Category Archives: Investing

Warren Buffett’s 2015 letter to the shareholders of Berkshire Hathaway and 2016 annual shareholder meeting

Every last Saturday of February, a must read for the weekend comes out: Warren Buffett’s letter to the Shareholders of Berkshire Hathaway [PDF, 2.4 MB].

Me at BRK 2011 annual shareholders meeting.

Me at BRK 2011 annual shareholders meeting.

This year’s letter was published on February 27th, and despite the fact that I normally share some lines about it in the blog just after having read it (1), this year I wanted to wait a couple of months before writing this post in order to conveniently share it today, the day before the annual shareholders meeting, to be held tomorrow Saturday April 30th, as it will be streamed live for the first time ever. I had the chance to attend such shareholder meeting in 2011 (see my review here) and I strongly recommend to those who haven’t to take a look at the stream at Yahoo Finance, from 9am Central Daylight Time.

From this year’s letter, I wanted to bring attention to the description of the acquisition at the end of 2015 of Precision Castparts Corp (for 32bn$ cash), the highlight of the year, and to the following quotes or passages on their hands-off management style, on their flexibility to allocate capital, on what a 2% real GDP growth means, on mortgage risk retention on the side of lenders, the discussion on the linkage between productivity and prosperity (a bit too long to be transcribed as an excerpt – from the page 20 of the letter to the 22) and on the need to act on climate change.

***

On their hands-off management style:

After the purchase, our role is simply to create an environment in which these CEOs – and their eventual successors, who typically are like-minded – can maximize both their managerial effectiveness and the pleasure they derive from their jobs. (With this hands-off style, I am heeding a well-known Mungerism: “If you want to guarantee yourself a lifetime of misery, be sure to marry someone with the intent of changing their behavior.”)

On their flexibility to allocate capital:

Our flexibility in capital allocation – our willingness to invest large sums passively in non-controlled businesses – gives us a significant edge over companies that limit themselves to acquisitions they will operate. Woody Allen once explained that the advantage of being bi-sexual is that it doubles your chance of finding a date on Saturday night. In like manner – well, not exactly like manner – our appetite for either operating businesses or passive investments doubles our chances of finding sensible uses for Berkshire’s endless gusher of cash. Beyond that, having a huge portfolio of marketable securities gives us a stockpile of funds that can be tapped when an elephant-sized acquisition is offered to us.

On what a 2% real GDP growth means (2):

America’s population is growing about .8% per year (.5% from births minus deaths and .3% from net migration). Thus 2% of overall growth produces about 1.2% of per capita growth. That may not sound impressive. But in a single generation of, say, 25 years, that rate of growth leads to a gain of 34.4% in real GDP per capita. (Compounding’s effects produce the excess over the percentage that would result by simply multiplying 25 x 1.2%.) In turn, that 34.4% gain will produce a staggering $19,000 increase in real GDP per capita for the next generation. Were that to be distributed equally, the gain would be $76,000 annually for a family of four. Today’s politicians need not shed tears for tomorrow’s children.

On the different views to be taken of certain intangible assets amortization no matter what accounting rules say about them (3):

[…] serious investors should understand the disparate nature of intangible assets. Some truly deplete in value over time, while others in no way lose value. For software, as a big example, amortization charges are very real expenses. Conversely, the concept of recording charges against other intangibles, such as customer relationships, arises from purchase-accounting rules and clearly does not reflect economic reality. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when earnings are calculated – even though, from an investor’s viewpoint, they could not differ more.

[…] We now have $6.8 billion left of amortizable intangibles, of which $4.1 billion will be expensed over the next five years. Eventually, of course, every dollar of these “assets” will be charged off. When that happens, reported earnings increase even if true earnings are flat. (My gift to my successor.)

I suggest that you ignore a portion of GAAP amortization costs. But it is with some trepidation that I do that, knowing that it has become common for managers to tell their owners to ignore certain expense items that are all too real. “Stock-based compensation” is the most egregious example. The very name says it all: “compensation.” If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?

Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring “earnings” figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing “access” to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.

Depreciation charges are a more complicated subject but are almost always true costs. Certainly they are at Berkshire. I wish we could keep our businesses competitive while spending less than our depreciation charge, but in 51 years I’ve yet to figure out how to do so. Indeed, the depreciation charge we record in our railroad business falls far short of the capital outlays needed to merely keep the railroad running properly, a mismatch that leads to GAAP earnings that are higher than true economic earnings. (This overstatement of earnings exists at all railroads.) When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.

