Thoughts After Reading Warren Buffett’s Annual Report Letter

The complete letter: http://www.berkshirehathaway.com/letters/2016ltr.pdf

• The letter opens with a chart showing the power of compound returns.

	Book Value	BRK.A Stock	S&P 500, Including Dividends
Compounded Annual Gain – 1965-2016	19.0%	20.8%	9.7%
Overall Gain - 1964-2016	884,319%	1,972,595%	12,717%

Note the difference between book value compounded at 19% versus 20.8% (stock appreciation). Over decades, a roughly 10% difference in annual rate of return results in overall returns well over two times as high.

Buffett seems to have decided early on that compounded returns are best achieved by investing long term in high quality companies, companies that themselves have the ability to compound earnings based on a competitive advantage or “moat.”

• The amount of capital that Berkshire Hathaway has to deploy:

As for Berkshire, our size precludes a brilliant result: Prospective returns fall as assets increase. Nonetheless, Berkshire’s collection of good businesses, along with the company’s impregnable financial strength and owner-oriented culture, should deliver decent results. We won’t be satisfied with less.

. . . almost the entire $15.5 billion we carry for goodwill in our insurance business was already on our books in 2000 when float was $28 billion. Yet we have subsequently increased our float by $64 billion, a gain that in no way is reflected in our book value.

(I think this means that Berkshire Hathaway’s insurance operations provide about $92 billion in investable assets).

Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!).

If the problem is that Berkshire Hathaway has so much money that results are penalized, the easiest solution might be to (1) stop borrowing money (about 26% of Berkshire Hathaway’s fixed capital is funded debt), and (2) exit the insurance business. I imagine he enjoys the challenge of the huge amounts of cash now at his disposal, enjoys being the Master of his chosen profession. And his investment strategy over the last several decades seems to include investing in low-volatility businesses and then levering the positions up.

However, he’s also said this:

Stay away from leverage. A long, long time ago a friend said to me about leverage, “If you’re smart you don’t need it. If you’re dumb you got no business using it.”
– Warren Buffett

There seems to be a contradiction there.

• The report contains an interesting review of the depreciation versus capital expenditure expense, including the write-off of goodwill in the insurance division.

On page 54 we itemize $15.4 billion of intangibles that are yet to be amortized by annual charges to earnings. (More intangibles to be amortized will be created as we make new acquisitions.)  . . . the 2016 amortization charge to GAAP earnings was $1.5 billion, up $384 million from 2015. My judgment is that about 20% of the 2016 charge is a “real” cost.

At BNSF, to get down to particulars, our GAAP depreciation charge last year was $2.1 billion. But were we to spend that sum and no more annually, our railroad would soon deteriorate and become less competitive. The reality is that – simply to hold our own – we need to spend far more than the cost we show for depreciation. Moreover, a wide disparity will prevail for decades.

All that said, Charlie and I love our railroad, which was one of our better purchases.

The insurance business does better than it appears and the railroad worse in terms of actual earnings. The relationship between depreciation and maintenance capital expenditures is a key consideration in the analysis of the quality of a business. It is interesting that Buffett likes the railroad business, which appears to have little or no competitive advantage or moat, and low-quality earnings.