WARREN BUFFETT’S LETTER TO HIS SHAREHOLDERS

<<If You Pass Some Money To Warren Buffett In 1964 To Invest, Your Money Will Increase By 1,826,163% By The End Of 2014>>

Some key points that we have summarised from a 43-page report for easy reading:

(I) BERKSHIRE HATHAWAY’S PERFORMANCE VS S&P 500

Berkshire’s book value increase by 751,113% from 1964 – 2014 as compared to 11,196% if you were to invest in S&P 500

YEAR 2014 IN BERKSHIRE

1. Berksire’s “Powerhouse Five” – which are (i) Berkshire Hathaway Energy (formerly MidAmerican Energy), (ii) BNSF, (iii) IMC (Previously known as Iscar in the past), (iv) Lubrizol and (v) Marmon had a record $12.4 billion of pre-tax earnings in 2014, up $1.6 billion from 2013. Of these 5 companies, Berkshire will spend $6 billion on plant and equipment in 2015 where the sum is nearly 50% more than any other railroad has spent in a single year and is a truly extraordinary amount, whether compared to revenues, earnings or depreciation charges.

2. Bershire’s subsidiaries have made 31 bolt-on acquisitions scheduled to cost $7.8 billion in aggregate. The largest acquisition was Duracell, which will not close until the second half of this year. It will then be placed under Marmon’s jurisdiction.

3. In October, Berkshire was contracted to buy Van Tuyl Automotive, a group of 78 automobile dealerships that is exceptionally well-run by Larry Van Tuyl, the company’s owner.

4. Berkshire’s yearend employees  totalled a record of 340,499, up from 9,754 from last year. The Bershire HQ has only 25 people.

5. Berkshire increased its ownership interest last year in each of its “Big Four” investments – American Express, Coca-Cola, IBM and Wells Fargo. It increased the ownership to 7.8% versus 6.3% at yearend 2013 for IBM. Stock repurchases at Coca-Cola, American Express and Wells Fargo raised the percentage ownership of each. Equity in Coca-Cola grew from 9.1% to 9.2%. Its interest in American Express increased from 14.2% to 14.8% and its ownership of Wells Fargo grew from 9.2% to 9.4%. Berkshire felt that these 4 companies are excellent businesses run by managers who are both talented and shareholder-oriented. Berkshire prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business.

6. Both Charlie and Warren Buffett aim to build Berkshire’s per-share intrinsic value by (1) constantly improving the basic earning power of our many subsidiaries; (2) further increasing their earnings through bolt-on acquisitions; (3) benefiting from the growth of our investees; (4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and (5) making an occasional large acquisition.

 (II) INTRINSIC BUSINESS VALUE

1. Since 1970, our per-share investments have increased at a rate of 19% compounded annually, and our earnings figure has grown at a 20.6% clip. Berskire’s main focus is to build operating earnings. That’s why Berkshire exchanged Phillips 66 and Graham Holdings stock for operating businesses last year and to contract with Procter and Gamble to acquire Duracell by means of a similar exchange set to close in 2015.

2.(i) First by float size is Berkshire Hathaway Reinsurance Group, managed by Ajit Jain. Warren said that Ajit’s underwriting skills are unmatched and Ajit is always looking for more lines of business he can add to his current assortment. (ii) BHSI is led by Peter Eastwood, an experienced underwriter who is widely respected in the insurance world. During 2014, Peter expanded his talented group, moving into both international business and new lines of insurance. (iii) Tad Montross  manages General Re. Warren said that a sound insurance operation needs to adhere to four disciplines: (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained. Tad sticks to all 4. (iv) GEICO which is managed by Tony Nicely. GEICO has the huge cost advantage the company enjoyed compared to the expenses borne by the giants of the industry.

I skipped 2 sections which are the Berkshire’s capital intensive businesses (ie. BNSF, BHE) and the Finance and Financial Products (Marmon, Clayton, etc.

 

(III) COMMON STOCK INVESTMENTS

1. See the top common holdings by Berkshire:

BRK Holdings

2. Warren said that he made a mistake by investing in Tesco. At the end of 2012, Berkshire 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. During 2014, Tesco’s problems worsened by the month. The company’s market share fell, its margins contracted and accounting problems surfacedBerkshire sold Tesco shares throughout the year and are now out of the position and its after-tax loss from this investment was $444 million, about 1/5 of 1% of Berkshire’s net worth. We sold stocks that were very cheap in order to buy others we believed to be even cheaper.

