A Few Life Lessons from 2017 Berkshire Annual Report

A Much Better Read Than Your Typical How-to Book

Published on:
April 20, 2018
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

Lessons#1: Focus

"At Berkshire what counts most are increase in our normalized per-share earning power. That metric is what Charlie Munger, my long-time partner, and I focus on - and we hope that you do, too."

Commentary: Vanity metrics such growth in EBITDA are distracting. And do not translate to an increase in book value over the long term.

Lesson#2: Business is a people’s game

"Betting on people can sometimes be more certain than betting on physical assets."

Commentary: In this quote, found in page 6, The Oracle from Omaha admits he knows little about the manufacturing operations. And had relied instead on the judgement of the CEO of Precision Castparts, Mark Donegan, in acquiring Wilhelm Schultz GmbH, a German maker of corrosion resistant fittings and piping systems. 

Lesson#3: Self Reliance

"Charlie and I never will operate Berkshire in a manner that depends on the kindness of strangers - or even that of friends who may be facing liquidity problems of their own. During the 2008-2009 crisis, we like having Treasury Bills - loads of Treasury Bills - that protected us from having to rely on funding sources such as bank line or commercial paper. We have intentionally constructed Berkshire in a manner that will allow it to withstand economic discontinuities, including such extremes as extended market closures."

Commentary: To sleep well at night, you need to rely on - and to be accountable to - one person: yourself.  

Lesson #4: Judgement

"Amortization charges were an additional $1.3 billion. I believe that in large part this items is not a true economic cost."

Commentary: It is the analyst’s job to understand which accounting conventions represent a true, economic reality.

Lesson #5: Goals

"Berkshire's goal is to substantially increase the earnings of its non-insurance group. For that to happen, we will need to make one or more huge acquisitions."

Commentary: Having clear investment goals is one of the best gift you can give yourself.

Lesson #6: Margin

"Berkshire, itself, provides some vivid example of how price randomness in the short term obscure long-term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest  work its magic. Year by year, we have moved forward. Yet Berkshire shares suffered four truly major dips. Here are the glory details:
March 1973 to January 1975:  High $93 and Low of $38. A 59.1% drop in stock price.
October 2, 1987 to October 27, 1987 as high as $4,250 as low as $2,675. A 37.05% drop in stock price.
June 19, 1998 to March 10, 2000 as high as $80,900 and low as $41,300. A 48.94% drop in stock price.
September 19, 2008 to March 5, 2009 high as $147,000 low as $72,400. A 50.7% drop in stock price.
This table offers the strongest argument I can muster against even using borrower money to own stocks. There is simply no telling how far stocks can fall in short period. Even if your borrowings are small and your positions are not immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions."

Lesson #7: Intelligence

"The bet illuminated another important investment lesson: Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors need instead is an ability to both disregard mob fears or enthusiasm and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period - or even to look foolish - is also essential."

Lesson #8: Risk

"Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date.”Risk" is the possibility that this objective won't be attained."

Lesson #9: Shareholders

"We do not follow the common practice of talking one-on-one with large institutional investors or analysts, treating them instead as we all other shareholders. There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his or her savings. As I run the company day-to-day - and I write this letter - that is the shareholder whose image is in my mind."

Commentary: In 1921, an amendment to the U.S. Constitution seeked to end the legal distinctions between men and women. And Berkshire demonstrates how that amendment translates in a corporate setting. I refer to, of course, the Equal Rights Amendment.

Lesson #10: Attention

"After our purchase, however, some very strange things took place in the bond market. By November 2012, our bonds - now with about five years to go before they matured - were selling for 95.7% of their face value. At that price, their annual yield to maturity was less than 1%. Or, to be precise, 0.88%.
Given the pathetic return, our bonds had become a dumb - a really dumb - investment compared to American equities. Over time, the S&P 500 - which mirrors a huge cross-section of American business, appropriately weighted by market value - has earned far more than 10% annually on shareholders' equity (net worth).”
In November 2012, as we considering all this, the cash return from dividends ont he S&P 500 was 2.5% annually, about triple the yield on our U.S. Treasury bond. These dividend payment were almost certain to grow. Beyond that, huge sums were being retained by the companies comprising the 500. These businesses would use their retained earnings to expand their operations and, frequently, to repurchase their shares as well. Either course would, over time, substantially increase earnings-per share. And - as has been the case since 1776 - whatever its problems of the minute, the American economy was going to move forward.
Presented late in 2012 with the extraordinary valuation mismatch between bonds and equities, Protégé and I agreed to sell the bonds we had bought five years earlier and use the proceeds to buy 11,200 Berkshire "B" shares. The result: Girls Inc. of Omaha itself receiving $2,222,279 last month rather than the $1 million it had originally hoped for.

Commentary: Take care of the pennies and the pounds will take care of themselves said Lord Chesterfield in 1747.

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