Over the weekend, Berkshire Hathaway released our (and everyone’s) favorite shareholder letter that never fails to serve as a World Class education in the high-art of capitalism. We devoured the 31-page letter and 123-page annual report over the weekend and noted these nine tidbits that were particularly applicable to running a bank. We are going to skip reporting on Berkshire’s performance as to focus on management insights but for context, it is important to note that Berkshire’s Class B common shares rose 23.4%, while book value increased 10.7%.
Here are some of the more interesting salient points:
Stock Buybacks: As usual, Warren Buffet continues to advocate for stock repurchases when, as an investment, buybacks returns better than the other alternatives. Berkshire loves to arbitrage and difference between the intrinsic value of the Company and its market value. As a rule of thumb, whenever Berkshire’s stock trades below its true value, which is approximately 1.2x book value (adjusted due to accounting conventions), repurchasing equity creates positive shareholder attribution. It is interesting to note for publically traded banks that because Berkshire has this implicit policy, its stock has traded in a narrow range around the Firm’s intrinsic value. This has the advantage of not only putting a “soft floor” on the stock price but also prevents inflated values and “disappointing shareholders.”
For The Love of Dividends: Berkshire provides a practical education when it comes to dividends. Berkshire nets considerably more from a dollar of dividends than it reaps from a dollar of capital gains. Berkshire points out that every $1 of capital gains that a firm realizes carries with it 35 cents of federal income tax plus state tax. However, the tax on corporate dividends is lower, and for Berkshire, it is effectively 10.5 cents per $1 of dividends.
Investment Fees: A lesson for both banks and bankers, Buffet spends a considerable amount of time deriding professional money managers that invest in other managed funds and get eaten alive by fees. In an ironic twist of behavioral economics, Buffet points out that is the wealthy or “smart” money that normally eschews low-cost index funds for “elite” managed accounts only to “waste” in Warren’s rough calculations, $100B over the past ten years. Buffet highlights the adage, “When a person with money meets a person with experience, the one with experience ends up with the money, and the one with money leaves with experience” while paying a deep tribute to Jack Bogle, the father of index investing.
In his lifetime, Buffet states that he has identified less than a dozen investment professionals that are capable of beating the market over the long term. Short-term success, often driven by luck, lead to a torrent of money into a fund, which usually leads to increase fees. The combination of higher fees and more assets under management make it almost impossible to beat an index.
Remember that is was Mr. Buffet that famously offered $500k to any investment manager that could select five funds that could match the Vanguard S&P 500 Index over a ten year period. That was nine years ago. So far, the Index fund is up 85.4% to date. The lead investment professional only has one fund that is at a 62.8% return, while the other four are at 2.0%, 7.5%, 8.7% and 28.3%.
Fake Profits: Buffet speaks out against management teams that feature “adjusted earnings” that exceed their GAAP earnings. The omission of restructuring costs and the accounting for stock-based compensation are two of the more common adjustments that managers like to leverage. On stock-based compensation, Buffet challenges - If CEOs want to leave out stock-based compensation in reporting earnings, they should be required to affirm to their owners one of two propositions: why items of value used to pay employees are not a cost or why a payroll cost should be excluded when calculating earnings.
Adjusted earnings are a systemic issue within companies as “CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well.” Goals like that can lead, for example, to bankers underestimating their loss reserves, a practice that has destroyed many industry participants. Business is too unpredictable to always “meet your numbers.” “Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.”
Allocate Capital When Others Are Fearful: Meg McConnell of the New York Fed had a good quote about panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.” During these periods, Berkshire’s Management extols remembering two things: “First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted.” When markets are frothy, get out. When markets undergo a credit shock, allocate more capital to the effort.
The 'Forever' Investment Horizon: Recently, we wrote about how banks need to increase the strategic horizon so that it better matches the long duration of their capital. Berkshire does just that. Mr. Buffett likes to say his hold time on his investments is "forever" since his capital is long-term in nature. That said, Berkshire management keeps everything available for sale and would sell it all at a moment’s notice should the situation warrant. One important point here is that any given investment horizon has to do more with having the right people than having the right asset.
Bank of America: While Buffet doesn’t spend too much time on his particular investments, he does highlight an interesting point on Bank of America. Uncharacteristically, he goes out of his way to say the BofA is undervalued and loves the fact that the Bank is repurchasing shares. In the past, he noted that he has the warrants for 700mm shares of BofA at $7.14 each (which equates to a current gain of a cool $12B) but would not exercise them until close to expiration as to increase his return. However, in this annual letter he says he would exercise the shares should the dividend reach $0.44/share (recently, BofA moved their dividend from $0.20 to $0.30). While Buffet doesn’t say why a target of 44 cents, at that level, proceeds, would equate to $300mm, or about the same as the 6% coupon on the preferred shares. You can imply that Berkshire still sees substantial upside value in bank stocks and BofA.
On Shareholder Information: “While I’m on the subject of our owners’ gaining knowledge, let me remind you that Charlie and I believe all shareholders should simultaneously have access to new information that Berkshire releases and, if possible, should also have adequate time to digest and analyze it before any trading takes place. That’s why we try to issue financial data late on Fridays or early on Saturdays and why our annual meeting is always held on a Saturday (a day that also eases traffic and parking problems).
We do not follow the common practice of talking one-on-one with large institutional investors or analysts, treating them instead as we do all other shareholders. There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his or her savings. As I run the company day-to-day – and as I write this letter – that is the shareholder whose image is in my mind.”
American Capitalistic Pride: Like he always does, Buffet takes time out to discuss the optimism of America and its current economic strength. This counters much of the political narrative that is going on today. Serving as a model for every bank CEO note to shareholders, Berkshire discusses the “miracle” that is our 240-year experiment where “Americans have combined human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law to deliver abundance beyond any dreams of our forefathers.” “Starting from scratch, America has amassed wealth totaling $90 trillion.”
Submitted by Chris Nichols on February 27, 2017