3. Warren defined investing as “the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.” He concluded from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. Warren said that 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. Warren also said that volatility is far from synonymous with risk. He advises that investors should focus on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.

4. Warren said that investors by their own behaviour can make stock ownership highly risky. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. He further said that huge institutional investors have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship. Rather than listen to their siren songs, investors – large and small – should instead read Jack Bogle’s The Little Book of Common Sense Investing. Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.”

NOTE: I would recommend that as an investor, you should read the entire section which is on page 18 – 19 of the shareholder’s letter.

 

(V) BERKSHIRE HATHAWAY INC ACQUISITION CRITERIA

If you have a business  right now and you want to sell it to Warren, here are the criteria:

Criteria

Most of the above criteria also serves as a checklist if you are investing in a business.

 

(VI) BERSHIRE PAST, PRESENT & FUTURE

BERKSHIRE’S PAST

Warren first purchased Berkshire’s shares (which was a textile company in an ailing industry) in December 1962. Fast forward, it was a big mistake and in 1985, he closed the company. He further said that he made the 2nd biggest mistake which are as follows:

At age 28, he met Charlie Munger which totally changes how Warren invests. Charlie said “Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices”. I personally liked that part where Warren said that as partners for so many years, they have never argued because whenever their opinion differs, Charlie would say “Warren, think it over and you’ll agree with me because you’re smart and I’m right.”

Another mistake Warren said was Dexter Shoe. When he purchased the company in 1993, it had a terrific record and in no way looked to him like a cigar butt. However, its competitive strengths were eroded because of foreign competition.

BERKSHIRE’S TODAY

Berkshire has never invested in companies that are hell-bent on issuing shares. That behavior is one of the surest indicators of a promotion-minded management, weak accounting, a stock that is overpriced and – all too often – outright dishonesty.

Warren also warned about spin-offs. Those type where a company A acquires company B and then split company B with numerous spin-offs. He cited a company called ‘LTV’ which purchased Wilson & Co., a huge meatpacker that also had interests in golf equipment and pharmaceuticals. LTV then split the parent into three businesses, Wilson & Co. (meatpacking), Wilson Sporting Goods and Wilson Pharmaceuticals, each of which was to be partially spun off. These companies quickly became known on Wall Street as Meatball, Golf Ball and Goof Ball. Subsequently, LTV and the spin-offs didn’t make it.

BERKSHIRE’S NEXT 50 YEARS

1. You can purchase Berkshire’s shares only if it’s purchased below its intrinsic value. The last time I heard Warren’s repurchase was Price/Book Value ≤ 1.2. Investors should not borrow to invest with Berkshire and if you do hold at least for 5 years. If not, invest somewhere else.

2. Warren believes that any event causing Berkshire to experience financial problems is essentially zero. He said that financial staying power requires a company to maintain three strengths under all circumstances: (1) a large and reliable stream of earnings; (2) massive liquid assets and (3) no significant near-term cash requirements. Ignoring that last necessity is what usually leads companies to experience unexpected problems.

3. Warren will continue to build the underlying per-share earning power of Berkshire by achieving  organic gains, make bolt-on acquisitions and enter new fields.

4. Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings. At that time our directors will need to determine whether the best method to distribute the excess earnings is through dividends, share repurchases or both. If Berkshire shares are selling below intrinsic business value, massive repurchases will almost certainly be the best choice. You can be comfortable that your directors will make the right decision.

5. Warren’s son, Howard Buffer, will succeed him as a nonexecutive Chairman.

6. A Berkshire CEO must be “all in” for the company, not for himself.

7. Berkshire’s directors believe that their future CEOs should come from internal candidates whom the Berkshire board has grown to know well.

“I am a lucky fellow to have you as partners.” ~ Warren Buffett.

Full Letter: http://www.berkshirehathaway.com/letters/2014ltr.pdf

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Cayden Chang

Founder of Mind Kinesis Value Investing Academy

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