The D & O Diary
A Closer Look at Buffett's Letter to Berkshire Shareholders
After market close on Friday, March 1, 2013, Warren Buffett delivered his annual letter to Berkshire shareholders. Buffett’s letters are widely read and closely studied for the insights he provides into the financial markets and into his own investment views. However, the most striking aspect of this year’s letter may be the topics he does not address. (Full Disclosure: I own BRK.B shares).
That is, despite Buffett’s age (82) and his recent health issues (in April 2012, he was diagnosed with stage 1 prostate cancer), Buffett does not address succession planning (except perhaps indirectly, as noted below). Despite the gridlock in Washington and the continuing difficulties in the Eurozone, Buffett does not directly discuss macroeconomic issues. Nor does this year’s letter include a marketplace critique, by contrast to recent years’ letters in which he has, for example, addressed the questionable value of investing in gold, potential problems with the dollar, or problems with the hedge fund business model.
What did Buffet talk about instead? Newspapers. Yes, newspapers. Excluding Buffett’s description of the upcoming Berkshire shareholders’ meeting, the letter is eighteen pages long. Buffett devoted three pages – more than 16% of the entire letter -- to newspapers. To be sure, Berkshire has purchased 28 daily newspapers in the last 15 months, but the total cost of these acquisitions is $344 million. Let’s put that into perspective. At year end, Berkshire had assets of $427.4 billion.
Why did Buffett devote so much of his letter to such a small part of Berkshire’s holdings? My theory is that it is a guilty conscience. He acknowledges at the outset that Berkshire’s newspaper acquisitions “may puzzle you” – not only because the newspaper business as a whole is in decline, but (more importantly) because the newspapers acquired “fell far short of meeting our off-stated size requirements for acquisitions.” (Not only that, but Buffett famously stated four years ago that, despite Berkshire’s long-standing investments in the Washington Post and the Buffalo News, he would not buy a newspaper at any price.)
Buffett knows he has been straying from his own principles in acquiring the newspapers. He tries to justify all of this in a 23-paragraph defense, but the overly-long explanation fails to provide a single convincing reason why he would disregard his “oft-stated” principles to invest in an industry that he acknowledges is in decline.
In my view, Buffett acknowledges the real reason for the newspaper acquisitions at the outset, when he acknowledges that “Charlie and I love newspapers.” (Those readers who have read any of Buffett’s many biographies know that he was a paper boy for the Washington Post while his father served in Congress.) Buffett’s long defensive explanation for the newspaper purchasers reads to me like the product of a guilty conscience Buffett makes it clear that he intends to continue to purchase newspapers – but only, he emphasizes in italics “if the economics make sense.”
Another topic Buffett addresses is the question of dividends – as in, when will Berkshire start paying them? He acknowledges that shareholders frequently ask him about dividends, and he notes that it “puzzles them that we relish the dividends we receive from most of the stocks that Berkshire owns, but pay nothing ourselves.” Anyone hoping that this prelude was the lead-in of an announcement that Berkshire is now about to pay dividends was sure to have their hopes dashed. In a lengthy, arithmetic-intensive exegesis, Buffett, in a schoolmaster role that he seems to relish, illustrates from a purely financial standpoint how Berkshire’s shareholders are better off (particularly from an after-tax point of view) if Berkshire retains and reinvests its earnings rather than paying them out in dividends. It is a masterful job.
The only thing that is missing from the lesson is an explanation of why he invests in so many dividend-paying companies himself. Surely if refraining from paying dividends really is better for Berkshire’s shareholders, why isn’t that true for shareholders of Coca-Cola, Wells Fargo and so on? Perhaps anticipating this concern, Buffett concludes his homily on dividends with a very brief and somewhat disconnected observation that companies should be clear and consistent about their dividend policy. He notes that he “applauds” the practices of many companies to pay consistent dividends while trying to increase them annually.
Let me put it this way: if I were allowed to ask Buffett a question at the Berkshire shareholders’ meeting in May, I would refer to this portion of his letter and then tell him I don’t understand why retained earnings are in Berkshire’s shareholders’ interests, but annually growing dividend levels are in the interests of the shareholders of the companies in which Berkshire invests. (If possible, an explanation that doesn’t require the use of slide rule would be appreciated.)
I won’t get to ask that question, so I will content myself with noting that there is another very important reason that Buffett doesn’t want Berkshire to pay a dividend; given his ownership interest in the company, a Berkshire dividend would be a huge taxable event for him. I don’t think I am going out on a limb by saying that as long as Buffett is around, there will never be a Berkshire dividend.
Though this year’s letter does not, as I noted at the outset, directly address succession planning, Buffett does provide a little reassurance in that area to Berkshire shareholders. He notes in the letter’s introductory section that Todd Combs and Ted Wechsler, the two investment managers he recently hired, not only outperformed the S&P 500 in 2012 by “double-digit margins,” but he also notes (in tiny type-face) that their returns “left me in the dust as well.” He also notes that the value of Berkshire’s investments in one of the companies in which both Coombs and Wechsler have invested – Direct TV – now exceeds $1 billion and therefore qualifies as one of Berkshire’s 15 top common stock investments. Buffett also notes that as a result of these two manager’s investment returns “we have increased the funds managed by each to almost $5 billion” including amounts coming from the pension funds of some of the subsidiaries.
