What I learn from Warren Buffett’s 2020 Shareholder letter

Warren Buffett’s shareholder letters are always filled with wonderful information and insights. This year's letter is no different, and I learned quite a few things.

Here are a few things I learn from Warren Buffett’s 2020 Shareholder letter.

$42.5 billion earnings in 2020

There are 4 components to Berkshire Hathaway (BRK)’s earnings:

1.       Operating Earnings, which is $21.9 billion

2.       $4.9 billion of realized capital gains

3.       $26.7 billion gain from an increase of net unrealized capital gains from BRK’s stocks

4.       Finally, an $11 billion loss from a write-down in the value of a few subsidiaries and affiliate businesses that BRK owns.

Buffett pointed out that the operating earnings are important, despite it isn’t the biggest source of earnings.

Despite these earnings, Buffett keeps in mind another important factor, but which isn’t included in their financial statements, the businesses’ Retained earnings that BRK invested. Especially those shares they brought from the public stock exchange.

As these companies use those retained earnings to:

·         Expand their business

·         Make acquisitions

·         Pay off debt

·         And to repurchase their stock

These actions build value to the companies and, of course, to BRK.

What I learn from this is that:

·         Regardless of the good fortune you received from other sources (e.g. share price rise), focus on what matters most. In this case, businesses should focus on their operating earnings.

·         Sometimes, important things aren’t recorded in financial statements. Look beyond the financial statements at times.

o   In BRK’s case, the retained earnings from its marketable shares.

Buffett acknowledged he made a mistake

In 2016, BRK brought Precision Castparts (“PCC”), and Buffett claims that he paid too much for the company.

Although Buffett still believed that he brought a fine company with good management running it. 

However, Buffett was too optimistic about the PCC’s profit potential and have to write down $11 billion.

I doubt this will be Buffett's last mistake of the same kind.

What I learn from this:

·         Is to own up and admit your own mistake.

·         Overpaying for a business is very possible in investing.

·         As such, buying a good or great company is more important.

Conglomerate

Buffett shared a little history about conglomerate, which most have label BRK as.

Conglomerates usually buy 100% of companies they are interested in.

However, there are 2 problems to this:

·         Most truly wonderful businesses have no interest to let anyone take over them

·         This result in Conglomerates buying mediocre businesses

o   Businesses that may not have the economic moat

To make matters worse, Conglomerates may find themselves having problems paying these mediocre businesses. As such some of these Conglomerates find another way to businesses cashless.

Sometimes, when a company buys over another company, what they can do are:

·         Pay full cash for the company.

o   For eg: if a Conglomerate is interested in ABC company.

o   And the ABC company worth $1million.

o   Conglomerate pays full cash $1million for it.

·         Pay shares for the company.

o   For eg: if Conglomerate is listed and the average share price is $50 for the past few months.

o   The ABC company is worth $1million again

o   Conglomerate pay ABC shareholders 20 thousand of their shares to them ($50 x 20,000 = $1 million) instead of cash

·         Pay part-cash, part-shares for the company.

o   For example, ABC company is worth $1million again

o   Both parties agree that Conglomerate pay $1/2 million in cash and $1/2 million in shares(which will be 10,000 shares)

Usually, the Buyer has to pay a premium to the other company. For example, ABC Company is worth $1million but the ABC shareholders only willing to sell it for $2million. Otherwise no deal

Conglomerates have to find a way to pay up. They may not have the cash all the time. As such, part-shares or full share deals are offered.

Some Aspiring conglomerateurs may result in creative accounting to portray conglomerate business are better than it is, thus making their shares more valuable than they should be.

As such, when they may a deal with a company they wish to buy with shares, they have more ‘dollars’ in the discussion.

For example:

·         Conglomerate shares’ intrinsic value $50

·         But because they employed creative accounting, the market assumes the Conglomerate share worth $150 and currently trading at that price

·          ABC Company is willing to sell the company at $2million, despite worth $1million.

·         Conglomerate offers a deal for full shares at $125/share (instead of $150 current trading price) with 16000 shares.

