Berkshire Hathaway’s annual shareholder letter is out and unlike that blue/black/white/gold dress (we really have no idea what color that dress is) meme, this letter is clearly in the color of packed insights and business lessons for all. We read all 42 pages of this 50th anniversary letter and boiled down the most important insights plus added analysis for your consideration. Any company that can produce an annual compounded return on market value of 21.6%, like Berkshire Hathaway has each year for the past 50 years has our full attention, so we were happy to do it. Many of these lessons from Messrs. Buffet and Munger are directly applicable to banking, particularly when it comes to M&A while the others are just solid business/finance/leadership points to keep in mind.
Below, please find our favorites:
Book value is a good proxy of value, but not ideal. Since stock price and intrinsic value always converge, market value is a better measure of wealth creation. To increase intrinsic value, Berkshire looks for the following: 1) Improve operating efficiencies at its companies; 2) Find “bolt on” acquisitions; 3) Look to increase top line revenue by expanding market share or the market; 4) Buy Berkshire shares when they are cheap and sell when they are dear; and, 5) Make an occasional whole acquisition when warranted.
A bolt on transaction where a well-priced business line can be added to an existing Berkshire company is preferred vs. a standalone company purchase. Berkshire did 31 bolt-on transactions last year, and they are looking for more in 2015. Acquirers gain by combining the bolt on acquisition with existing management while adding new products and customers to an existing distribution and customer base. A bolt-on acquisition is usually not only a good standalone investment, but makes your current investment more profitable. We always wonder why banks pay premiums for whole banks yet pass up revenue generating teams with assets that can come at book value.
On Driving Value through Risk
When it comes to taking on risk, banks, like Berkshire’s insurance arms, need to do five things successfully to make money in the long-term: 1) Understand all exposures that might cause a loss; 2) Accurately understand the probability of a loss occurring and the cost if it does; 3) Price the risk so that a profit can be made given the expected loss and operating expenses; and, 4) Walk away if that pricing cannot be obtained regardless of what your competition is doing. This seems simple enough, but how many bankers take on risk where they don’t fully grasp the probabilities of default or loss given default?
Berkshire’s Six Investment Criteria
Berkshire makes a plea to hear directly from principals, as opposed to investment bankers, for new acquisitions. Berkshire mandates the following six criteria: 1) $75mm of pre-tax earnings unless it is a bolt on transaction; 2) Demonstrated consistent earnings (no turnarounds or startups); 3) A track record of a superior return on equity with little or no debt; 4) Quality management; 5) Simple businesses; and, 6) A clear offering price (this needs to be stated upfront).
In addition, no unfriendly takeovers, no auctions, and, our favorite lesson from the letter - usually the transaction needs to be an all cash transaction.
This is probably the most important point in the whole letter, particularly for banks that regularly use their stock as currency for a bank purchase - Unless the principals can convince Berkshire that they have more intrinsic value in their stock than Berkshire has in theirs, Berkshire does not want to give away value and considers cash a cheaper currency to purchase an equity position.
If the entire above criteria are met, Berkshire can usually give an opinion as to their interest level “customarily within five minutes.”
Our second favorite lesson from the letter was this quote - “Don’t buy fair businesses at wonderful prices, but wonderful businesses at fair prices.”
“Banker’s focus will be describing “customary” premiums-to-market price that are currently being paid for acquisitions – an absolute asinine way to evaluate an attractiveness of an acquisition.”
Berkshire would rather “own a non-controlling, but substantive portion of a wonderful company than owning 100% of a so-so company.” Having the flexibility of being able to buy part or a controlling interest in a company “doubles the chances of finding uses for Berkshire’s endless gusher of cash.”
The Value of Float
Proper liquidity management helps drive value by leveraging Berkshire’s float. Similar to banks, being under-invested in loans and securities does not allow the firm to maximize customer profitability (since the float is derived from the customer). Yes, the low-interest rate environment has hurt, but this should improve.
The Heinz investment was a “no-brainer” - not only does the company have dominate market share and great cash flow, but management holds themselves to an extraordinary level and is never satisfied with just beating competition. When Berkshire talks about quality management, Heinz is a great example.
On Bank of America
Berkshire has yet to exercise 700mm options for Bank of America that expire in 2021. If you include these options, BofA is Berkshire’s 4th largest investment behind American Express, Coke and Devita. It fully plans on exercising these in the coming years and if it did today, the net gain would be $7.5B.
On Volatility and Risk
The “pedagogic assumption” that is taught at business schools that volatility and risk are the same is “dead wrong.” “Volatility is far from being synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”
This point is making us rethink our position as we have often equated the two. We can see his point if Buffet is talking about stock price volatility. However, we still believe that cash flow volatility is a pretty good indicator of risk. That said we plan on relooking at our current beliefs here.
“Who has ever benefited during the past 238 years from betting against America?” Investing in the fabric of the U.S. economy gives Berkshire “tailwinds” in which to then be able to focus on intrinsic value. Luckily, America’s “best days lie ahead.”
On Management & the Board
A CEO’s “first priority would be reservations of much time for quiet reading and thinking particularly that which might advance his determined learning no matter how old he becomes.”
"CEOs need to fight off the ABCs of business decay, which are arrogance, bureaucracy and complacency."
A Chairman “should not be subject to pressure from colleagues having a vested interest in maintaining the status quo. If horses had controlled investment decisions, there would be no auto industry.”
Berkshire directors carry no director and officer liability insurance. At Berkshire, directors walk in investors shoes.
Beware of purchase accounting – it often doesn’t come close to reflecting reality.
GEICO’s low relative cost structure and superior management allows it to keep increasing market share. This is a great lesson for banks that move for process savings.
The shareholder letter had 3 pages of “selling” as Buffet touted his products directly to businesses and consumers – how many banks miss the opportunity to talk up their wares instead of just the company?
Submitted by Chris Nichols on March 01, 2015