Warren Buffett published his now famous annual letter to Berkshire Hathaway’s shareholders on Saturday February 22nd 2020. He’s known to communicate openly both good and bad. Buffett uses a rule when writing his annual letter: write as if his auntie, who doesn’t understand complicated terms, would read it and communicate key business numbers as if he’s the investor who would read the letter.
The compound interest that Buffett achieved for Berkshire Hathaway from 1965 to 2019 is remarkably 20.3%. This is the best record that any investor can achieve for the duration of 54 years.
Lesson 1: Power of retained earning
It’s easier for people to see when the company pays dividends. When companies retain earnings, many factors need to be considered.
Buffett wrote about retained earnings and its importance to the company’s growth many times.
This time, he quoted Edgar Lawrence Smith, the author of the popular book Common Stocks as Long-term Investments, and John Maynard Keynes. Smith planned to argue that bond performs better in deflationary period and stock performs better in the inflationary period. He was in a shock.
Keynes captured Smith’s insights: “I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest (Keynes’ italics) operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”
Rockefellers, Carnegie, and Ford amassed mind-boggling wealth by retaining a huge portion of their earnings to fund growth.
Buffett has followed them to retain all Berkshire Hathaway’s earnings. He reinvested $121 billion in the last decade into the company.
Lesson 2: criteria to acquire businesses
Buffett looks for three things in a business:
- They must earn good return on the net tangible investment required in their operation
- They are run by able and honest managers
- They must be available at sensible prices
Those types of businesses are rare. Down markets often offer more opportunities to own such businesses.
Lesson 3: acquiring good businesses
Tom Murphy gave Buffett an advice: “to achieve a reputation as a good manager, just be sure you buy good businesses.”
Reviewing his record which has losers and winners, Buffett concluded: “Acquisitions are similar to marriage. They start, of course, with a joyful wedding – but then reality tends to diverge from pre-nuptial expectations… I’d have to say it is usually the buyer who encounters unpleasant surprises. It’s easy to get dreamy-eyed during corporate courtships.”
Even though Buffett does not sell losers, they became stagnate and required less and less capital from Berkshire. Capital allocation is one of Buffett’s specialty. He allocated like he invested: more to the winners and less or none to the losers.
Lesson 4: Don’t forecast
as the pundits who opine on forecasting reveal far more about themselves than they reveal about the future.
Lesson 5: 5 factors of Buffett’s optimism on Berkshire’s future.
- Berkshire’s assets are deployed in extraordinary variety of businesses that on average earn attractive return on invested capital.
- Berkshire’s positioning of its controlled businesses within a single entity with substantial amount of capital endows it with some important and enduring competitive advantages.
- Berkshire’s financial affairs will unfailingly be managed in a manner allowing the company to withstand external shocks of an extreme nature.
- We possess skilled and devoted top managers for whom running Berkshire is far more than simply having a high-paying and/or prestigious job.
- Berkshire’s directors are constantly focused on both the welfare of owners and the nurturing of a culture that is rare among giant corporations. (A new book called Margin of Trust will be published)
Lesson 6: board of directors
When a CEO wants to make an acquisition, he/she hardly brings in consultants or directors that would likely challenge him/her.
If a director’s income is largely tied with directorship fee, the director is not independent. He/she would not challenge the CEO for the fear of losing their directorship. In addition, CEO often looks at a director’s track record and would more likely bring in directors who have not opposed to CEOs.
At Berkshire, directors got paid a tiny fee compared to their net worth. Berkshire’s directors also buy their own shares instead of being granted.
For the full annual letter, please visit https://berkshirehathaway.com/letters/2019ltr.pdf