18 observations from Berkshire’s 2014 annual report

Just an upfront note: I have written down those items while reading the 2014 annual report for the first time. Usually I read them at least twice. This year’s report contains a 4 page letter from Charlie Munger (page 39), nicely summarizing the “Berkshire system”. Overall, Buffett and Munger seem to emphasize in this year’s report that they see a great future ahead for Berkshire, even without them on board.

I would recommend anyone to read the annual report first before reading any comments from secondary sources. It is a lot to read but it is definitely worth your time.

My personal take is that it will be extremely hard for any succesor to fit into Buffett’s (and Munger’s) shoes. This company was built by and around two geniuses. Yes, the “Berkshire system” does have some enduring qualities but combined with the size of the company, it will be extremely hard to deliver outstanding performance ging forward.

Call for comments: Comments from my readers about what items you did find especially noteworthy would be highly appreciated !!!!

1. 50 year history

They have changed the layout of the 50 year table (included Berkie’s stock performance, especially they dropped the difference between book value increase and S&P 500. Buffett has mentioned several times that he doesn’t see increase in book value as the main yardstick anymore. However I am surprised that now he changes the layout.

I guess there is some vanity on his side included. The old layout would have shown that he has now underperformed the 3rd year in a row based on his old benchmark. Multiple expansion did help Berkie’s share price a lot over the last few years. As mentioned above, the company now is so big that it seems to be already too difficult to perform well under the old standard,

2. Problems at Burlington

Burlington was his biggest acquisition and 2014 seems to have been a bad year. I wonder how 2015 will look like if oil production (and transport) will go down at some point in time. It looks like that they had under invested in their infrastructure and do now have to put a lot of money back into the business.

The story at BNSF, however – as I noted earlier – was not good in 2014, a year in which the railroad disappointed many of its customers. This problem occurred despite the record capital expenditures that BNSF has made in recent years, with those having far exceeded the outlays made by Union Pacific, our principal competitor.
The two railroads are of roughly equal size measured by revenues, though we carry considerably more freight (measured either by carloads or ton-miles). But our service problems exceeded Union Pacific’s last year, and we lost market share as a result. Moreover, U.P.’s earnings beat ours by a record amount. Clearly, we have a lot of work to do.

3. Car dealership acquisition

In October, we contracted to buy Van Tuyl Automotive, a group of 78 automobile dealerships that is exceptionally well-run. Larry Van Tuyl, the company’s owner, and I met some years ago. He then decided that if he were ever to sell his company, its home should be Berkshire. Our purchase was recently completed, and we are now “car guys.”
Larry and his dad, Cecil, spent 62 years building the group, following a strategy that made owner-partners of all local managers. Creating this mutuality of interests proved over and over to be a winner. Van Tuyl is now the fifth-largest automotive group in the country, with per-dealership sales figures that are outstanding.

Another acquisition based on personal contact and a lot of patience from Buffett’s side. Owner-partnership at local level seems to be a good formula for such businesses (see Les Schwab).

4. He mentioned the classic book “Where Are the Customers’ Yachts?”

Was alway on my list but I didn’t manage to read it yet.

5. Some “gems” on the insurance industry:

Competitive dynamics almost guarantee that the insurance industry, despite the float income all its companies enjoy, will continue its dismal record of earning subnormal returns on tangible net worth as compared to other American businesses. The prolonged period of low-interest rates our country is now dealing with causes earnings on float to decrease, thereby exacerbating the profit problems of the industry.

Berkshire’s underwriting insurance profit is down, only a small profit increase at GEICO. He is suffering too, but the companies still produce positive technical results. Howevr there was no NatCat in 2014, so expect losses if there are large Natcats again. Even Buffett cannot fully escape the pricing pressure in insurance.

6. How to measure interest coverage

(Our definition of coverage is pre-tax earnings/interest, not EBITDA/interest, a commonly used measure we view as seriously flawed.)

I had written about the stupidity of EBITDA, especially for capital-intensive businesses already a few times. Good to hear the “master” on this.