·         Naturally, the ABC shareholders will want this, as the current price of the Conglomerate share is $150, they got $25/share more than they asked for. $150 x 16000 shares = $2,400,000, which is $400,000 more!

·         However, if based on Conglomerate’s actual intrinsic value, which is $50/share

·         Conglomerate paid $800,000 worth of share value.

Buffett also notes that Wall Street loves this type of deal, as the fees it generates and the press loves to promote such business management as geniuses to hype up the interest.

Buffett explained that BRK doesn’t mind owning part or all of a business. As long as it is a good company with good management.

He is convinced that owning a part of a wonderful business is better than owning 100% of a business that is struggling. It is more profitable, more enjoyable, and far less work to do. In short, it is easier.

What I learn from this section are:

·         Buy a wonderful business with great management is easier

·         Conglomerates may resort to creative accounting to achieve a better deal

·         In investing, make your life easier by keeping things simple. You aren’t rewarded with harder difficulty.  

What is creative accounting?

Creative accounting capitalizes on loopholes in the accounting standards to falsely portray a better financial status of the company.

Berkshire Hathaway’s 4 core businesses

Buffett explains that BRK has 4 core businesses that hold the most of BRK’s value:

·         Property/casualty insurance operation

·         Burlington Northern Santa Fe Railway Company (BNSF)

·         5.4% ownership of Apple

·         Berkshire Hathaway Energy (BHE)

Property/casualty insurance operation

BRK’s insurance fleet operates with more capital than its competitors worldwide. Along with the cash BRK received annually from non-insurance businesses allows the BRK insurance sector to employ equity investment strategy heavily. While its competitors must focus on bonds due to both regulatory and credit-rating reasons.

Buffett explained that because of the low yield, some even negative returns, bonds are giving in the current market condition; bonds investors should reconsider their strategy.

BRK has $138 billion of insurance “float” to deploy in its investment. Although the money doesn’t belong to BRK, BRK can still use it and earn more returns.

Burlington Northern Santa Fe Railway Company and Berkshire Hathaway Energy

Buffett recently learned that BRK has the highest property, plant, and equipment amount in the USA. The second is AT&T.

This comes with high capital expenditures and depreciation costs for many years. For example, BNSF will experience damages to their tracks due to extreme weather and have to pay for the cost of maintenance. BHE has to rework its outdated grid for renewable energy.

Despite so, both companies, BNSF and BHE, deliver good returns despite the nature of business.

Although asset-heavy companies can be good investments, Buffett prefers business that requires:

·         minimal assets to conduct high-margin business

·         able to scale sales volume with little capital required

Apple

Buffett explained the power of repurchases.

BRK has been buying Apple Shares from 2016 to 2018; BRK has 5.2% of Apple.

However, because Apple has been buying back its shares, at no cost to BRK, that stake increased to 5.4%.

BRK has also repurchased back its “A” Shares. This has the same effect on investors, increasing investors’ ownership of BRK.

However, because BRK owns Apple shares, which Apple does its share repurchasing, will also help BRK investors to increase their Apple ownership.

This compounding effect between these 2 companies comes at no cost for BRK investors.

What I have learned from this section:

·         Bonds investors need to relook at their strategy

·         Assets-heavy companies can be profitable

·         Buffett prefers business that requires minimal assets to conduct high-margin business and able to scale sales volume with little capital required

·         Insurance companies have a way to use other-people-money to make more money for them.

·         The share buyback is another element of compounding interest.

In Summary

Warren Buffett focuses heavily on the business's operation performance, despite BRK’s capital gains are the largest earnings.

Some things are important but aren’t reflected on the financial statements, for example, the reinvestment from the earnings and the repurchasing shares the companies have done. Although they are out of sight, doesn’t mean it isn’t working for you. Retained earnings and share repurchasing are elements of a company doing their ‘compounding interest’ for you.

Bonds don’t seem to be a good deal at the moment in general.

As much as possible, invest in companies that can scale their revenue with little capital and gain a high margin. But that doesn’t mean assets-heavy companies are a bad investment.

My major takeaway is that the most important he is focusing on is to find great business first. Understand how the business works, what are their strength and weakness. Then follow the business. This makes life easier.