Warren Buffett is a name any investor will recognize. He ranks high in the list of investing gurus. I am sharing what I liked most in Warren Buffett’s annual letter for 2012. His letters to shareholders make for great investing reading. There’s a lot to learn from what he has written over the years.
What is so great about Warren Buffett?
Image source: Mark Hirschey
How about a 19.7% compounded annual returns in book value of Berkshire Hathaway Inc. from 1965 to 2012? Berkshire Hathaway is the investment vehicle which holds stakes in multiple businesses that they have bought over many years. Many of the businesses have been also held for many years. Long-term!
Warren Buffett Annual Letter 2012 take-aways
His letters are usually easy to read and witty. The 2012 letter is no exception.
Share price will eventually reflect increasing book value
It’s our job to increase intrinsic business value – for which we use book value as a significantly understated proxy – at a faster rate than the market gains of the S&P. If we do so, Berkshire’s share price, though unpredictable from year to year, will itself outpace the S&P over time. If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund.
Earnings growth is good but it should be matched by earnings per share growth, else it is useless. For all that you read in the financial news papers and TV channels about increasing profit after tax or net profit, start looking deeper. Focus on per share figures. If a company is growing the business by constantly raising equity and increasing number of shares, it dilutes the earnings. Growth at the cost of excess dilution is not good for investors in a company.
Consequently, the $9.7 billion gain in annual earnings delivered Berkshire by the five companies (he is talking of BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy) has been accompanied by only minor dilution. That satisfies our goal of not simply growing, but rather increasing per-share results.
This is one point that always puzzles me. In boom years, fund-raising announcements of companies were matched by immediate jumps in share prices. Many do not pause to consider whether the growth in absolute earnings is worth it, if is at the cost of dilution. A drop in earning per share (EPS) every few years because of dilution is usually not positive for investors.
Looking beyond the immediate troubles
A thought for my fellow CEOs: Of course, the immediate future is uncertain; America has faced the unknown since 1776. It’s just that sometimes people focus on the myriad of uncertainties that always exist while at other times they ignore them (usually because the recent past has been uneventful).
This needs no explanation. You can extend this to your investment decisions also. In the credit crisis of 2008-09 many good stocks were battered down. There were rich pickings to be made. Few did so. Many came in to the market later.
Floats – using others money for free
Property-casualty (“P/C”) insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over decades. This collect now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit.
I had shared Sanjay Bakshi’s presentation on floats and moats earlier.
The same principle can be applied to your investing analysis. Any company that enjoys healthy terms on working capital usually is a better choice than companies which are squeezed by customers and suppliers. This is because you get to use cash that belongs to others for your business. To that extent the business is financed by external money. The clincher here is that at no cost to the company.
Such companies usually have healthy operating cash flows.
If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That’s like your taking out a loan and having the bank pay you interest.
Moats that protect a business
At MidAmerican, meanwhile, two key factors ensure its ability to service debt under all circumstances: the company’s recession-resistant earnings, which result from our exclusively offering an essential service, and its great diversity of earnings streams, which shield it from being seriously harmed by any single regulatory body.
Warren Buffett talks of “essential service” and “diversity of earnings”. MidAmerican is an energy company that caters to markets in Midwest America.
You too should look for companies that are in a sweet spot. Search for companies that have products or services which are indispensable and cannot be harmed too much by competition or regulation.
Over-paying for a good company
Of course, a business with terrific economics can be a bad investment if the price paid is excessive.
One may be tempted to buy a great company at an excessively high valuation. The case of Infosys is a prime example. Infosys was trading at crazy valuations during the dotcom boom of 2000. People who got in during that period were underwater for a long time.
It is wise to look at current valuation ratios with respect to past valuation ratios for the same company. You can have a look at a video tutorial that I have created on How to calculate historical price to earnings ratios.
To give a dividend or not to give a dividend
A number of Berkshire shareholders – including some of my good friends – would like Berkshire to pay a cash dividend. It puzzles them that we relish the dividends we receive from most of the stocks that Berkshire owns, but pay out nothing ourselves.
Extra cash that is lying with the company rightfully belongs to shareholders. But is it better to pay a dividend to shareholders or rather invest it productively in the existing business?
Berkshire Hathaway has investments in various companies. So the question for Berkshire is whether to return cash to shareholders through the dividend route or retain it with itself.
And if it keeps it what should it do with the cash? Warren Buffett explains this lucidly.
… our first priority with available funds will always be to examine whether they can be intelligently deployed in our various businesses.
If there is any cash left,
Our next step, therefore, is to search for acquisitions unrelated to our current businesses. Here our test is simple: Do Charlie and I think we can effect a transaction that is likely to leave our shareholders wealthier on a per-share basis than they were prior to the acquisition?
If there is still more cash left after acquisitions,
The third use of funds – repurchases – is sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the surest way to use funds intelligently: It’s hard to go wrong when you’re buying dollar bills for 80¢ or less.
Here, Warren Buffett talks of repurchases as they are referred to in America or buybacks as they are called in India.
This is crystal clear thinking for which Buffett is famous for. This is what a responsible company should do. Consider this when you invest in a company.
- Does the company continue to operate businesses which do not provide adequate returns on equity to shareholders?
- Does the company squander money on careless acquisitions?
- If there is excess cash on the company’s balance sheet, what is it doing with cash exactly?
Warren Buffett Annual Letter 2012
You can also download Warren Buffet Annual Letter 2012.