7. Clayton: Bought for 1,7 bn in 2003, Earnings 2014 558 mn USD

Clayton homes seems to have been another, underappreciated home run for buffet. At 15 times P/E a 500% return in 11 years, not bad.

8. TESCO:

2013, I soured somewhat on the company’s then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior “thumb-sucking.” (Considering what my delay cost us, he is being kind.)

Was one of the biggest loosers of all time, acted to slowly. Would be interesting to know what exactly irritated him. Interestingly, the decision didn’t include thoughts on competition form Aldi, Lidl etc. but only Tesco management.

9. Market timing / borrowed money

Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. 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. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet

Very good advice. Borrowing is only good if your name is Buffett and you call it “float” or “Non-recourse”…..

10. On Cigar butt investing

Those were the days. For small investors, Cigar butt investing might still work….

My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.

11. On 60s Conglomerates:

Since the per-share earnings gains of an expanding conglomerate came from exploiting p/e differences, its CEO had to search for businesses selling at low multiples of earnings. These, of course, were characteristically mediocre businesses with poor long-term prospects. This incentive to bottom-fish usually led to a conglomerate’s collection of underlying businesses becoming more and more junky. That mattered little to investors: It was deal velocity and pooling accounting they looked to for increased earnings.

That basically is valid for all “roll up” situations. Targets with lower P/Es will get scarcer and have less quality over time.

12. On private equity

In truth, “equity” is a dirty word for many private-equity buyers; what they love is debt. And, because debt is currently so inexpensive, these buyers can frequently pay top dollar. Later, the business will be resold, often to another leveraged buyer. In effect, the business becomes a piece of merchandise.

Great sentence, however would sound more honest if he hadn’t teamed up for mega-leveraged buyout Heinz with 3G.

13. Instant classic

But Charlie told me long ago to never underestimate the man who overestimates himself.

This is very helpful advise in many situations, especially if you want to short a company…..

14. Derivatives

New collateral requirements mean no more “float” in writing options:

Some years ago, we became a party to certain derivative contracts that we believed were significantly mispriced and that had only minor collateral requirements. These have proved to be quite profitable. Recently, however, newly-written derivative contracts have required full collateralization. And that ended our interest in derivatives, regardless of what profit potential they might offer. We have not, for some years, written these contracts, except for a few needed for operational purposes at our utility businesses.

15. Insurance, float & liquidity

Moreover, we will not write insurance contracts that give policyholders the right to cash out at their option. Many life insurance products contain redemption features that make them susceptible to a “run” in times of extreme panic. Contracts of that sort, however, do not exist in the property-casualty world that we inhabit. If our premium volume should shrink, our float would decline – but only at a very slow pace.

A hidden hint in my opinion that you don’t want to own life insurance companies…..

16. From Munger letter, biggest mistakes

What were the big mistakes made by Berkshire under Buffett? Well, while mistakes of commission were common, almost all huge errors were in not making a purchase, including not purchasing Walmart stock when that was sure to work out enormously well. The errors of omission were of much importance. Berkshire’s net worth would now be at least $50 billion higher if it had seized several opportunities it was not quite smart enough to recognize as virtually sure things.

That would be agood question to both on the AGM: Why was it sure that WalMart would work out “enormously well” and why didn’t they buy a boatload ?

17. Munger on the Age of incoming CEOs

Compare this to a typical big-corporation system with much bureaucracy at headquarters and a long succession of CEOs who come in at about age 59, pause little thereafter for quiet thought, and are soon forced out by a fixed retirement age.

A very good observation and something to keep in mind when looking at companies. In a situation like that you rarely see long-term strategies implemented.

18. Munger on recreating Berkshire

Berkshire’s marvelous outcome in insurance was not a natural result. Ordinarily, a casualty insurance business is a producer of mediocre results, even when very well-managed. And such results are of little use. Berkshire’s better outcome was so astoundingly large that I believe that Buffett would now fail to recreate it if he returned to a small base while retaining his smarts and regaining his youth.

