Every year, Berkshire Hathaway shareholder or not, investors from all around the world
anticipate the Oracle of Omaha's wisdom. Over the weekend, the annual shareholder letter
was released and these were my top 5 takeaways… --
Hey there. My name is Stephen Spicer and it’s my goal to help you invest smarter. And what
better way to do that, than by learning from the Master. There was one thing that Buffett
implied that I didn’t really agree with though… I’ll put that into a separate
video - so be sure to subscribe and hit that notification bell so you don’t miss it!
Now, if you haven’t had a chance yet to read over the letter yourself - I’ll leave
a link for you right at the top of the description. And real quick, if you’re a fan of videos
like this (where we can learn from wisdom distilled from the Greats), take a second
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work that goes into these videos.
Without further ado, let’s get to it:
The first big lesson came from his warning about screwy accounting practices commonly
used by many corporations. I think there’s a valuable lesson to be learned here from
the point Buffett is trying to make, but I also want to come at this from the other side
as well - provide you with an alternate perspective…
...here’s what Buffett said - [After talking about how much money Berkshire’s subsidiaries
made last year, he explained:]
When we say “earned,” moreover, we are describing what remains after all income taxes,
interest payments, managerial compensation (whether cash or stock-based), restructuring
expenses, depreciation, amortization and home-office overhead.
That brand of earnings is a far cry from that frequently touted by Wall Street bankers and
corporate CEOs. Too often, their presentations feature “adjusted EBITDA,” a measure that
redefines “earnings” to exclude a variety of all-too-real costs.
For example, managements sometimes assert that their company’s stock-based compensation
shouldn’t be counted as an expense. (What else could it be – a gift from shareholders?)
And restructuring expenses? Well, maybe last year’s exact rearrangement won’t recur.
But restructurings of one sort or another are common in business – Berkshire has gone
down that road dozens of times, and our shareholders have always borne the costs of doing so.
Abraham Lincoln once posed the question: “If you call a dog’s tail a leg, how many legs
does it have?” and then answered his own query: “Four, because calling a tail a leg
doesn’t make it one.” Abe would have felt lonely on Wall Street.
It’s really easy to get sucked into the numbers that managements feed you (...or analysts).
If you’re not aware of this fact that Buffett details - if you just take what they tell
you at face value - you CAN get burned.
So, Buffett’s warning is appropriate and timely for anyone trying to invest smarter.
So… be aware of that.
BUT… if you’re trying to compare a company to its peers, then you’ll be best served
if you can get it as close as possible to an apples-to-apples comparison. To this end,
an adjusted figure can be entirely practical and extremely helpful. (If you’d like more
information on EBITDA - how to calculate it, what it means - I have a video that I’ll
link to in the description.)
But as a simple example of what I’m talking about here, as Buffett mentioned, companies
have different restructuring expenses from year to year. And yes, although those will
absolutely come up again, and should be accounted for by you as the potential investor, they’re
not coming up in the same year or to the same degree for every single company inside a peer
group. Meaning, if you don’t factor them out for the sake of deriving a comparable
company analysis, your end result will be skewed - it’ll be inaccurate, wrong. Just
because the one incurred the higher capital expenditure this year, that doesn’t mean
it necessarily deserves a lower valuation today as a result.
I hope that makes sense. To have a fair comparison - one upon which you could make an educated
investment decision - the companies need to be at the same level. Any expense like those
would need to be factored out to make this possible. And you should note: that might
even require you doing your own “adjusted” calculations - you shouldn’t assume that
each company in a particular industry structures that figure - the one they report as their
adjusted-EBITDA - in the exact same way.
AND THEN - if you still really like the stock, if it does seem to be relatively undervalued
- THEN, heed Buffett’s council and consider those additional expenses. Because as he says,
they are indeed very real expenses that will ultimately be borne by the shareholder - potentially,
you. --
My second big takeaway from the letter is how serious Buffett is about repurchasing
Berkshire shares. It’s kind of exciting.
He said:
It is likely that – over time – Berkshire will be a significant repurchaser of its shares,
transactions that will take place at prices above book value but below our estimate of
intrinsic value.
Clear enough. But that was just the first time of several that he either mentions or
alludes to this happening in the future. And obviously - with the news last year about
them changing the way that process works for Berkshire - we already had an idea this was
coming. But this letter really drives it home.
Aside from the mentions, he took time to express caution with the way it would be done - referencing
the carelessness with which many corporations use buybacks to boost share price.
On top of that, he gave a couple very detailed examples of how this has worked in his favor
in the past. You know, warming shareholders up to the idea.
He talked about how in the late 70’s they originally purchased enough GEICO shares to
own ⅓ of the company. And how, over time, that third grew to ½ without Berkshire spending
a dime. You guessed it - it was through the magic of GEICO buying back its own shares.
He provides another example with American Express. He explains:
All of our major holdings enjoy excellent economics, and most use a portion of their
retained earnings to repurchase their shares. We very much like that: If Charlie and I think
an investee’s stock is underpriced, we rejoice when management employs some of its earnings
to increase Berkshire’s ownership percentage.
Here’s one example… Berkshire’s holdings of American Express have remained unchanged
over the past eight years. Meanwhile, our ownership increased from 12.6% to 17.9% because
of repurchases made by the company. Last year, Berkshire’s portion of the $6.9 billion
earned by American Express was $1.2 billion, about 96% of the $1.3 billion we paid for
our stake in the company. When earnings increase and shares outstanding decrease, owners – over
time – usually do well.
