Every year, investors from Wall Street to Main Street await Berkshire Hathaway Chairman and CEO Warren Buffett’s annual letter to the company’s shareholders, for his commentary on the current business and economic environment, for his investment insights, and for his occasional folksy and humorous observations. In the run-up to the release of this year’s letter, which took place this past Saturday morning, there was hope that this year’s letter might do a little more – say, explain how Buffett intends to deploy the company’s growing mountain of cash, or comment on recent negative developments at Kraft Heinz. Although this year’s letter contains the usual ration of Buffett’s brand of investment wisdom, those who were looking for more undoubtedly were disappointed. Buffett’s February 23, 2019 letter can be found here. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)
As a long-time and devoted reader of Buffett’s annual letters, I have to say the most striking feature of this year’s letter is how short it is. Indeed, the brevity of this year’s letter continues a trend that has developed in the last two or three years, where the annual letter has shrunk in length (and, honestly, in scope) compared to prior years. Along with the shrinking size, the letters have also become increasingly formulaic; unfortunately, this year’s version is no exception to this trend. Much of the text in this year’s letter consists of repetition of familiar Buffett tropes – the value of accrued earnings; the importance for investors of reducing management fees; the value of insurance float — but with very little of his accustomed humor or investment insight.
Buffett’s letter is of course a part of the company’s annual report of its financial results, and in 2018, the company, according to GAAP accounting, earned $4 billion, after GAAP-required adjustments for the company’s unrealized investment gains and losses. Importantly, the company’s results reflect a $3 billion non-cash loss, reflecting impairment of intangible assets (largely relating to the company’s equity interest in Kraft Heinz). Berkshire’s significant loss related to Kraft Heinz is attributable to Kraft Heinz’s own write-off of intangible assets during 2018. This past week Kraft Heinz announced that it was taking a $15.4 billion write-down of the value of its investments in its Kraft and Oscar Mayer brands, cutting its dividend, and that it was the subject of an SEC investigation. According to news reports, the decline in Kraft Heinz’s share price following these revelations this past week shaved $4 billion off of the value of Berkshire’s investment in the company.
Given the magnitude and nature of these developments, it might have been expected that Buffett might have something to say about all of this, but his letter actually has very little commentary about Kraft Heinz. Given how unusual Berkshire’s Kraft Heinz investment was, the circumstances seem to suggest that some kind of commentary would be appropriate. In investing in Kraft Heinz in 2015, Berkshire, by contrast to its usual acquisition practices, did not acquire the company outright on its own, but rather unusually went into the deal with a private equity partner, 3G Capital. The deal’s logic depended plans for dramatic cost-cutting, and also has wound up requiring 3G affiliated-persons becoming actively involved in company management – by contrast to the usual Berkshire acquisition pattern, where prior management remains in place and Berkshire as the new owner takes a hands-off approach. The fact that as investment the Kraft Heinz deal was so far outside the Berkshire mold and that it has now gone south really does seem to call for some kind of commentary, particularly given Buffett’s past disclosure practices.
It is also impossible not to think about what has gone wrong with the Kraft Heinz deal in the context of Berkshire’s growing mountain of cash. As of year-end 2018, the company’s balance sheet included $112 billion of cash and cash equivalents (plus another $20 billion fixed income instruments). The problem for Buffett is that it is increasingly difficult to find ways to invest these amounts of money, at least under Buffett’s preferred approach of buying entire companies. Berkshire’s last significant acquisition was its January 2016 $32 billion acquisition of Precision Castparts. The problem for Buffett, as he noted in the 2017 letter and he observed again this year, is that Berkshire is competing for deals with equity investment funds that also are awash in liquidity; as a result, he noted in this year’s letter, “prices are sky-high for businesses possessing decent long-term prospects.”
The drift of Buffett’s letter is that he is not going to get caught up in overpaying for deals, although I have to say it is in this specific context that I really would have liked to have heard more from Buffett about the Berkshire’s Kraft Heinz investment and the way it has worked out. It really does look like Berkshire overpaid for its Kraft Heinz investment. From my perspective, the question has to be asked, is the Kraft Heinz investment an example of what can happen if Berkshire does strain to try to find ways to make deals in order to try to find ways to put its cash hoard to work.
That said, it certainly is more interesting to know what Buffett intends to do with Berkshire’s cash going forward. First and foremost, Berkshire will, Buffett says, always retain a cash cushion in order to be able to honor its insurance commitments. He says, “I will never risk getting caught short of cash.”
More importantly, from an investment perspective, given the “disappointing reality” that prices for attractive acquisition targets are “sky high,” in 2019, Berkshire is likely to again expand its holdings of marketable equities – a proposition that Buffett took great pains to emphasize was not “a market call.” Buffett notes that Berkshire has continued to buy stocks where the valuations allowed for better returns than might be available if Berkshire were to purchase businesses in their entirety; pursuant to this logic, in 2018, the company purchased $43 billion of marketable securities, while selling only $19 billion. (The aggregate year-end value of Berkshire’s equity investments was $173 billion.)
