My investing muse - what we can learn from Berkshire's FY2021 letter to their shareholders

Berkshire shared their letter to shareholders on 26 Feb 2022.  For any value investor, this is one of the times when we hear from two of the greatest value investors of our time - Mr Charlie Munger and Mr Warren Buffett.  

Performance of Berkshire as compared with S&P500 since 1964

If you have invested with Berkshire in 1964, you would have gained a portfolio increase of 3,641,613% or 36,416x.  This translate to a compound annual gain of 20.1% (between 1964 to 2021).  Over the same period, S&P500 would give you a compound annual gain of 10.5% or 30,209% gain if you started investing from 1964.

Such returns put them at the pinnacle of value investing.  I have been exploring a few ETFs or indices to invest in.  After seeing the record, I would strongly recommend investing directly into Berkshire shares instead.  With a proven 20.5% compounded annual return, our investment into Berkshire could double in less than 5 years.

Here are my thoughts after reading this letter.  The words in italics are extracted from the letter:

"Charlie Munger, my long-time partner, and I have the job of managing a portion of your savings. We are honored by your trust. Our position carries with it the responsibility to report to you what we would like to know if we were the absentee owner and you were the manager... Our policy is to treat all shareholders equally" 

This is a partnership of trust, build upon values of stewardship.  In separate interviews, they (Mr Buffett and Mr Munger) do not agree to the Wall Street practice of buying or selling shares constantly.  This will inflate the commissions earned by the fund managers and does not always lead to greater profits for the investors.  Berkshire acts professionally to all shareholders and is always in their best interest.  Reporting requires us to understand the correct point of view - in this case, Berkshire puts itself in the shoes of its investors.

"We did, though, make reasonable progress in increasing the intrinsic value of your shares. That task has been my primary duty for 57 years. And it will continue to be."

29.6% (from 2021) is considered reasonable progress.  What better ways have they demonstrated modesty?  This is also one fine example of "managing expectation".

"Whatever our form of ownership, our goal is to have meaningful investments in businesses with both durable economic advantages and a first-class CEO. Please note particularly that we own stocks based upon our expectations about their long-term business performance and not because we view them as vehicles for timely market moves. That point is crucial: Charlie and I are not stock-pickers; we are business-pickers."

Key to meaning investments: It is not about buying stocks but investing in a business with durable economic advantages, excellent top management.  All these are done with a long term view.  Coming to business ownership, it is either owning partial or the entire business.

"I make many mistakes... That shooting-fish-in-a-barrel experience is very rare in negotiated transactions and never occurs en masse. It is also far easier to exit from a mistake when it has been made in the marketable arena."

They admitted that their investments include businesses with varying performance - some with excellent returns and some with marginal.  It is not just about the honesty seen in this statement but the humility behind them.  They have also mentioned that they do cut losses to exit from mistakes.

"Shooting-fish-in-a-barrel" implies ease to land a good catch or deal.  Such cases are rare.

"Many people perceive Berkshire as a large and somewhat strange collection of financial assets. In truth, Berkshire owns and operates more U.S.-based “infrastructure” assets – classified on our balance sheet as property, plant and equipment – than are owned and operated by any other American corporation. That supremacy has never been our goal. It has, however, become a fact.

At yearend, those domestic infrastructure assets were carried on Berkshire’s balance sheet at $158 billion. That number increased last year and will continue to increase. Berkshire always will be building."

Berkshire owns and operates more U.S. based infrastructure assets than any other U.S. company.  They intend to continue building more infrastructure over the years.  Personally, we can consider researching businesses involved in infrastructure and "construction" like their investments into $LOWE and the railroad.

"Every year, your company makes substantial federal income tax payments. In 2021, for example, we paid $3.3 billion while the U.S. Treasury reported total corporate income-tax receipts of $402 billion. Additionally, Berkshire pays substantial state and foreign taxes."

Berkshire paid taxes and it accounted for a good chunk of the total corporate income-tax received by U.S. 

"From an $8.6 million purchase of National Indemnity in 1967, Berkshire has become the world leader in insurance “float” – money we hold and can invest but that does not belong to us. Including a relatively small sum derived from life insurance, Berkshire’s total float has grown from $19 million when we entered the insurance business to $147 billion."

Berkshire is the world leader in insurance "float" (to hold and invest on behalf of their clients) at $147 billion.  The amount snowballed from $19 million when they first started their insurance business.  It is fair to say their good track record has been well rewarded over time - a sign of good stewardship.

The 4 giants of Berkshire are their insurance business, Apple, BNSF (US rail) and BHE (a utility powerhouse).

1.  Insurance

"The insurance business is made to order for Berkshire. The product will never be obsolete, and sales volume will generally increase along with both economic growth and inflation. Also, integrity and capital will forever be important. Our company can and will behave well."

