What I learned from the Berkshire Hathaway 2015 Annual Report
- Tenor of American politics diminishes great advances in the U.S.
- Investment strategies of adding to existing business lines and underwriting risk based on actual default risk as opposed to competition still work and should be encouraged.
- Accurate accounting shouldn’t disregard relevant charges in favor or EBITDA valuations.
- Success comes from staying in your lane. For Berkshire, this means friendly acquisitions, large purchases and partnership with like-minded long term holders of companies.
- Burlington Northern Santa Fe, Insurance and Clayton Homes business all improved in a diminishing market, but conditions for the insurance market look difficult in the next ten years.
- The shareholder meeting will be simulcast for the first time this year. Details are below.
Executive Summary
Warren Buffett, inarguably one of the most successful investors in history, released his annual letter to the shareholders of Berkshire Hathaway in late February 2016. The annual report he publishes through his conglomerate, Berkshire Hathaway, is one of the most highly anticipated and widely read in the financial world.
In this year’s letter, Mr. Buffett brushed past last year’s disappointing stock performance, elaborated on Berkshire’s joint venture with private-equity firm 3G, explains his math of why those born in America today are the luckiest in history, and defended manufactured-housing unit Clayton Homes. In 2015, the conglomerate ’s profits reached $24.1 billion, up from $19.9 billion in 2014.
In case you haven’t had the chance to read the 2015 annual letter yourself, we have highlighted what we think are the biggest takeaways. Much of the letter focuses on specific dealings of Berkshire Hathaway, and gives some information and insight about what shareholders can expect next. Whether you’re a banker, investor, business owner or dreamer, we hope you’ll find the following recap of his 31-page letter worth your time.
American Optimism
Mr. Buffett takes time to express optimism of America and its current economic strength, despite much of the pessimism candidates have created throughout this election year. The negativity has many Americans believing their children will not live as well as they themselves do. Mr. Buffett couldn’t disagree more, affirming, “The babies being born in America today are the luckiest crop in history.”
Buffett says that while GDP growth remains at 2% (which he agrees would like to be higher), it is not a major problem for our economy, claiming the 2% rate will still translate into massive returns. The market will continue to provide more – in every sense of the word. The size of the pie is still growing, but the question is “how” the pie will be split up.
Bolt-Ons
Berkshire completed 29 acquisitions of businesses last year that were additive to existing holdings; a favored tactic due to cost savings. He describes these types of acquisitions as having a better return as there is less infrastructure and cultural issues. Berkshire looks for business lines that have managers in place, a proven track record, and share Buffett’s efficiency philosophy. In short, Mr. Buffett is willing to pay a higher price for well-run companies with strong balance sheets and good management teams because they generate a better return on investment over time.
Risk Management for Underwriting
Mr. Buffett lays out the formula for sound credit underwriting that all bankers know, but considers worth repeating. Credit managers must:
- Understand all exposures that might cause the bank to incur losses,
- Conservatively assess the likelihood of any exposure actually causing a loss beyond its reserves (as well as the implicit cost),
- Charge a credit spread, on average, that will deliver a profit after both loss costs and operating expenses are covered; and
- Be willing to walk away (if the appropriate credit spread isn’t obtainable).
- Buffett reminds us, most flunk the 4th test by misgauging competition.
Reporting Adjusted Earnings
Mr. Buffett speaks out against companies and analysts that choose to ignore GAAP earnings (which are reported in SEC filings) and more common tendency to rely on companies’ adjusted earnings numbers (EBITDA) as a valuation guide. It has become common for managers to tell owners to ignore certain line items (such as stock-based compensation) as an expense item. Some amortization costs and nearly all depreciation costs – the expenses companies incur as their assets gradually lose value over time – are legitimate expenses and shouldn’t be omitted from earnings calculations. The concern is that these types of reporting can lead to misleading numbers that may deceive investors.
Acquisitions
Mr. Buffett reminds investors that he will only make friendly acquisitions and Berkshire will only go “where they are welcome”. However, he takes the opportunity to explain how and when a hostile deal may be justified. These would be cases when CEOs “forget that it is shareholders for whom they should be working” or managers are just “woefully inept”. When directors are blind to problems in the companies where they serve or “simply reluctant to make changes required, new faces are needed.” But Mr. Buffett is clear – Berkshire Hathaway will not engage in unfriendly takeovers.