Given that the purchase of equity securities is therefore apparently going to continue to be such an important part of Berkshire’s plan at least for the near term, I would have liked to have heard more about what specifically the company has in mind now. Part of the reason for this concern is that recently it has not always been clear exactly what Berkshire is doing. For example, Berkshire took up a $2.1 billion stake in Oracle in the third quarter and then sold it in the fourth quarter. Berkshire also sold about three million shares of its massive holding of Apple shares. These just don’t seem like traditional Berkshire moves. Perhaps these are a reflection of the move toward the increasing management of Berkshire’s equity investments by Buffett’s investment designees, Todd Combs and Ted Weschler. But Buffett has always managed his company based on well-evolved and clearly articulated plans. The plan doesn’t seem as clear these days.
There is, according to Buffett’s most recent letter, one more thing that Buffett intends to do with the company’s cash, and that is to buy back company shares. Buffett is clear that Berkshire will continue, from time to time, to repurchase its own stock, where it can buy at a discount to Berkshire’s “intrinsic value.” Buffett has some interesting comments about who might be selling their shares in these transactions; the sellers may include those who “may have found investments that they consider more attractive than Berkshire,” about which some of these investors “will be right” – “There unquestionably are many stocks that will deliver far greater gains than ours.” Which, if true, really does kind of raise the question for Berkshire shareholders of whether they want to remain Berkshire shareholders, or even why they should remain Berkshire shareholders? If I had the opportunity, I would really welcome the chance to discuss this whole line of discussion in his letter with Buffett.
Although Buffett does not say so explicitly, the one thing that is clear in his letter is that Berkshire is not going to use its massive cash mountain to pay a shareholder dividend. A recurring theme in Buffett’s letter is the value to investors of retained earnings and how intelligently redeployed retained earnings can create investor wealth. Indeed, the one kind of folksy and anecdotal interlude in this year’s letter is a brief passage about the growth of wealth in America over the course of the country’ history. Buffett begins this discussion noting that he made his first investment 77 years ago, and that the country’s history prior to that point can be divided into two preceding 77 year periods. Just as during Buffett’s 77 years as an investor the value of his investments have grown through reinvested earnings (“retained earnings [have been] the key to Berkshire’s prosperity”), the value of America’s wealth has grown through reinvested earning – if, Buffett notes, “our forefathers has instead consumed all they produced, there would have been no investment, no productivity and no leap in living standards.”
Buffett concludes this discussion of America’s bountiful economic history, which he attributes to what he calls “The American Tailwind,” with a couple of interesting closing points. The first is that “there are also many other countries around the world that have bright futures” – about which, he says, American should rejoice, since “Americans will be both more prosperous and safer if all nations thrive.” (Buffett adds in a swinging aside that “it is beyond arrogance for American businesses or individuals to boast that they have ‘done it alone’.”) At Berkshire, he says, “we hope to invest significant sums across borders.” This last point, about Berkshire’s willingness to invest abroad is interesting, because, with a few notable exceptions, Berkshire’s investing patterns have been largely to almost exclusively focused on domestic investments.
The other interesting thing about Buffett’s discussion of The American Tailwind is about how it has come about and what it means for the future. As for how it came about, he notes that “our country’s almost unbelievable prosperity has been gained in a bipartisan manner” — for example, during Buffett’s 77 year investing career, here have been seven democratic Presidents and seven republican Presidents. During that time, there have been a number of scary and even dangerous circumstances, all of which “engendered scary headlines,” though “all are now history.” Over the next 77 years, “the major source of our gains will almost certainly be provided by The American Tailwind. We are lucky – gloriously lucky – to have that force at our back.”
Buffett’s historical retrospective is one of many different messages in the shareholder letter that underscore that Buffett, and his side-kick Charlie Munger (Berkshire’s Vice Chairman) are getting really old. (Buffett will be 89 this summer.) The consideration of Buffett’s age inevitably leads next to speculation about Berkshire’s succession plans. As Buffett notes in his letter, in early 2018, Berkshire did take some concrete steps toward putting a succession structure in place, when he put Ajit Jain in charge of all of Berkshire’s insurance operations and Greg Abel in charge of all other operations. In his shareholder letter, Buffett commented that as a result of these changes, “Berkshire is now better managed than when I alone was supervising operations.” If these changes don’t exactly amount to an express succession plan, they do at least seemingly provide a bridge to the eventual succession.
So, O.K., that’s all fine. Now let’s go back and talk about the part where Buffett said “There unquestionably are many stocks that will deliver far greater gains than ours.” Unquestionably? Many? Far greater? Discuss.