This is the thirty-fourth in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2016. For all of the prior shareholder letters, see here.
The 2010 letter weighs in at 14,660 words, a 34% increase from 10,930 words the prior year (apparently Buffett was a bit depressed in 2009 from the overhang of the financial crisis). Berkshire's increase in net worth during the year was 13% of beginning 2010 net worth.
BURLINGTON NORTHERN PREDICTION
Berkshire acquired the Burlington Northern railroad in 2010 for approximately $34 billion (consisting of $22 billion of cash plus $12 billion worth of Berkshire stock). Buffett made a prediction in the 2010 shareholder letter that owning Burlington Northern would "increase Berkshire’s 'normal' earning power by nearly 40% pre-tax and by well over 30% after-tax". With the benefit of hindsight, we can now check the accuracy of Buffett's prediction. First we need to determine what "normal" earning power meant in 2010. Buffett stated that he could "estimate that the normal earning power of the assets we currently own [i.e., including Burlington] is about $17 billion pre-tax and $12 billion after-tax, excluding any capital gains or losses". Thus, we can triangulate that at the time Buffett estimated that Burlington would increase Berkshire's after-tax income by about $2.8 billion (in other words, Burlington's contribution of $2.8 billion would equal approximately 30% of the remainder of Berkshire's $9.2 billion in after-tax earnings, and together they would total $12 billion).
Fast forward to the 2016 10-K filing and we find that Burlington Northern contributed $3.6 billion in net income to Berkshire in 2016. The railroad also contributed net income of $4.2 billion in 2015 and $3.9 billion in 2014. Thus it appears that Buffett was fairly conservative in his prediction about Burlington in the 2010 letter, as actual results have trended well above the $2.8 billion mark over the past three years (granted, there has been considerable economic growth in the U.S. since 2010, so this should explain much of the difference). Given that Berkshire's stock has appreciated from approximately $100,000 per A share at the time the Burlington acquisition was announced to around $254,000 per A share currently, the effective purchase price for Burlington has increased from $34 billion in 2010 to $52.5 billion today, meaning that Berkshire earned back about 6.8% of its adjusted purchase price for Burlington in 2016 ($3.6 / $52.5). Good, but not phenomenal.
Below is a summary of Burlington Northern's financial performance for the past three years, taken from the 2016 10-K:
DOES BERKSHIRE REALLY "PREY ON THE POOR"; OR "IS DEBT EVIL"?
Buffett includes the following discussion in the 2010 shareholder letter of Berkshire subsidiary Clayton Homes, a seller/financer of mobile homes:
Clayton owns 200,804 mortgages that it originated. (It also has some mortgage portfolios that it purchased.) At the origination of these contracts, the average FICO score of our borrowers was 648, and 47% were 640 or below. Your banker will tell you that people with such scores are generally regarded as questionable credits.
Nevertheless, our portfolio has performed well during conditions of stress. Here’s our loss experience during the last five years for originated loans:
Year Net Losses (as a Percentage of Average Loans)
2006 .............................. 1.53%
2007 .............................. 1.27%
2008 .............................. 1.17%
2009 .............................. 1.86%
2010 .............................. 1.72%
Our borrowers get in trouble when they lose their jobs, have health problems, get divorced, etc. The recession has hit them hard. But they want to stay in their homes, and generally they borrowed sensible amounts in relation to their income. In addition, we were keeping the originated mortgages for our own account, which means we were not securitizing or otherwise reselling them. If we were stupid in our lending, we were going to pay the price. That concentrates the mind.
If home buyers throughout the country had behaved like our buyers, America would not have had the crisis that it did. Our approach was simply to get a meaningful down-payment and gear fixed monthly payments to a sensible percentage of income. This policy kept Clayton solvent and also kept buyers in their homes.
Home ownership makes sense for most Americans, particularly at today’s lower prices and bargain interest rates. All things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks. (The two best investments were wedding rings.) For the $31,500 I paid for our house, my family and I gained 52 years of terrific memories with more to come.
But a house can be a nightmare if the buyer’s eyes are bigger than his wallet and if a lender – often protected by a government guarantee – facilitates his fantasy. Our country’s social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford.