Good advice for all “would be Buffets”: Forget it. Berkshire was a “one off”.

14 comments

  • “…Meatball, Golf Ball and Goof Ball”

    Once more Warren hits on Wallstreet quite a few times and exposes their folly….Charly calling them “helpers”…
    Both remind us that brokers and others are not there to help investors with their performance.

  • I would prefer to learn more about what they think regarding real economic goodwill and pricing power of Berkshire’s subsidiaries.
    As StrictlyValue said, the letter doesn’t really elaborate.

    Berkshire’s increased their IBM ownership, what is a mystery for me. Radically simplified applications and databases means less service and consulting.

  • One additional interesting point:
    Buffetts objection to the new CEO also being Berkshire’s Chairman is sensible. He suggests his son, but with no salary and i clear job description.

    Do you know more about redemption features of life insurance? I thought the insurance company pays, when the insured is dead. Until then the insured has to pay. Maybe these contracts with redemption are only life insurance by name?
    “Many life insurance products contain redemption features that make them susceptible to a “run” in times of extreme panic.”

    Do you think the whole annual report is worth reading or just the first 43 pages? I have read only the letters of every annual report so far. Only fast-read the rest.

  • Pingback: Weekly market round-up: 2 March 2015 | Dustin's Blog

  • I like to look at the development of the listed holdings. Interesting to see that not a single share has been sold at the Big 4 – Wells Fargo, Coca Cola, American Express, IBM – even though 3 out of the 4 have become somewhat controversial. Berkshire’s ownership of these companies has gradually increased, thanks to share buybacks and some purchases. The letter doesn’t elaborate on these holdings, nor on the sale of the energy businesses Exon Mobil and ConocoPhilips.

  • For me the biggest loss when Buffet leaves the company will not be his qualities as an investor but his qualities as a businessleader. I think it will be close to impossible for someone else to do what Buffet is doing at BH, to get all those CEOs at the subsidiaries to work towards a common goal really takes a truly outstanding leader.

  • I read every Berkshire report cover to cover. The only one of my holdings that I do because I care about getting a decent return on my own investments but I really don’t give a crap about business. I know I should read more and each time I read a Berkshire report or anything else Buffet writes – I dig a little deeper into the topic but pretty soon my interest wanes. I love the logic of what Buffett does but the details tend to bore me.

    I think Buffett is an incredible teacher. His ability to take incredibly complex topics like business accounting and make it so easy to understand with simple language and almost no wasted words, is a truly amazing gift. He is also very entertaining – crucial to the vaguely interested.

    After I read Berkshire’s report I feel I have some decent understanding of what Berkshire is. Now I have to trust that he isn’t full of shit – but I think he gives any thoughtful person plenty of enough evidence in his reports to trust him.

    I think the most interesting thing for me in this report is the piece that Munger wrote. He broke down the reasons why he thinks Berkshire will continue to outperform. He concludes that there will never be another Buffett but the structure of Berkshire is superior so it will still outperform. I’m a little on the fence about that because I buy into the structure argument, but my bet is that over the next 50 years Berkshire will under perform the index.

    • I wouldnt buy in the 50 years in future-prediction as well, but it looks as they made good fundaments. I suppose it could flourish further 10 years.

      But 50 years? heck, thats a really long time!
      As a German I look backwards and do not suppose to have 50 years without radical breaks.

      I’ll show it on the history of my grandfather:
      1. Born 1914 in the “German Empire” that was build to last for long. But they probably started, at least entered an evil war and lost. 1918 came a revolution.
      2. 1918 “Weimarer Republik”, democratic republic build to last. Some disposessions, but not much. But in 1932 a relative majority of German voted for Hitler, later in 1933 even an absolute majority. So next step:
      3. 1945 “Nazi Germany” or “Third Reich”, a facist and racist peoples dictatorship, build to last 1.000 years. Many disposessions and murdering of people with “wrong” race, religion and political opinion. And they started an evil war and lost it 1945, luckily. So up to the next chapter.
      4. 1945: “German Democratic Republik”, socialist peoples ditatorship, build to last. Quite a lot disposessions. It also didn’t last, it failed economically, not fulfilling its own promises. So next revolution, 1989.
      5. 1990: “German Reunification” in a democratic republic. Build to last. Quite some disposessions for GDR-people, expecially those owning houses that once belonged to others.