Some great lessons in there about the proper way for management and shareholders to view
buybacks. And something to definitely look forward to in the future.
--
The third big lesson slash takeaway is one that particularly resonated with me. Part
of my modus operandi is to help people invest smarter - to help them be prepared no matter
what happens. Most investors aren’t invested this way - they aren’t (even psychologically)
prepared for something to happen that (maybe) hasn’t ever happened before…
In fact, most investment advisors - most professionals - fall short from this perspective. It’s
one of the main reasons I left my industry career years ago. It’s one of the driving
themes of my book STOP INVESTING LIKE THEY TELL YOU…
That you should be prepared - come what may.
And although Buffett and I might do that differently, it’s refreshing to hear him acknowledge
this reality that so many stock-and-bond-only advocates (and “experts”) conveniently
ignore.
He captures the sentiment in his observations about the future possibilities for Berkshire’s
insurance subsidiaries when he says:
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 a hurricane 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 megacatastrophe strikes, we will get our share of the losses and they will be big – very
big.
Buffett is acknowledging the reality that some catastrophe that has never before been
experienced - whether it’s tomorrow or decades from now - that it WILL happen.
And he’s prepared. After explaining the specifics of how Berkshire is prepared (with
its significant portfolio of cash equivalents), he emphasizes:
Berkshire will forever remain a financial fortress. In managing, I will make expensive
mistakes of commission and will also miss many opportunities, some of which should have
been obvious to me. At times, our stock will tumble as investors flee from equities. But
I will never risk getting caught short of cash.
I wanna give you one final thought (of Buffett’s) on the subject. (Just as Nassim Taleb does
in his inspiring book FOOLED BY RANDOMNESS,) in this part of the Letter, Buffett draws
the comparison to Russian Roulette - which you should keep in mind because I’ll be
referencing it again in the next video about where I disagree with Buffett.
He explains:
We use debt sparingly. Many managers, it should be noted, will disagree with this policy,
arguing that significant debt juices the returns for equity owners. And these more venturesome
CEOs will be right most of the time. At rare and unpredictable intervals, however, credit
vanishes and debt becomes financially fatal. A Russian Roulette equation – usually win,
occasionally die – may make financial sense for someone who gets a piece of a company’s
upside but does not share in its downside. But that strategy would be madness for Berkshire.
Rational people don’t risk what they have and need for what they don’t have and don’t
need.
Awesome!
I can’t tell you what will happen or exactly when it might happen, because it’ll be unexpected
and very well may have never happened before. But I’ll be prepared as best I can for it.
It’s so good to get that vibe from the Man himself as well.
--
The fourth lesson - one that you might find heartening ...or discouraging - is when Buffett
said:
Prices are sky-high for businesses possessing decent long-term prospects.
So, for all of you struggling to find the next steal of a company… keep that in mind:
Buffett is struggling too. There aren’t always deals. And when you have strict standards
like he does - the standards that have helped him achieve the success he’s had - when
the market in general is elevated like this… you just come up empty handed. It happens.
And that brings to mind an important point: if you haven’t been investing for very long,
you should really take special note of Buffett’s observation and remember that your gauge for
- your experience with - valuing companies is limited to the time that you’ve been
doing it… that’s true for everyone. ...but, in this case, according to Buffett, you’re
doing it during a time when it’s just very difficult to find a good company on sale - it’s
surely not as often as you see or hear hyped around all the time…
Something may seem “fair” or “undervalued” by today’s standards, but that doesn’t
tell you the complete story. You need a broader perspective - like what Buffett has with most
of his 88 years on this Earth being spent actively studying companies.
So, be patient. It’s okay. Don’t lower your standards. You’re not just collecting
a ticker symbol with the hopes that they’ll be some Greater Fool to buy it from you later
at a higher price. That’s not investing. Buffett explains:
Charlie and I do not view the $172.8 billion detailed above as a collection of ticker symbols
– a financial dalliance to be terminated because of downgrades by “the Street,”
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 about 20% on the net tangible equity capital required
to run their businesses. These companies, also, earn their profits without employing
excessive levels of debt.
Those are his high standards, and today, prices are just too high for him to meet those standards
very often. And he’s okay with that. You can be too.
--
My fifth takeaway here was not so much as lesson as - I thought - a brilliant way of
framing the issue of corporate taxes.
I’ll just let Buffett explain:
Begin with an economic reality: Like it or not, the U.S. Government “owns” an interest
in Berkshire’s earnings of a size determined by Congress. In effect, our country’s Treasury
Department holds a special class of our stock – call this holding the AA shares – that
receives large “dividends” (that is, tax payments) from Berkshire. In 2017, as in many
years before, the corporate tax rate was 35%, which meant that the Treasury was doing very
well with its AA shares. Indeed, the Treasury’s “stock,” which was paying nothing when
we took over in 1965, had evolved into a holding that delivered billions of dollars annually
to the federal government.
He’s using this as a way of explaining why the tax cut from 35% to 21% benefited the
A and B shareholders so dramatically in 2018. And, of course, that goes the other way as
well as taxes increase in the future.
I just appreciate the simple way Buffett framed this complicated issue.
--
So, those were my five biggest takeaways from the Letter. Which do you find most helpful?
Let us know in the comments. And if I didn’t mention your favorite part of the Letter,
I hope you’ll share that too.
Now, as I mentioned earlier, there was one big issue I had with what Buffett said - I’ll
dive into that one for you in the next video. So, don’t forget to subscribe and click
the bell!
I’ll see you there! Take care.