On mortgage risk retention:

Barney Frank, perhaps the most financially-savvy member of Congress during the panic, recently assessed the 2010 Dodd-Frank Act, saying, “The one major weakness that I’ve seen in the implementation was this decision by the regulators not to impose risk retention on all residential mortgages.” Today, some legislators and commentators continue to advocate a 1%-to-5% retention by the originator as a way to align its interests with that of the ultimate lender or mortgage guarantor.

At Clayton, our risk retention was, and is, 100%. When we originate a mortgage we keep it (leaving aside the few that qualify for a government guarantee). When we make mistakes in granting credit, we therefore pay a price – a hefty price that dwarfs any profit we realized upon the original sale of the home. […]

Some borrowers, of course, will lose their jobs, and there will be divorces and deaths. Others will get overextended on credit cards and mishandle their finances. We will lose money then, and our borrower will lose his down payment (though his mortgage payments during his time of occupancy may have been well under rental rates for comparable quarters). Nevertheless, despite the low FICO scores and income of our borrowers, their payment behavior during the Great Recession was far better than that prevailing in many mortgage pools populated by people earning multiples of our typical borrower’s income.

On the need to act on climate change:

This issue bears a similarity to Pascal’s Wager on the Existence of God. Pascal, it may be recalled, argued that if there were only a tiny probability that God truly existed, it made sense to behave as if He did because the rewards could be infinite whereas the lack of belief risked eternal misery. Likewise, if there is only a 1% chance the planet is heading toward a truly major disaster and delay means passing a point of no return, inaction now is foolhardy. Call this Noah’s Law: If an ark may be essential for survival, begin building it today, no matter how cloudless the skies appear.

(1) See the review I made of 2009, 20122013 and 2014 letters.

(2) In relation to that I recommend reading Thomas Piketty’s “Capital in the 21st Century” (of which I may write a review at a later point in time). There he explains how for most of history, human kind has lived a small growth rate and we may well come back to that.

(3) Every year letter discusses that, always with some variation, I keep recommending a detailed look at it.

Advertisements

Leave a comment

Filed under Investing

The Theory of Interstellar Trade

This blog post is not about the movie Interstellar, which I haven’t watched yet, but about a rather wonkish paper (as its author would put it) that I stumbled upon very recently.

The American economist and Nobel laureate Paul Krugman wrote in 1978 the paper “The Theory of Interstellar Trade” [PDF, 516KB]. The paper is simply hilarious. One of the best pieces I have ever read. It has just 15 pages and in them the author sets out to search how interest charges should be computed in interstellar trade when goods travel at close to the speed of light. It mixes economy with very light special relativity and great doses of humour. The author himself remarked in the introduction:

It should be noted that, while the subject of this paper is silly, the analysis actually does make sense. This paper, then, is a serious analysis of a ridiculous subject, which is of course the opposite of what is usual in economics.

Well, given today’s ventures, it might not be so silly 😉

Let’s review some of the highlights and conclusions derived from the paper:

To start with, he sets some fundamental considerations:

There are two major features distinguishing interstellar trade from the interplanetary trade we are accustomed to. The first is that the time spent in transit will be very great, since travel must occur at less than the light speed; round trips of several hundred years appear likely. The second is that, if interstellar trade is to be at all practical, the spaceships which conduct it must move at speeds which are reasonable fractions of the speed of light.

Because interstellar trade will take so long, any decision to launch a cargo will necessarily be a very long-term investment project […]

The second feature of interstellar transactions cannot be so easily dealt with (physicists are not as tolerant as economists of the practice of assuming difficulties away). If trading space vessels move at high velocities, we can no longer have an unambiguous measure of the time taken in the transit. The time taken by the spacecraft to make a round trip will appear less to an observer on the craft than to one remaining on Earth. […]

To solve the problem he refers to the Minkowski space-time, and includes the following diagram with the note below:

"Readers who find the Figure II puzzling should recall that a diagram of an imaginary axis must, of course, itself be imaginary".

“Readers who find the Figure II puzzling should recall that a diagram of an imaginary axis must, of course, itself be imaginary”.

By comparing the returns from actual trade between planets with the return of bonds he arrives at the First Fundamental Theorem of Interstellar Trade:

When trade takes place between two planets in a common inertial frame, the interest costs on goods in transit should be calculated using time measured by clocks in the common frame, and not by clocks in the frames of trading spacecraft.

