Just to give you a heads up, this post might not add a lot of value to you if you have been tracking the career of Mr. Warren Buffett religiously or have been reading his annual reports on a regular basis. However, I hope this post is informative to aspiring investment managers who were as ignorant as me to not read Berkshire Hathaway’s annual reports in the past. I must confess that I was truly mesmerized having read the annual report, and would highly recommend it to people who want to step in to the field of asset management. One of the things that I had learnt about reading an investment report was that you can get an idea about how prudent and sensitive management is towards shareholder’s capital by simply looking at its annual reports. If you find an annual report that – is not fancy (no colors, less pictures, etc.), has no CEO’s picture, and has no excessive use of buzz words (synergy, mergers and acquisitions, cost savings, etc.), be rest assured that management is possibly sensible. No prize money for guessing how Berkshire Hathaway’s annual report looks like. Below are few of the key takeaways, which I found useful, from Berkshire Hathaway’s annual report from 2013 and the investment philosophy of Mr. Buffett and what makes Berkshire Hathaway a great business.
INVESTMENT PHILOSOPHY FOR PROFESSIONALS AND NON-PROFESSIONALS
• Macro, market predictions, and daily vagaries a waste of time: Time predicting the market direction or understanding the impact of macro conditions on stock prices can rather be better invested in understanding the individual businesses. Mr. Buffett gives a tale of two investment purchases he did few decades ago. He bought a farm 50 miles a north of Omaha in 1986 and NYU Real Trust Property (RTC) in 1993 at depressed prices. His investments were not based on what economic conditions, interest rates, or stock market might be in 1987 or 1994. What matters most, as per him, is the ability to make sound judgment on future productivity of the assets. Daily valuations of the assets doesn’t matter. He believes, a game can only be won if you focus on the playground and not on the scorecards. Similarly, if you buy a piece of business (by buying its stocks), you should be lest bothered about what the stock price will be tomorrow, in a month or even in a year. You should be able to sit calm and patient if you can buy a stock today and stock market closes tomorrow for next five years, and you are not able to see the daily stock price movements. I would like to add a tidbit over here, that if you realize that business conditions have changed dramatically during your investment horizon, you should be humble enough to make the adjustments into your past investment thesis and sell the stocks if you are not positive about the long term business outlook. I have personally made this mistake quite a few times when I was not agile enough in my thought process to make adjustments to my investment thesis despite drastic change in the business underlying.
• Low cost index fund – If you don’t know ABC’s of investment, then don’t look further to find the next winner in the stock market. You will be better off if you can invest in a low cost index fund. Mr. Buffett has in fact advised his trustee in his will to invest his 90% of cash holdings in a low cost index funds (possibly Vanguard).
• Knowing the perimeter of your circle of competence – Circle of competence is defined by the businesses you can understand very well. As per Buffett, once you establish your circle of competence and find interesting business proposition, determine if you can establish the earnings for next five years or more. Once you establish that and if you find stocks trading at a reasonable price below the bottom boundary of your estimate, then go ahead and invest in that business. Mr. Buffett might make it sound extremely simple, however most of us do realize that it not often the case.
• ALWAYS focus on intrinsic value per share and not on the book value per share – Mr. Buffett has for most of the time claimed that BRK’s intrinsic value is way above its book value. The reason that he attributes to this phenomenon is that it is difficult for an outsider to truly understand the true economic value of BRK’s controlling businesses. He gave an interesting example to help us understand difference between the two.
Cost of MBA + foregone earnings of two years = Book value of the education
Discounted value of (Future earnings post MBA – Earnings if you had not done an MBA) at an appropriate discount rate = Intrinsic value of the MBA. This could not have been explained simpler than this.
WHAT MAKES BERKSHIRE AN EXCEPTIONAL BUSINESS AS A WHOLE?
• GUSHER OF CASH FLOW
One of the major source of cash flow generation for BRK has been its insurance business. Float arising from the insurance business has increase from USD 39.0 million in 1970 to USD 77,240 million in 2013 i.e. compounded annual growth rate (CAGR) of 19.1%. Insurance businesses receive premiums upfront and pay claims later. This model leaves a company holding large sum of money i.e. called as “float”. This float has not only provided BRK with enough cash to look for good investment opportunities, but also kept the company at bay from the liquidity crunch. On top of the float generated by these insurance and re-insurance businesses of BRK, they have also been consistent in generating underwriting profits (premiums paid – expenses and loses) consistently especially in last 11 years. On the other hand, insurance and re-insurance industry as a whole has been reporting underwriting loses. This ever increasing moat has been the reason for ever increasing gap between the intrinsic value and book value of BRK. Warren Buffett believes that BRK’s great managers, financial strength, and variety of businesses with huge moats, makes its insurance business unique in the world.
