Berkshire Hathaway Annual Letter thoughts

Blog post #434

Warren Buffett’s Berkshire Hathaway Inc.’s 2019 Annual Shareholders Letter was released Saturday, February 22nd, before the coronavirus outbreak had a major impact on US stock markets.

This letter has been required reading for me for as long as I can remember. There are always lessons to be gleaned from Buffett’s letter which can help all of us to be better investors and smarter financially.

Due to the additional market volatility caused by the coronavirus outbreak, we wrote about that last week. If you have not read it, the link is HERE.

Below are my comments, followed by selected portions of Buffett’s writings (in italics)from the 2019 Berkshire Hathaway Annual Letter.

WWM: Buffett stresses the value of long term investing every year, and this year he emphasized this point through the importance of compounding…how money grows in value over time by compounding.

Buffett: He cites a book review written by economist John Maynard Keynes, of a book written in 1924, Common Stocks as Long Term Investments, by Edgar Smith. “…Thus there is an element of compound interest operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders…

Buffett: “…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.”

WWM: The following are Buffett’s thoughts on investing, interest rates and the future. THE FOLLOWING PARAGRAPHS SHOULD BE REQUIRED READING. He feels that in the long run, stocks will far outperform fixed income investments, but you must be prepared to handle huge declines in stocks along the way. If you can do that, he feels you will be well rewarded. We agree with this analysis.

Buffett: Buffett does not view Berkshire’s vast stock holdings “as a collection of stock market wagers – dalliances to be terminated because of downgrades by “the Street,” an earnings “miss,” expected Federal Reserve actions, possible political developments, forecasts by economists or whatever else might be the subject du jour.

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.

Returns of that order by large, established and understandable businesses are remarkable under any circumstances. They are truly mind-blowing when compared to the returns that many investors have accepted on bonds over the last decade – 2.5% or even less on 30-year U.S. Treasury bonds, for example.

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!

WWM: Berkshire has owned energy / utility companies for 20 years, starting with an Iowa based utility. Their use of converting wind to electricity and how Berkshire Energy has gone from a traditional to a wind-based utility, while keeping rates far lower than their competition, which benefits the residents and users of this utility, is quite instructive. This Iowa based utility will be wind self-sufficient by 2021 (a feat he says no other investor-owner utility located anywhere can state)….and profitable and providing huge cost savings to their client base. Sounds like win-win to me. Required reading!

Buffett: 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.

WWM: A huge portion of Berkshire Hathaway’s profits and growth has come from their massive insurance business. Buffett states that while they have had underwriting profits in 16 of the last 17 years, he does not expect that to repeat. The risks are massive and he is prepared for huge negative outcomes. He knows catastrophes will occur….he (and we) just don’t when or why.

Buffett: “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.

WWM: Berkshire Hathaway pays billions of dollars a year in Federal corporate tax….and hopes and expects to pay even more in the future. Incredible statistic for a company that started 55 years ago and generated losses for many years.

Buffett: In 2019, Berkshire sent $3.6 billion to the U.S. Treasury to pay its current income tax. The U.S. government collected $243 billion from corporate income tax payments during the same period. From these statistics, you can take pride that (Berkshire Hathaway) delivered 1.5% of the federal income taxes paid by all of corporate America…In most future years, we both hope and expect to send far larger sums to the Treasury.

Source: 2019 Berkshire Hathaway Annual Shareholder Letter, released Saturday, February 22, 2020. See Berkshirehathaway.com.

Disclosure: Brad Wasserman, author of this blog post, owns a small number of Berkshire Hathaway shares, which were purchased to enable me to attend Berkshire’s annual meeting. All my other stock investments are in DFA mutual funds, which is one of the primary mutual funds companies that we recommend to our clients.

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