After proving the theorem take a look at this other passage:

theorem

 

The author then takes on investigating possible arbitrage in interstellar transactions, and arrives to the Second Fundamental Theorem of Interstellar Trade:

If sentient beings may hold assets on two planets in the same inertial frame, competition will equalize the interest rates on the two planets.

It goes without saying that I recommend the reading of this paper.

Leave a comment

Filed under Economy, Investing

Warren Buffett’s 2014 letter to the shareholders of Berkshire Hathaway

Every last Saturday of February, a must read for the weekend comes out: Warren Buffett’s letter to the Shareholders of Berkshire Hathaway [PDF, 499KB]. This year, it is the 50th anniversary since Buffett took over the company, and thus together with the letter both him and Charlie Munger, his partner and vice chairman, have included as well two letters describing the last 50 years, what made them so successful and what can be expected in the following years. The 3 letters together make up 42 pages, a strongly recommended read.

From this year’s letter, I wanted to bring attention to the following quotes or passages on simplicity of some transactions, on the sale of TESCO, the distinction between volatility and risk, not using borrowed money to invest, consequences of using shares instead of cash for acquisitions, the synergies announced in M&A, the importance of cash, trust and bureaucracy:

***

On simplicity of some transactions and trust. Last year he introduced the acquisition of Nebraska Furniture Mart, this year is the turn of National Indemnity:

[…] since 1967, when we acquired National Indemnity and its sister company, National Fire & Marine, for $8.6 million. Though that purchase had monumental consequences for Berkshire, its execution was simplicity itself.

Jack Ringwalt, a friend of mine who was the controlling shareholder of the two companies, came to my office saying he would like to sell. Fifteen minutes later, we had a deal. Neither of Jack’s companies had ever had an audit by a public accounting firm, and I didn’t ask for one. My reasoning: (1) Jack was honest and (2) He was also a bit quirky and likely to walk away if the deal became at all complicated.

On pages 128-129, we reproduce the 1 1 ⁄2-page purchase agreement we used to finalize the transaction. That contract was homemade: Neither side used a lawyer. Per page, this has to be Berkshire’s best deal: National Indemnity today has GAAP (generally accepted accounting principles) net worth of $111 billion, which exceeds that of any other insurer in the world.

Offer Letter for National Indemnity (retrieved from BRK 2014 annual report [PDF, 2.2MB])

Offer Letter for National Indemnity (retrieved from BRK 2014 annual report [PDF, 2.2MB])

On the advantages of using an animated character as advertising tool in low cost operations:

[…] No one likes to buy auto insurance. Almost everyone, though, likes to drive. The insurance consequently needed is a major expenditure for most families. Savings matter to them – and only a low-cost operation can deliver these. […]

[…] Our gecko never tires of telling Americans how GEICO can save them important money. The gecko, I should add, has one particularly endearing quality – he works without pay. Unlike a human spokesperson, he never gets a swelled head from his fame nor does he have an agent to constantly remind us how valuable he is. I love the little guy.

On his lack of decisiveness in selling TESCO:

[…] An attentive investor, I’m embarrassed to report, would have sold Tesco shares earlier. I made a big mistake with this investment by dawdling.

At the end of 2012 we owned 415 million shares of Tesco, then and now the leading food retailer in the U.K. and an important grocer in other countries as well. Our cost for this investment was $2.3 billion, and the market value was a similar amount.

In 2013, I soured somewhat on the company’s then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior “thumb-sucking.” (Considering what my delay cost us, he is being kind.)

During 2014, Tesco’s problems worsened by the month. The company’s market share fell, its margins contracted and accounting problems surfaced. In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.

We sold Tesco shares throughout the year and are now out of the position. (The company, we should mention, has hired new management, and we wish them well.) Our after-tax loss from this investment was $444 million, about 1/5 of 1% of Berkshire’s net worth.

On volatility versus risk:

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

On not using borrowed money to invest:

[…] borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.

A confession after having introduce the major mistake of acquiring Berkshire (a sinking textile company) out of stubborness:

Can you believe that in 1975 I bought Waumbec Mills, another New England textile company? Of course, the purchase price was a “bargain” based on the assets we received and the projected synergies with Berkshire’s existing textile business. Nevertheless – surprise, surprise – Waumbec was a disaster, with the mill having to be closed down not many years later.

