Warren Buffett has written a letter to Berkshire Hathaway shareholders each year since 1965. In them, he reflects on the company’s annual performance and its future. When read continuously, Buffett’s letters discuss the business and investing ideas that transformed Berkshire from a failing textile business into one of the world’s largest companies.
Here are six things I learned reading Berkshire Hathaway Letters to Shareholders 1965-2013:
1. How Berkshire Hathaway Is Structured
Berkshire Hathaway operates as a holding company with three revenue streams:
- Subsidiaries: Majority owned operating businesses like GEICO, Dairy Queen, and NetJets.
- Marketable Securities: Minority investments in companies like American Express and Coca Cola, along with bonds, Treasury bills, and other financial instruments.
- Financial Transactions: Berkshire occasionally participates in arbitrage of public stocks, foreign exchange derivatives, and other one-off transactions.
Insurance subsidiaries like GEICO and General Re Insurance play a particularly important role. They hold huge “floats”; insurance premiums collected but not yet paid as claims. Berkshire generates billions of dollars in profit by investing these floats, often acquired at zero cost, in marketable securities.
2. How Berkshire Changed What It Bought
Warren Buffett studied under the father of value investing, Ben Graham. Not surprisingly, Berkshire’s early investments were in public company stocks Warren judged to be good value.
Today, Berkshire prefers to acquire entire operating businesses. This change in strategy gives Berkshire enormous power over capital allocation, as we’ll see next.
3. How Berkshire Reallocates Retained Earnings
When Berkshire acquires a business, it acquires the right to allocate that company’s earnings. As Warren explains:
After meeting the needs of those businesses, we often have very substantial sums left over. Most companies limit themselves to reinvesting those funds within the industry in which they have been operating. That often restricts them, however, to a “universe” for capital allocation that is both tiny and quite inferior to what is available in the wider world.
In other words, by owning companies outright, Berkshire can re-invest profits into the most globally attractive opportunities.
4. How Berkshire Values Opportunities, Then and Now
Early Berkshire investments focused on finding companies trading at a discount to their intrinsic value: the present value of expected future cash flow, including a margin of safety. In other words, spending one dollar today would return more than one of today’s dollars in the future.
Later, Warren and Charlie wisely expanded their investment criteria:
The primary factors of our evaluation are:
- The certainty with which the long-term economic characteristics of the business can be evaluated;
- The certainty with which management can be evaluated, both as to its availability to realize the full potential of the business and to wisely employ its cash flows;
- The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;
- The purchase price of the business;
- The levels of taxation and inflation that will be experienced.
Costly failed investments taught have Berkshire the importance of owning businesses with sustainable competitive advantages. On several occasions, Warren made a great “value” investment only to have profits disappear earlier than expected. Berkshire’s original textile mill is a great example of making a “value” investment in a failing business.
5. How Berkshire Builds Shareholder Value
In summary, Charlie and I hope to build per-share intrinsic value by:
- improving the earning power of our many subsidiaries;
- further increasing their earnings through bolt-on acquisitions;
- participating in the growth of our investees (minority investments);
- repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and
- making an occasional large acquisition.
6. How Berkshire Plays A Long Game
Charlie and I have always preferred a lumpy 15% return to a smooth 12%.
Wall Street analysts have a near tyrannical focus on short term, quarterly increases in earnings per share. Berkshire, on the other hand, takes a longer view. It happily welcomes lumpy results if the long term average return is higher.
This brings us to risk. Berkshire wisely defines risk as “the possibility of loss or injury, not volatility.” Real investors welcome volatility as an opportunity to buy companies at a discount.
Pick up Berkshire Hathaway Letters to Shareholders 1965-2013 and learn about business and investing from the best.
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