Berkshire Hathaway Inc. (BRK.A, BRK.B) released its annual report on Feb. 22, 2020. As usual, Chair Warren Buffett's letter is of interest to Berkshire's shareholders and other investors alike who look to the investing sage for pearls of wisdom. Here are five key takeaways from this year's letter:
Warren Buffett's 2019 Annual Letter: Five Takeaways
- "[Vice Chair] Charlie [Munger] and I urge you to focus on operating earnings--which were little changed in 2019--and to ignore both quarterly and annual gains or losses from investments, whether these are realized or unrealized."
- "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.”
- "We constantly seek to buy new businesses that meet three criteria...But the opportunities to make major acquisitions possessing our required attributes are rare."
- "In reviewing my uneven record, I’ve concluded that acquisitions are similar to marriage: They start, of course, with a joyful wedding--but then reality tends to diverge from pre-nuptial expectations."
- "Charlie and I long ago entered the urgent zone [regarding age]. That’s not exactly great news for us. But Berkshire shareholders need not worry: Your company is 100% prepared for our departure."
More detailed comments made by Buffett on these points follow below.
Focus on Operating Earnings
"Our advising that in no way diminishes the importance of these investments to Berkshire. Over time, Charlie and I expect our equity holdings--as a group--to deliver major gains, albeit in an unpredictable and highly irregular manner." As the result of mark-to-market accounting on its investment portfolio now required under GAAP accounting rules, Berkshire's reported net income swung from just $4 billion in 2018 to $81.4 billion in 2019, despite operating earnings that were "little changed."
"Those market gyrations led to a crazy 1,900% increase in GAAP earnings! Meanwhile, in what we might call the real world, as opposed to accounting-land, Berkshire’s equity holdings averaged about $200 billion during the two years, and the intrinsic value of the stocks we own grew steadily and substantially throughout the period."
The Power of Equities Long-Term
Buffett remains convinced that stocks will continue to outperform bonds if interest rates and corporate tax rates remain low. Berkshire's top equity holdings at the end of 2019 were American Express Co. (AXP), Apple Inc. (AAPL), and Bank of America Corp. (BAC). He reiterated his belief in the great "American tailwind," but added a touch of caution on the volatility of equity markets and those who take on too much leverage.
"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 [economist and financial advisor Edgar Lawrence Smith, writing in a 1924 book], 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!"
Three Investment Criteria
"First, they must earn good returns on the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price."
"When we spot such businesses, our preference would be to buy 100% of them. But the opportunities to make major acquisitions possessing our required attributes are rare. Far more often, a fickle stock market serves up opportunities for us to buy large, but non-controlling, positions in publicly-traded companies that meet our standards."
Berkshire's GAAP operating earnings include operating earnings from controlled companies (when Berkshire owns more than 50% of the shares). However, Berkshire's operating earnings include just dividends from non-controlled companies, which are much lower than pro-rata shares of their retained earnings.
Acquisition Track Record
"Over the years Berkshire has acquired many dozens of companies, all of which I initially regarded as 'good businesses.' Some, however, proved disappointing; more than a few were outright disasters. A reasonable number, on the other hand, have exceeded my hopes."
Regarding corporate acquisitions in general, Buffett observes: "It is usually the buyer who encounters unpleasant surprises. It’s easy to get dreamy-eyed during corporate courtships."
Buffett turned 89 in August 2019, and his longtime lieutenant Charlie Munger reached 96 in January 2020. The absence of a publicly-announced succession plan has worried shareholders for a number of years.
Buffett offered no guidance on this matter, other than to assure investors that "we possess skilled and devoted top managers," plus directors who "are constantly focused on both the welfare of owners and the nurturing of a culture that is rare among giant corporations."
Meanwhile, Buffett indicates that his will requires the executors not to sell any of his Berkshire sales. Rather, his holdings of class A shares are to be converted to class B shares and distributed to various foundations in an orderly process lasting roughly 12 to 15 years after his death.