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The oracle of Omaha has released annual letter to shareholders, and there is an ongoing buzz around the commentary of the great investor across the world. His followers are flooding social media with their respective perspectives.
As at 31 December 2019, Berkshire Hathaway Inc. was carrying cash and cash equivalents of approximately USD 128 billion, including short-term investments in U.S. Treasury Bills, while its retained earnings were recorded at approximately USD 402.5 billion.
Retained earnings are fodder for growth
Mr Buffet talks about almost a century-old book by Edgar Lawrence Smith, which argued that fixed-income investments are likely to outperform equities in a period of deflation with reverse being true amid inflationary periods.
Mr Smith’s book revamped the perception of investors towards retained earnings, and great economists like J.M. Keynes noted that the real value of an investment at compound interest is quite apart as against dividends.
Mr Buffet notes that managing retained earnings becomes difficult when it’s huge and ever growing. Charlie Munger, his partner in managing Berkshire, and Mr Buffet seek to invest in diverse businesses.
Their stock-picking requires a business to pass on three criteria, which include a sensible price, honest management and returns on net tangible capital. He notes that the retained earnings held by their portfolio companies would at least deliver equal or better capital gains.
Acquisitions are much like a marriage
Berkshire has acquired many businesses over the years, and many of them operate privately. Despite a reasonable number of businesses exceeding the expectations, there has been disappointments as well as disasters.
Mr Buffet notes that acquisitions are much like a marriage, celebrated at the beginning, then expectations meet reality. And, sometimes the marriage delivers great results, and the opposite is true when expectations are curtailed.
On Berkshire’s acquisitions history, he reckons that the record has been acceptable with marriages (acquisitions) exceeding expectations while some have made him recall his conviction at the time of proposal.
He has observed that overtime, a ‘poor’ business tends to stagnate, and the operations require an even smaller percentage of his conglomerate’s capital. On the other hand, ‘good’ businesses tend to find opportunities to grow, thus uncovering opportunities for further investments at attractive rates. he he
As both businesses differ from each other in an operating sense, the capital allocated to the conglomerate’s winners become an expanding part of its capital.
He notes the trajectory of Berkshire, which had been a troubled business requiring large sums of conglomerate’s capital prior to acquisition in 1965, and some ‘good’ acquisitions brought a meaningful shift, and by 1980s, Berkshire needed a tiny portion of the capital.
Pain of lower rates
In the last decade, interest rates across the world had trended lower, even negative in some countries. This had meant a constant flow of capital at lower interest rates, thus improving liquidity.
However, for insurance businesses that invest in secured investments, including Berkshire Hathaway’s insurance verticals, the investment options have been limited augmented with diminishing returns as interest rates had trended lower in the last decade.
Mr Buffet notes that insurers have been flocking away to new investment asset classes, including alternative and lower graded bonds that promise to pay a higher yield. And, these new investment classes are ‘dangerous’.
Meanwhile, Berkshire’s insurance businesses have been on a steady ship, owing to its mountain of capital, a surplus of cash and a diverse stream income. All of these factors have positioned Berkshire in a flexible position.
Berkshire has delivered an underwriting profit in the last 16 years out of 17 years, and during the 17-year period, the pre-tax gain totalled $27.5 billion. He says that it is the result of the insurance managers’ focus in maintaining underwriting results.
GUARD Insurance Group – special mention
Notably, Mr Buffet has mentioned a business, which was bought in 2012 at the discretion of Berkshire’s Insurance Vice Chairman – Ajit Jain. GUARD Insurance was acquired for $221 million, and Mr Jain had told that Sy Foguel, CEO of the company, would be a star at the conglomerate.
Fast forward to 2019, the acquired business had generated a premium volume of 1.9 billion, substantially up as against 2012 with a satisfactory underlying profit. Meanwhile, Mr Foguel has driven the business to new regions and new products while increasing its float by 265%.
Stop worrying about things you can’t control
Mr Munger and Mr Buffet do not view their investment holdings as a collections bet, which would be influenced by upgrade or downgrade by the street’s analysts, earnings misses, political development and monetary policy actions, etc.
Meanwhile, they view the portfolio in terms of the performance of underlying companies such as the return generated on net tangible equity capital required to run the businesses while having sustainable debt.
Both the investors do not prefer forecasting interest rates and believe that, if the existing rates environment or similar continues to persist for a decade with corporate tax rates at the same level, equities would outperform fixed income investments.
On Stock buybacks
He notes that his conglomerate would only buyback its shares when he and Mr Munger believe that the stock price is undervalued in the market, and the conglomerate is left with ample amount of cash after purchasing the stocks.
Both the investors want to have a lower number of shares outstanding, and aggressive stock purchases are likely when their estimate of price-to-value discount widens further. However, they would not be buying stocks at any given level. Berkshire’s shareholders with an urge to sell their holdings worth $20 million or more may contact their brokers to get the cash in lieu of shares.