Most Important Development of 2015
Mr. Buffest says, “Our BNSF (Burlington Northern Santa Fe) railroad dramatically improved its service to customers last year.” BNSF is a major chunk of Berkshire, so its results matter. He calls the improvements “the most important development at Berkshire during 2015.” For the U.S. railroad industry as a whole, aggregate ton-miles fell last year, and earnings weakened. But BNSF maintained volume, and pre-tax income rose by more than $600 million to a record $6.8 billion. However, he notes that he expects lower after-tax earnings for the railroad this year.
Record Size Deal in 2015
The “Powerhouse Five” is a collection of Berkshire’s largest non-insurance businesses, consisting of Berkshire Hathaway Energy, IMC, Lubrizol, Marmon and (the largest of group) BNSF railroad. The set of five companies, (which were acquired with mostly cash and not stock) earned $13.1 billion in 2015, an increase of $650 million over 2014. Mr. Buffett announced their biggest deal ever in 2015, now making it their “Powerhouse Six” for 2016. The newcomer is Precision Castparts Corp. (finalized in January 2016). Purchased for over $32 billion in an all-cash transaction; it is the biggest acquisition ever by Mr. Buffett. And he points out that, with the deal, Berkshire now owns 10 companies outright that, if they were independently owned, would be listed on the Fortune 500.
Berkshire’s Praise of 3G
Last year was a big year for 3G (the Brazilian private-equity firm 3G Capital Partners LP) and Berkshire. The two teamed up on Heinz’s purchase of Kraft. Mr. Buffett defends the partnership with the company and 3G’s reputation of buying companies and slashing jobs. But, he says, 3G seeks not just to buy and build businesses but hold them. This is what Mr. Buffett typically points to which distinguishes 3G from typical private-equity firms. Berkshire, he reminds readers, seeks to buy businesses that operate like Berkshire that are run by “cost-conscious and efficient managers.” 3G seeks to buy companies that “offer an opportunity for eliminating many unnecessary costs.”
Mr. Buffett praises 3G and says he’ll continue to look for opportunities to invest more of Berkshire’s capital in the firms 3G buys.
Insurance Revenues May Slip
Berkshire’s insurance operations are bigger by revenue than its railroad and the power companies combined. Collectively, Berkshire’s insurance units brought in premium revenue of $41 billion in 2015. However, Mr. Buffett believes that the next 10 years of insurance-industry results won’t be as good as those of the past decade.
Geico is the second-largest car insurer in the U.S., with a 11.4% market share. That’s up from a 2.5% share when Berkshire took full ownership of the company in 1995. It’s still smaller than State Farm at #1, but by Mr. Buffett’s 100th birthday, he predicts (somewhat jokingly) that Geico will take over that spot. Still, a glance over at Berkshire’s 10-K shows that 2015 wasn’t a great year for the car insurer. Premium revenue rose by about 11% to $22.7 billion as the company added more policyholders and raised rates, but pre-tax earnings fell by 60% as the frequency and severity of claims rose. That’s an issue that has faced most U.S. car insurers.
Defending Clayton Homes
Mr. Buffett defends scrutiny surrounding mortgage lender Clayton Homes, the second-largest home builder in America, distinguishing it from other (more careless) lenders prior to the financial crisis. Purchased by Berkshire in 2003, Mr. Buffett points out that Clayton keeps every mortgage it originates, and assumes 100% of the risk (versus moving it to another party). With very minimal payout in fines and customer refunds, more than 95% of its borrowers were current on their mortgage payments.
Shareholders Meeting to be Webcasted
For the first time ever, Mr. Buffett and Mr. Munger plan to webcast the annual meeting, offering two reasons for the decision. First, to help reduce the record attendance of 40,000+ attendees last year, which “strained” capacity; and second, Mr. Buffett humorously points out that shareholders should not have to travel to Omaho to see how he and Mr. Munger look and sound. However, between the newspaper throwing contest with Mr. Buffett himself, a 5K, cocktail parties, and a table tennis challenge, one can see the allure to being there to experience it all in person. The webcast will be broadcast on Saturday, April 30, at 10 a.m. EST at https://finance.yahoo.com/brklivestream.
Beki Golden