Warren Buffett’s Letters to Shareholders

In an American economy where most fund managers have struggled to beat the index, Warren Buffett has been something of an incredible exception. Consider these statistics! Over the last 52 years since Buffet’s company, Berkshire Hathaway started investing in equities it has given an annualized return of 21% compounded. What is more interesting is that in the last 52 years, the company has actually given negative returns only in 10 years. The Berkshire Hathaway annual letter to shareholders has become something like a Bible for investors and corporates alike. The latest annual letter to shareholders for the year 2016 has the quintessential Buffett touch to it. Here are some of the key insights for investors and corporates in India alike. Over to a dose of Buffettology!

 

Focus more on normalized earnings growth of the business…

 

Over the last 10 years, Indian corporates have been overtly focused on quarterly earnings and forward-looking guidance. Investors of the calibre of Buffett and Munger have rightly pointed out that trying to give guidance in an uncertain world is both needless and a diversion from the core role of the custodians of wealth. According to Buffet, the focus should be solely in ensuring that the normalized earnings of the company over a period of time are on a growth path, notwithstanding the vagaries of quarterly spurts and setbacks. Today, there is a big debate in India about the need to pay out special dividends in case of companies with large cash piles. Berkshire Hathaway has had among the highest proportion of dollar earnings retained in the business. After all, as Buffett himself puts it, “When you can give a great compounded return to shareholders, why not put all the money back into the business”.

 

When to buy back shares and when not to buy back shares…

 

This, once again, is a debate that is extremely relevant to Indian companies in the current context. Buffett makes a very important point with respect to buy back of shares. His insight is that any buyback of shares must be more beneficial to the continuing shareholders than to the outgoing shareholders. That means, any company planning a buyback, must do it at a price that is lower than the intrinsic value of the business. This is a very simple yet profound argument. Remember, that intrinsic value of the share is distinct from the market value of the share, although Buffett holds that in the long run they tend to converge. For example, if the intrinsic value of a share is Rs.500/share, and if the buyback is done at Rs.550/- then the outgoing shareholders will benefit at the cost of the continuing shareholders. This is an important insight for Indian companies while planning buybacks. To encourage shareholders to take a long term view, buybacks must be done at below intrinsic value.

 

Why we all should love the upfront inflow business…

 

This is a classic dilemma that most businesses in India face. You have a great business model but then the liquidity terms are simply unfavourable to you. Your inflows are back-ended and your outflows are front-ended. That is a classic case for a liquidity mismatch that has been responsible for the demise of many businesses. Buffett gives the example of the property & casualty insurance business, which has been the core focus of Berkshire Hathaway. In this business, premiums are collected upfront but liabilities arise either at a later date or get stretched over decades. According to Buffet, this “Collect Now; Pay Later” model gives any business the much needed float not only to sustain the business but also to grow the business organically. Consider the case of Berkshire Hathaway. Their business float has grown from $1.6 billion in 1990 to $91.6 billion in 2016.

 

Need for more meaningful management commentary…

 

This is once again a very important point that Warren Buffett makes. As an investor, Buffett focuses on companies that show a greater degree of transparency and make a clean breast of the hidden risks and costs of the business. Company managements tend to underplay the full costs of a restructuring with the result that there are negative surprises down the line. As Buffett puts it very succinctly, “Managements that tend to hide behind adjusted earnings tend to make me nervous”. This is a critical insight for many Indian companies. In many cases, sudden earnings surprises are an outcome of opaque reporting and underplaying the implicit risks in the business. A little more honesty in your annual reports may make your financials less attractive but it will surely make it more real.

 

Accounting for stock-based compensation…

 

This has once again been a grey area in accounting for a very long time. Today it is quite common for large and small companies to compensate their top managements via stock. This could be either in the form of stock options or in the form of warrants. The reason Buffett has a problem with this form of compensation is that its true liability is not accounted for in the books of accounts. According to Buffet, like cash compensation; stock compensation is also a liability for the company in question and hence needs to be accounted for. It has already been documented that stock compensation has two major shortcomings. Firstly, it forces companies to be opaque about the actual costs by hoping that these stock compensations will pay for themselves. Secondly, it forces executives to take inordinate risks on behalf of the company. That is a huge misalignment.

 

Passive management of funds versus Active management of funds…

 

Finally, the most surprising revelation from the annual report has come with respect to passive investing. Despite being one of the world’s most successful active investors, Buffett has identified John Bogle as the man who contributed most to investor wealth. John Bogle, incidentally, is the founder of Vanguard which introduced the concept of index investing to the world. According to Buffet, Bogle and Vanguard have saved small investors billions of dollars in management fees by making them invest in index funds. The insight for investors is that be very conscious of the costs that you bear as an investors. When you are trying to create wealth over the long term, these fund management costs add up to quite a bit. In fact Buffett has wagered ½ a million dollars that nobody can select 5 hedge funds that will beat the index funds over the next 10 years. Till now, Buffett has been bang on target!

 

Like his previous annual letters to shareholders of Berkshire Hathaway, the 2016 letter to shareholders also contains a wealth of investment and corporate insights. Through these annual letters, the legend of Warren Buffett lives on!