      My grandfather experienced 5 very different social orders in his life of 100 years, every one build to last. And every new system turned the previous society quite strongky upside down, companies included. So for me it seems a very overbold claim to assume that a company should not only survive but prosper and outperformes for a period of half a century.

      The United States are more stable with social orders, but their economy and their biggest companies also quite totally changed over every time limit of 50 years. Competitive free market economy is not designed to leave biggest companies remain biggest companies over such a long period of time.

  • Add-on to 12)
    Later, the business will be resold, often to another leveraged buyer. In effect, the business becomes a piece of merchandise.
    -> Jorge & Co IMO do not have this attitude. E.g. they have also used significant leverage for the ABusch acquisition – still are very much owner-oriented, and not in for a quick flip.

    to 18)
    Good advice for all “would be Buffets”: Forget it. Berkshire was a “one off”.
    -> BRK will always be one of a kind. BUT that doesn’t mean that the float-model isn’t still useful—e.g. Pabrai & Biglari with their latest acquisitions sure think so.

    @Roger: I like vii). Who prioritizes reading & thinking in the business world nowadays? 🙂

    I love the following lines:
    In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.
    Market forecasters will fill your ear but will never fill your wallet.
    Yogi Berra said, “Every Napoleon meets his Watergate.”
    We are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That’s important: If horses had controlled investment decisions, there would have been no auto industry.

    Interesting:
    So why did I purchase NICO for Berkshire rather than for BPL? I’ve had 48 years to think about that question, and I’ve yet to come up with a good answer. I simply made a colossal mistake.

    btw:
    Did anybody have a “greenmail”-feeling when considering Buffett’s behavior with his BRK-position back in 1964?

  • Very nice composition! I also think Berkshire was an “one off” for this formula. Now it a known and probably quite offbeaten track, so other people have to find other new ways to get comparable success.

    By the way: My personal highlight up to now was Mungers Job description for the Chairman of Berkshire, as it is so totally different from the usual view of chairmans of big enterprises. It is worth thinking what other companies can learn of it

    “Berkshire’s Chairman would reserve only a few activities for himself.
    (i) He would manage almost all security investments, with these normally residing in Berkshire’s casualty insurers.
    (ii) He would choose all CEOs of important subsidiaries, and he would fix their compensation and obtain from each a private recommendation for a successor in case one was suddenly needed.
    (iii) He would deploy most cash not needed in subsidiaries after they had increased their competitive advantage, with the ideal deployment being the use of that cash to acquire new subsidiaries.
    (iv) He would make himself promptly available for almost any contact wanted by any subsidiary’s CEO, and he would require almost no additional contact.
    (v) He would write a long, logical, and useful letter for inclusion in his annual report, designed as he would wish it to be if he were only a passive shareholder, and he would be available for hours of answering questions at annual shareholders’ meetings.
    (vi) He would try to be an exemplar in a culture that would work well for customers, shareholders,
    and other incumbents for a long time, both before and after his departure.
    (vii) His first priority would be reservation of much time for quiet reading and thinking, particularly that which might advance his determined learning, no matter how old he became; and
    (viii) He would also spend much time in enthusiastically admiring what others were accomplishing.”

    Just take the last bullit: Have you ever read in any job description “spend much time in enthusiastically admiring what others were accomplishing”? Its a psychological gem!
    Even when it should be known, that open admiration from seniors you admire yourself is a much better work motivation than lots of higher salaries or such – the leading style of many seniors can be summarized to the old swabian saying “Net gschompfa isch globt gnuag” aka “To not be yelled at is praise enough”.
    What a different approach!

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