What's interesting about this discussion is that Clayton is presented as the model of moral and financial probity, only putting its customers (mainly subprime borrowers) into homes they can afford. A far different picture of Clayton was painted by the Seattle Times, however, which in a series of articles in 2015 and 2016 about the company claimed that Clayton preys on poor minorities. One article in the series stated the following:
The company [i.e., Clayton] is controlled by Warren Buffett, one of the world’s richest men, but its methods hardly match Buffett’s honest, folksy image: Clayton systematically pursues unwitting minority homebuyers and baits them into costly subprime loans, many of which are doomed to fail, an investigation by The Seattle Times and BuzzFeed News has found.
Clayton’s predatory practices have damaged minority communities — from rural black enclaves in the Louisiana Delta, across Spanish-speaking swaths of Texas, to Native American reservations in the Southwest. Many customers end up losing their homes, thousands of dollars in down payments, or even land they’d owned outright.
Buffett disputed some of the Seattle Times' allegations [his response can be found here], however it's worth reflecting on the fact that a person normally does not become worth eleven figures by being a patsy.
This also brings to mind a recent investment made by Berkshire in troubled Canadian subprime mortgage lender Home Capital Group, described in news reports as follows:
Home Capital Group Inc said billionaire Warren Buffett's Berkshire Hathaway Inc will provide a new C$2 billion ($1.50 billion) line of credit to its unit Home Trust Co, ending the Canadian lender's strategic review process. Berkshire will also indirectly buy C$400 million of Home Capital's common shares in a private placement through its unit Columbia Insurance Co, Home Capital said on Wednesday.
"Home Capital's strong assets, its ability to originate and underwrite well-performing mortgages, and its leading position in a growing market sector make this a very attractive investment," said Warren Buffett, Berkshire chairman and CEO.Berkshire will hold an about 38.39 percent equity stake in Home Capital after buying 40 million shares at an average price of about C$10.00 per common share.
Berkshire will make an initial investment of C$153.2 million to buy 16 million common shares and an additional investment of C$246.8 million to purchase 24 million shares through a private placement. The additional investment is subject to shareholder approval, while the initial investment will not require approval from shareholders. Canada's biggest non-bank lender also said it will continue to explore further asset sales and financing deals over the next year, but has concluded its strategic review process that began in April.
"This investment from Berkshire not only addresses Home Capital's near-term requirements for additional liquidity and a lower-cost credit agreement, but also facilitates what the Board feels is the best available path to long-term success," Home Capital's Chair Brenda Eprile said.
Berkshire will not be granted any rights to nominate directors to Home Capital board or any governance rights as an equity holder, Home Capital said.
The C$2 billion loan facility, expected to be effective on June 29, will replace the existing one for a similar amount between Home Trust Company and a major institutional investor.
On Tuesday, the company said it would sell a portfolio of commercial mortgage assets valued at C$1.2 billion to bolster its liquidity and trim outstanding debt on a C$2 billion emergency facility it agreed with the Healthcare of Ontario Pension Plan in April.
Last week, Home Capital reached a C$30.5 million settlement with the Ontario Securities Commission, settled a class action lawsuit and accepted responsibility for misleading investors about problems with its mortgage underwriting procedures. The settlement is expected to help secure long-term financing at sustainable interest rates, investors and analysts said.
Interestingly, after extolling Clayton Homes' lending practices in the 2010 letter, Buffett devotes a separate section of the letter to expounding on the perils of debt, as follows:
Life and Debt
The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire.
Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.
Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.
On the one hand, Buffett says that Clayton's loans to its subprime borrowers are OK because these people "borrowed sensible amounts in relation to their income". On the other hand Buffett says that leverage is extremely dangerous because it's so addictive and can easily lead to personal or professional bankruptcy. So, is debt generally bad or good? Does Berkshire facilitate a "cycle of poverty" via its investments in companies like Clayton and Home Capital, trapping unwitting low income borrowers in financial commitments they can't possibly live up to? Or is Berkshire simply facilitating the responsible provision of capital to low-income consumers so they can purchase residences of their own (with the side benefit of simultaneously building up an equity stake therein, a form of forced savings), thereby escaping the treadmill of perpetual renting? The answer, my friend, is blowin' in the wind.
For the record, in 2010 Berkshire's stock appreciated 21%, beating the S&P 500 by 6%, the Giants beat the Rangers 4-1 in the World Series and the Packers beat the Steelers 31-25 in Super Bowl XLV. Next up, 2011, the International Year of Forests, as declared by the United Nations (no, not a joke).