain and Able as the front runners to succeed Buffett.
Buffett adds a few notes in the so-called “Owner’s Manual” section of the annual letter to hel understand the question of what these developments may mean for the actual leadership succession. In this section, Buffett explains that at his death, his family members and the board will be involved in picking and overseeing the managers who will oversee the business. The anticipated management structure will be that Buffett’s current job will be split in two, with one manager serving as CEO and responsible for operations, and with responsibilities for investments given to one or more other managers. Who those managers will be will “depend on the date of my death.” Berkshire’s board members know Buffett’s current recommendations for these two positions.
Discussion
It is always worth reading Buffett’s letter, particularly this year. Buffett’s analysis of his ten-year investment wager and its lessons for investors (“large and small”) should be required reading for anyone in thinking about how to manage their investment activity. The lessons about keeping things simple by betting on the American economy while at the same time keeping costs as low are valuable for any investor.
I was particularly interested to read Buffett’s comments about the effects of the 2017 cat losses on Berkshire’s insurance results. I was frankly a little bit surprised at the extent to which Buffet seemingly sought to communicate that the losses were no big deal for Berkshire. In many other contexts, an effort to communicate that the extraordinary losses are no big deal might well be viewed with suspicion. And there is more than a little bit of the discussion that reads like an advertisement for Berkshire’s insurance businesses. Just the same, his emphasis on the fact that Berkshire is well-positioned to survive a mega-catastrophe is well-taken.
I thought that there is more that could have been said about Berkshire’s extraordinary year-end cash position. It is relevant of course that Buffett has had a hard time finding suitable acquisition targets. But there are other things Berkshire might do with the cash besides an acquisition. For example, Berkshire could use the cash to buy back shares. . Buffett is not opposed to the idea of a buy back. However, a buy back seems unlikely in the near future. Buffett has said in the past that Berkshire would buy back the company’s stock if its price falls below 120% of book value; as of Friday, both classes of Berkshire stock were trading at 166% of book value. But even if the time is not right for a share buy-back, Berkshire could distribute some of the cash to its shareholders in the form of a dividend. Historically, Buffett has been opposed to paying dividends because of the extent to which the dividend amounts would be subject to taxation. However, given the size of Berkshire’s cash hoard the possibility of a dividend seems like a pertinent topic worthy of discussion.
In addition, the letter was uncharacteristically short, and included quite a bit of griping, including, for example, a complaint about how new accounting reporting rules will complicate investors’ perspective on the company – as well as his gripe about the poor state of the M&A playing field.
If what he said was a little bit grumpy, there are some other things he didn’t say that are just as surprising in their absence as what he did say. Buffet’s letter does not, for example, mention Trump, Brexit, China, immigration, or the growing federal deficit. Buffett said nothing about the troubles at Wells Fargo, even though Wells Fargo remains as the company in which Berkshire has it largest stock investment. Indeed, other than merely reporting the financial impact on the company from the tax reform legislation, Buffet’s letter said nothing at all about the tax bill despite its extraordinary impact on the company’s financial report. The letter also had nothing to say about the recently announced health insurance arrangement between Berkshire on the one hand and Apple and JP Morgan Chase on the other hand (organized, according to Buffet’s statement at the time, because of the “angry tapeworm” in the American economy that health costs represent).
All of that said, Buffet’s letter is still worth reading. Anybody that wants to self-administer a strong dose of optimism about the American economy will want to read the letter, if only to feel better about the future. Buffet’s analysis of the ten-year bet along is worth everyone’s time.
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