For us who are looking for a business that will not be obsolete, sales moving with economic growth and hedge against inflation, we need to consider insurance in our portfolio.  With Fed planning to raise the interest rates to counter the inflation, insurance should be considered as part of our portfolio.

2.  Apple

Apple's repurchase (of their own stocks) has helped Berkshire increase their ownership from 5.39% to 5.55%, without spending a single cent.  Every 0.01% share amounted to approximately $100 million, meaning a "capital" gain of $1600 million alone from such buyback. 

On top of this, Apple paid USD$785 million in terms of dividends in 2021.  Thus, share buybacks are typically a bullish indicator for stocks.  On the contrary, we need to look out for companies who keep adding shares into circulation - leading to earnings and ownership dilution.

3.  BNSF

BNSF their railway company made record earnings of $6 billion in 2021 after travelling 143 million miles and carrying 535 million tons of cargo.  I guess many of us do not know that Berkshire is one of the key supply chain players in U.S. too.

4.  BHE

This 4th giant earned a record $4 billion in 2021.  This company has evolved over time and has "become a utility powerhouse (no groaning, please) and a leading force in wind, solar and transmission throughout much of the United States."

"Below we list our fifteen largest equity holdings, several of which are selections of Berkshire’s two long-time investment managers, Todd Combs and Ted Weschler. At yearend, this valued pair had total authority in respect to $34 billion of investments, many of which do not meet the threshold value we use in the table. Also, a significant portion of the dollars that Todd and Ted manage are lodged in various pension plans of Berkshire-owned businesses, with the assets of these plans not included in this table."

From the above, Berkshire has put in a succession plan, giving Todd Combs and Ted Weschler full autonomy of $34 billion worth of investments.  This is a great example of empowerment. This is part of their succession planning as both Buffett and Munger are in their 90s.  This should give us confidence that Berkshire can continue to do well in the years to come.

15 of the largest holdings by Berkshire

The list above details the 15 biggest holdings by Berkshire.  This is an important list that we can derive the following:

• Berkshire is an international company with its biggest investments that are in China and Japan.
• Berkshire remains heavily invested in the US and has branched out to Asia.  Some of us may consider this "diversification (geographical)".
• As of 31st Dec 2021, these 15 biggest holdings have grown by 235%.
• From the allocation, we can see a mixture of banking institutions, automakers, consumer staples, telecommunications, energy and a mixture of Japanese conglomerates

The current price of $VZ is $53.32 and Berkshire paid about $59.10 per share

Potential investing Tip from Berkshire

• From the table, we can calculate the approximate cost price for each share from the 15 holdings.  If the current prices are "close" to the costs price, it can be well worth it for us to consider adding some of these.  1 stood out in particular "Verizon" ($VZ) being the only one making a loss out of the 15.  From the table, we worked out that Berkshire paid about $59.10 per share for $VZ.  Understanding their due diligence, they would have paid $59.10 with a margin of safety built-in.  Thus, we should research this stock before arriving at our own conclusion.  Let us not clone Berkshire blindly.  We need to arrive at our own conclusion so that we do not invest based on borrowed convictions.
• Other opportunities remain for Mitsui, Mitsubishi which are not too far from the price paid by Berkshire (knowing that a margin of safety has been built-in).
• Berkshire intends to increase their stake in Pilot.

Let us not forget to do our due diligence before investing.

"Berkshire’s balance sheet includes $144 billion of cash and cash equivalents (excluding the holdings of BNSF and BHE). Of this sum, $120 billion is held in U.S. Treasury bills, all maturing in less than a year. That stake leaves Berkshire financing about 1⁄2 of 1% of the publicly-held national debt.

Charlie and I have pledged that Berkshire (along with our subsidiaries other than BNSF and BHE) will always hold more than $30 billion of cash and equivalents. We want your company to be financially impregnable and never dependent on the kindness of strangers (or even that of friends). Both of us like to sleep soundly, and we want our creditors, insurance claimants and you to do so as well."

To be financially impregnable, Berkshire always holds more than $30 billion of cash and equivalents.  This works out to be more than 4% of their market cap ($718 billion) 3.4% of their total assets ($873 billion) and 7% of their total liabilities ($422 billion).  A sizeable $120 billion is held in U.S. treasury bills that mature in less than a year.  If we have cash on hand, we should consider parking these in short term bills that would compensate for the inflationary costs.  

"After my initial plunge, I always kept at least 80% of my net worth in equities. My favored status throughout that period was 100% – and still is. Berkshire’s current 80%-or-so position in businesses is a consequence of my failure to find entire companies or small portions thereof (that is, marketable stocks) which meet our criteria for long- term holding.