Fig 1: Collective float generated by GEICO, General Re, BH Reinsurance, and other
Source: Berkshire Hathaway Annual Report 2013
• CAPITAL INTENSIVE BUSINESSES AT EXCELLENT INTEREST COVERAGE RATIO
The two major operations that BRK owns that are highly capital intensive and regulated by government are BNSF (Burlington Northern Santa Fe) and Mid American Energy. Such businesses require heavy investments in long lived assets. However, the main characteristic of these two businesses is the interest expenses incurred by them is easily maintained by their excellent earnings power. This is clearly evident from their interest coverage ratios. These two businesses contributed to 33% of pre-tax earnings of BRK worth $7.8 billion. Apart from the appealing business economics that these two of the businesses offer, the reason that Warren Buffett gives for acquiring these two companies was simplistic as usual – “Society will forever need transportation and energy and it is in self-interest of government to fund these projects.”
Fig 2: Interest coverage ratio of BSNF and MidAmerican
Source: Berkshire Hathaway Annual Report 2013
Apart from these investments, BRK does own Iscar and Marmon that belong to its big investments. Stock portfolio of BRK includes four excellent businesses’ – Wells Fargo, Coca Cola, American Express, and IBM – run by excellent managers who are talented and Shareholder oriented. One of the major equity position that BRK holds which is not listed in its investment list is Bank of America (BAC). It has right to buy 700 million shares any time prior to September 2021 for $5 billion i.e. $7.14 price per share. At the time of writing this blog, BAC is trading at $17.18 / share, an unrealized gain of whooping $7 billion i.e. 140.25%.
10x Pretax earnings: Just a coincidence?
While doing my research for writing this blog, I ended up reading an excellent post from the blogger “The Brooklyn Investor”. I would like to consolidate what was written in it. Buffett has always maintained 10x pretax earnings or 10% pretax yield as a valuation benchmark for the private deals. However, 10x of pretax earnings is what precisely Warren Buffett has been paying off for controlling businesses as well as for investments – BNI stock purchase and acquisition, KO, WMT, Lubrizol, IBM, WFC, and USB.
10x pretax earnings is approximately equivalent to 15 P/E, which has been average of US industries in last century. Buying an excellent growth business at this valuation makes sense. However, it would be stupid to assume that this is the only criteria for Warren Buffett to make investments. Having said that, it is quite intriguing that despite the below businesses being from different industries, having different capital structures, having different competitive dynamics, etc Mr. Buffett bought most of them at around 10x of pretax earnings. This criteria of buying businesses at 10x of pretax earnings can certainly be a good filter before making any future security purchase.
Table: Investments / acquisitions of BRK and their pretax earnings
SOME KEY LEARNING
• Humility to accept mistakes. Warren Buffett in his annual reports has humbly accepted mistakes he made in past. Though I must say they are very few and small in magnitude.
• Intrinsic value is what all matters in valuing a business. If you are reasonably good in estimating intrinsic value, you will excel in this field.
• Let go the opportunities if you don’t understand the business.
• Save for the rainy day. At BRK he has set a benchmark of around $20 billion of cash at any given point of time.
• Don’t keep jumping fences, say no to quick profits.
• Recognize your circle of competence and stay inside it.
• Focus on pretax earnings, EBITDA is a flawed measure.
And this is what Warren Buffett advises to aspiring business managers by giving an example of Mrs. B (Rose Blumkin), owner of Nebraska Furniture Mart (NFM). BRK is the current owner of NFM.
Figure 3: Advice to aspiring business managers by Warren Buffett
Source: Berkshire Hathaway Annual Report – 2013
FINAL NOTE – In this letter he has mentioned that – “Next year’s letter will review our 50 years at Berkshire and speculate a bit about the next 50.” Since last couple of years he has been gung ho about the 3T’s – Todd Combs, Ted Weschler, and Tracy Cool. It would be interesting to see if he will finally announce his successor in next year’s annual shareholder’s meeting.