On his initial strategy of buying low priced small companies and why he changed it:

[…] Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.

But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well.

In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise. […]

On using shares instead of cash for acquisitions:

Consequently, Berkshire paid $433 million for Dexter and, rather promptly, its value went to zero. GAAP accounting, however, doesn’t come close to recording the magnitude of my error. The fact is that I gave Berkshire stock to the sellers of Dexter rather than cash, and the shares I used for the purchase are now worth about $5.7 billion. As a financial disaster, this one deserves a spot in the Guinness Book of World Records.

Several of my subsequent errors also involved the use of Berkshire shares to purchase businesses whose earnings were destined to simply limp along. Mistakes of that kind are deadly. Trading shares of a wonderful business – which Berkshire most certainly is – for ownership of a so-so business irreparably destroys value.

On the trumpeted synergies announced in M&A:

(As a director of 19 companies over the years, I’ve never heard “dis-synergies” mentioned, though I’ve witnessed plenty of these once deals have closed.) Post mortems of acquisitions, in which reality is honestly compared to the original projections, are rare in American boardrooms. They should instead be standard practice.

On cash:

At a healthy business, cash is sometimes thought of as something to be minimized – as an unproductive asset that acts as a drag on such markers as return on equity. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.

American business provided a case study of that in 2008. In September of that year, many long-prosperous companies suddenly wondered whether their checks would bounce in the days ahead. Overnight, their financial oxygen disappeared.

At Berkshire, our “breathing” went uninterrupted. Indeed, in a three-week period spanning late September and early October, we supplied $15.6 billion of fresh money to American businesses.

On trust and bureaucracy:

With only occasional exceptions, furthermore, our trust produces better results than would be achieved by streams of directives, endless reviews and layers of bureaucracy. Charlie and I try to interact with our managers in a manner consistent with what we would wish for, if the positions were reversed.

The books that are recommended this year in the letter are:

  • “Where Are the Customers’ Yachts?”, by Fred Schwed,
  • “The Little Book of Common Sense Investing”, by Jack Bogle,
  • “Berkshire Hathaway Letters to Shareholders”, compilation by Max Olson,
  • a new book in preparation commemorating the 50th anniversary of Berkshire Hathaway under present management.

Another article about Jim Ling in D magazine (from 1982) is recommended to understand the mentality of some CEOs running holdings at the time and why some negative perception towards holdings continue to exist today.

Finally, in the two last letters from Buffett and Munger, in which they review the future prospects of Berkshire there is some language that will no doubt stir again the rumours of whether Buffett may step down as CEO and / or chairman anytime soon. We will see.

For nostalgic investors, in this year’s annual report it is embedded Berkshire’s 1964 annual report (pages 130-142).

See the review I made of 2009, 2012 and 2013 letters.

1 Comment

Filed under Books, Investing

Stiglitz on shareholders’ mistreatment

A few days ago I published a book review of “The Roaring Nineties” by the Nobel prize Joseph E. Stiglitz. I wanted to share here some passages related to how shareholders, investors are mistreated by those who are supposed to work for them and how alignment of incentives play a role in this.

[On boards of directors] “Here again there was another conflict of interest. Boards are supposed to protect the interests of all shareholders. But some boards, whose members often receive large fees for membership and attendance, were frequently more concerned with pleasing the CEO than fulfilling their supposed fiduciary responsibilities.”

[On one-offs] “[executives] found ways to boost their earnings – through sam transactions which allowed them to book revenues even if they didn’t really have them, or by moving expenses off the books, or by using one-time write-offs (time and time again), to try to give the appearance of robust normal profits. Their objective was to create the appearance of alluring success […] and cash out before the world discovered the truth.”

[On incentives] “The bankruptcy report spoke of “numerous failures inadequacies and breakdowns in the multilayered system designed to protect the integrity of financial reporting system at WorldCom, including the board of directors, the audit committee, the company’s system of internal controls and the independent auditors”. The problem, I would argue, was deeper, and touched not only WorldCom: the problem was with incentives – for the management, and for those who were supposedly watching over management.”

[On the subject of fines] “They accepted fines of unprecedented levels […] but, in most cases, only after being assured that their CEOs would not do [jail] time. […] in many cases it was not the CEOs but the companies that paid them;  indeed, the fines imposed on corporations for such bad behavior represent a curious case where the victim is punished twice over. For ultimately, the shareholders – who have already been cheated by corporate management- bear the costs of such fines.