In case anyone misses the significance of these portions of the Berkshire letter, Buffett adds that “Todd and Ted are young and will be around to manage Berkshire’s massive portfolio long after Charlie and I have left the scene. You can rest easy when they take over. “ Lest anyone have any doubts about these two investment managers’ vigorous youth, Buffett notes (in talking about the 5K race to be run at the upcoming shareholders’ meeting) that Wechsler has run a marathon in 3:01 and Coombs has run a 5K in 22 minutes. (I find this emphasis on vigorous youth amusing in an annual report for a company whose annual meeting has for years has featured what amounts to a comedy routine by a couple of wise-cracking senior citizens)
And though Buffett says nothing about the current paralysis in Washington, he does have a message of hope for investors discouraged by the many problems besetting the world: “I made my first stock purchase in 1942 when the U.S. was suffering major losses throughout the Pacific war zone. Each day’s headlines told of more setbacks.” Throughout the period since, “every tomorrow has been uncertain. America’s destiny, however, has always been clear: ever-increasing abundance.” Berkshire is backing up these words with actions. In 2012, the company invested $9.8 billion in plant and equipment, with 88% of that investment in the United States – a figure that is 19% higher than in 2011, which was the previous high. “Opportunities,” Buffett writes, “continue to abound in America.”
Buffett focuses a portion of his letter talking about what he calls Berkshire’s “big four” investments – American Express, Coca-Cola, IBM and Wells Fargo. Buffett notes that Berkshire’s ownership interest in all four increased during 2012 and “is likely to increase in the future.” For long-time Buffett devotees such as myself, the inclusion of American Express, Coca-Cola and Wells Fargo on this this list is unremarkable, as all three are long-time Berkshire holdings. The show-stopper is IBM, the shares of which Buffett acquired for the first time in 2011. Not only is IBM now a “big four” investment, but the cost of Buffett’s IBM investments is larger than the cost of any other current common stock investment in Berkshire’s portfolio (the current value of the IBM investment is second only to Wells Fargo). After nearly a half a century of refusing to invest in technology companies because he said he didn’t understand them, Buffett’s most costly common stock investment is in a technology company. Clearly, Buffett’s little frolic into newspaper acquisitions is not the only instance where Buffett has strayed from his “oft stated” investment principles.
For readers of this blog, one area of particular interest will be Buffett’s analysis of Berkshire’s insurance businesses, which, according to Buffett, “shot the lights out last year.” The businesses have not only given Berkshire $73 million of “float” to invest, but also collectively produced a $1.6 billion pre-tax underwriting gain – the tenth consecutive year Berkshire’s insurance businesses collectively posted an underwriting profit. The underwriting profit, remarkable under any circumstances, is all them more noteworthy given the devastating impact of Hurricane Sandy. Among other things, for GEICO, Sandy represented the “largest single loss in history,” three times larger than the loss from Hurricane Katrina. From my reading of Berkshire’s financial statements, the insurance businesses produced a post-tax underwriting profit of $1.0 billion on earned premium of $34.5 billion, implying (on a rough calculation) a combined ratio of about 97.1.
Buffett ruefully notes that the production of an underwriting profit is not uniform across the insurance industry; once again, as he has in several past shareholder letters, Buffett calls out State Farm, naming and shaming one of GEICO’s biggest competitors, because as of 2011, it had produced an underwriting loss in eight of the last eleven years. (The company’s 2012 results have not yet been released.) Buffett puts a concluding note on this condemnation with the observation that “There are a lot of ways to lose money in the insurance, and the industry never ceases searching for new ones.” (In fairness to State Farm and to readers of this blog, I should point out Buffett wrote almost the same identical things in his 2011 letter. Buffett does have a certain affinity for certain shop-worn themes.)
In his shareholder letter, Buffett emphasizes the sheer magnitude of the float that the insurance businesses have produced and how quickly it has grown. He doesn’t tease out how powerful the availability of this float is. It is only be reading through the footnotes of the accompanying financial statements that it can be learned that, in addition to the $1.6 billion in underwriting profit, the insurance businesses produced investment income of $3.4 billion.
Buffett concludes his analysis of the insurance business with a warning about the industry’s “dim prospects.” The industry has been benefitting from higher yields on its “legacy” bond portfolios. The yields on these older assets are much higher than are available today and that will be available “perhaps for many years.” As these legacy assets mature out of the portfolios, “earnings of insurers will be hurt in a significant way.”
Much of the mainstream media coverage of Buffett’s letter has focused on the fact that by Buffett’s own reckoning, 2012 was a subpar year for Berkshire. Buffett himself notes the irony of using the term “subpar” to describe a year that produce a gain of $24.1 billion. But using the fact is that for only the ninth time in 48 years, the percentage gain in Berkshire’s book value was less than S&P’s percentage gain with dividends included. Because Buffett himself adopted this measure as Berkshire’s standard of comparison, it is fair to judge the company on that basis. But let’s be clear – Berkshire’s shareholders are not complaining.
In the twelve months, Berkshire’s share price has climbed a rather remarkable 27.28% (to an all-time high) compared to 11.16% for the S&P 500 The company had 2012 revenues $162 billion, which represents an increase of $13.2 billion over 2011’s $143 billion in revenue. As noted above, the company had 2012 year- end assets of $427.4 billion, compared to $392.6 billion at the end of 2011.
Berkshire’s shareholders may or may not be persuaded that they can “rest easy” when Buffett and Charlie Munger have left the scene. But for now, it seems likely that the company’s shareholders will be very happy once again to enjoy the octogenarians’ comedy routine at this year’s annual meeting. As for what may lie ahead, only time will tell. All I know is that I happen to live with somebody who is exactly Buffett’s age, an experience that fills me with a great deal of trepidation about how long the current comedy routine will be amusing.
My review of the latest Buffett biography -- "Tap Dancing to Work" -- can be found here.
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