Charlie and I have endured similar cash-heavy positions from time to time in the past. These periods are never pleasant; they are also never permanent. And, fortunately, we have had a mildly attractive alternative during 2020 and 2021 for deploying capital. "

Berkshire targets to keep at least 80% of its net worth in equities.  However, they could not find many opportunities recently.

Purchases made by Berkshire in 2021

Purchased made by Berkshire in 2020

Kindly note that these are the list of buys by Berkshire from 2020 to 2021.  However, Berkshire has sold quite a number of shares since the start of the pandemic in Q1/2020.  In fact, Berkshire has exited from some positions totally and has not held these stocks for a great length of time (unlike their previous investments).

The list above serves as a filter for me.  Due diligence will still need to be done before investing.  Let us not forget that we should limit ourselves to investing in companies where we have a circle of competence where we have more in-depth understanding and knowledge than most.  I need to remind myself against FOMO, YOLO and exercise discipline not to invest if no good opportunities present themselves.

Shares repurchase

"There are three ways that we can increase the value of your investment. The first is always front and center in our minds: Increase the long-term earning power of Berkshire’s controlled businesses through internal growth or by making acquisitions. Today, internal opportunities deliver far better returns than acquisitions. The size of those opportunities, however, is small compared to Berkshire’s resources.

Our second choice is to buy non-controlling part-interests in the many good or great businesses that are publicly traded. From time to time, such possibilities are both numerous and blatantly attractive. Today, though, we find little that excites us.

That’s largely because of a truism: Long-term interest rates that are low push the prices of all productive investments upward, whether these are stocks, apartments, farms, oil wells, whatever. Other factors influence valuations as well, but interest rates will always be important.

Our final path to value creation is to repurchase Berkshire shares. Through that simple act, we increase your share of the many controlled and non-controlled businesses Berkshire owns. When the price/value equation is right, this path is the easiest and most certain way for us to increase your wealth. (Alongside the accretion of value to continuing shareholders, a couple of other parties gain: Repurchases are modestly beneficial to the seller of the repurchased shares and to society as well.)

I want to underscore that for Berkshire repurchases to make sense, our shares must offer appropriate value. We don’t want to overpay for the shares of other companies, and it would be value-destroying if we were to overpay when we are buying Berkshire. As of February 23, 2022, since yearend we repurchased additional shares at a cost of $1.2 billion. Our appetite remains large but will always remain price-dependent."

Berkshire shared 3 ways to increase the value of investments:

1. internal growth of Berkshire's controlled businesses or making acquisitions with internal opportunities offering better returns than acquisitions.
2. Buy non-controlling part-interests in good/great business that are publicly traded> but there are few such opportunities.
3. Repurchase of Berkshire shares > only possible when shares offer appropriate values.  this means that there is no overpaying also for Berkshire shares.

Long term low-interest rates have an inflationary effect on the market.

Berkshire's lack of investments is not due to a lack of appetite but must remain price-dependent.  As Warren Buffett once said in a letter to his shareholders, “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

"As we’ve discussed, insurance “float” of the right sort is of great value to us. As it happens, repurchases automatically increase the amount of “float” per share. That figure has increased during the past two years by 25% – going from $79,387 per “A” share to $99,497, a meaningful gain that, as noted, owes some thanks to repurchases."

Thanks to share repurchase, $BRK.A has increased by 25% in the past 2 years. 

Berkshire paid tribute to a few, namely Mr Paul Andrews (TTI) whom he met through a mutual friend John Roach.  Much length was spent to acknowledge the quality of man, in his passion for the business and his charitable acts.  I am reminded that it is not always about what I know but rather who I know (and is willing to give me a chance).

Business owners can be tempted to sell our "companies" to a competitor or a financial buyer whose intent was probably to flip the business for a quick profit - without intending to grow or manage the business. In the end, it is about finding investors who would share and empower the passion of the business owner - to build the business.

Berkshire went on to purchase BNSF thanks to Paul who "sized up Berkshire to be the right home for TTI."

"Teaching, like writing, has helped me develop and clarify my own thoughts. Charlie calls this phenomenon the orangutan effect: If you sit down with an orangutan and carefully explain to it one of your cherished ideas, you may leave behind a puzzled primate, but will yourself exit thinking more clearly."

Teaching (like writing) can help us to develop and clarify our own thoughts - known as the orangutan effect by Charlie.

"Finally, at Berkshire, we found what we love to do. With very few exceptions, we have now “worked” for many decades with people whom we like and trust. It’s a joy in life to join with managers such as Paul Andrews or the Berkshire families I told you about last year. In our home office, we employ decent and talented people – no jerks. Turnover averages, perhaps, one person per year."

The keys to Berkshire's success is to find what they love to do and to "work" with people they like and trust.  They seek to employ decent & talented people and thus enjoy minimal turnover.