[On executives’ greed and regulation] “The deregulation mentality made the suggestion of increased government regulation […] an anathema. What worried many were shareholder suits, which they viewed as simply reflecting the rapacious greed of lawyers, not part of a system of checks and balances against the rapacious greed of corporate executives.”

Leave a comment

Filed under Economy, Investing

“A bird in the hand is worth two in the bush” (speech)

Thanks to the drive of some individuals (Sarah, EduardoDominique) a new Toastmasters corporate club (1) is being created within Airbus in Toulouse, where I work.

I joined Toastmasters in 2007 when I lived in Madrid and I have written often about Toastmasters in this blog, however I had become inactive in the last couple of years. This new initiative is very convenient and thanks to it I am engaging myself again in the association.

Today, I gave again a prepared speech in Toastmasters (2). In this post I just wanted to share it. Find it here, “A bird in the hand is worth two in the bush”, and below:

A bird in the hand is worth two in the bush

The topic of the speech is known for the reader of this blog: impact of delays in aircraft development projects seen as investment projects, the time value of money, discounting cash flows, break even, etc.

The feedback that I got: It was well received, especially the introduction, the interaction with the audience, the structure and how the topic was introduced and the main points called back in the end. However, I lost some individuals with the last slide, which needed some more explanation. I should have simplified the graphic. Some demanded more pauses and better vocalization.

(1) Up to now it is a prospect Toastmasters club.

(2) Project #1 of the “Speeches by Management” advanced manual: “The briefing”.

1 Comment

Filed under Aerospace & Defence, Investing, Toastmasters

Transcript of 2014 Berkshire Hathaway Annual Q&A with Warren Buffett and Charlie Munger

Last Saturday, May 3rd, Berkshire Hathaway held in Omaha its annual shareholder meeting, attended by over 30,000 shareholders. The most expected part of that weekend is the Q&A session of the meeting, in which Warren Buffett and Charlie Munger answer to dozens of questions.

The meeting is neither televised, nor recorded or streamed. However, the financial website Motley Fool has done a terrific job publishing a transcript of the session. Find the link here and allow yourself at least a couple of hours to read through it (the Q&A session takes hours itself!). I strongly encourage the reading. As a teaser, find below some of the gems:

No CEO looks at proxy statements and comes away thinking that I should be paid less.” Warren Buffett.

“We can’t earn same return on capital with over $300 billion market cap. Archimedes said he could move the world with a long enough lever. I wish I had his lever” Buffett

“If you are in any social organization, if you keep belching at the dinner table, you’ll be eating in the kitchen” Buffett (on Boards of Directors)

“Cash or available credit is like oxygen: you don’t notice it 99.9% of the time, but when absent, it’s the only thing you notice” Buffett

“By the standards of the rest, we over-trust. […] because we carefully selected people who should be over-trusted” Charlie Munger

“There’s something about owning a brand to educate yourself about things you might do in the future.” Buffett

At the beginning, we knew nothing. We were stupid. If there’s any secret to Berkshire, it’s that we’re pretty good at ignorance removal.” Munger

“… if you think you understand, you’re not paying attention.” Munger

“There’s changes going on with all our businesses. We want managers to think about change, what’s going to be needed for the future” Buffett

“Being realistic when realizing your own shortcomings is important.” Buffett (on the circle of competence)

“There’s a point you start getting inverse correlation between wealth and quality of life” Buffett

“I think America made a huge mistake by letting the public school systems go to hell…” Munger

(on home mortgage market) “you had the biggest bunch of thieves & idiots running things, I’m not trusting private industry in this field” Munger

“The net utility from finance majors has been negative.” Buffett

Some other readings I recommend in relation to this post:

Leave a comment

Filed under Investing

Buffett and Branson on airline business

While reading a few days ago Warren Buffett’s Letter to the Shareholders of Berkshire Hathaway, I was reminded of NetJets, the fractionary ownership of planes business which has as parent company. The fact that BRK owns such a company is quite ironic bearing in mind the following quote from Buffett:

“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

But then again, Richard Branson, another prominent businessman, founded Virgin Atlantic, which is now part of the Virgin Group, chaired by Branson, who is quoted saying:

“The quickest way to become a millionaire in the airline business is to start out as a billionaire.”

Are these cases of “do as I say, not as I do”?

Leave a comment

Filed under Aerospace & Defence, Investing