This is the thirty-fifth 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 2011 letter weighs in at 13,480 words, an 8% decrease from 14,660 words the prior year. Berkshire's increase in net worth during the year was 4.6% of beginning 2011 net worth.
STOCK MARKET CAGE MATCH: BUFFETT'S TWO MAJOR 2011 INVESTMENTS VERSUS THE S&P 500
Buffett mentions that Berkshire made two large investments in public companies in 2011, namely Bank of America and IBM, which he describes as follows:
Finally, we made two major investments in marketable securities: (1) a $5 billion 6% preferred stock of Bank of America that came with warrants allowing us to buy 700 million common shares at $7.14 per share any time before September 2, 2021; and (2) 63.9 million shares of IBM that cost us $10.9 billion. Counting IBM, we now have large ownership interests in four exceptional companies: 13.0% of American Express, 8.8% of Coca-Cola, 5.5% of IBM and 7.6% of Wells Fargo. (We also, of course, have many smaller, but important, positions.)
Six years later, with the benefit of hindsight we can assign a grade to these investments of "C". The Bank of America investment was clearly a grand-slam home run. The preferred securities have paid Berkshire nearly $2 billion in dividends, while the warrants are now $17/share in the money, or $11.9 billion in aggregate. Together, Berkshire has racked up $13.7 billion in pre-tax gains on just a $5 billion investment in BAC, representing an outstanding CAGR of 24.6%. Below is a chart of BAC with the date of Buffett's investment highlighted:
The IBM investment, however, has basically been a dud. 63.9 million shares at a cost basis $10.9 billion equates to $170/share. Today these same shares can be bought for $154/share, or about 10% lower than Buffett was buying in 2011. Granted, during the 6 years since Buffett's purchase Berkshire would also have received about $26/share in dividends, or about $17/share after taxes, thus bringing the investment basically back to breakeven. Below is a chart of IBM with the date of Buffett's investment highlighted:
Combined, the dual BAC and IBM investments in 2011 have generated approximately $13.7 billion in pre-tax gains versus a total basis of $15.9 billion, representing an aggregate 86% gain and a CAGR of 10.9%. In comparison, if Buffett had simply invested the $15.9 billion in the Vanguard 500 Index fund during May, June, July and August of 2011 (approximately when the BAC and IBM investments occurred), Berkshire would actually have come out better by about 2% per year. The VFINX has appreciated from 121.3 to 226.2 during the applicable timeframe, an aggregate gain of 86% (precisely the same as the BAC/IBM combined aggregate gain (including dividends)); however, a VFINX holder would also have received a dividend yielding around 2% annually during the period. Thus, the total return for the VFINX holder would have been about 13% versus Buffett's 11% for BAC/IBM. Below is a chart of the VFINX with the relevant measurement date highlighted:
As Buffett is prone to state, beating the indexes is hardly an easy job. The above analysis illustrates this point. Moreover, it illustrates how crucial stock selection and concentration of investments can be, as well as the general superiority of buying hated stocks versus loved stocks. Buffett's $11 billion investment in IBM yielded basically nothing over 6 years, whereas an investment less than half that size in BAC has yielded a bonanza of riches for Berkshire. In this case, Buffett obviously would have been much better off simply plowing as much capital as possible into BAC at 2011's depressed prices than putting anything into IBM stock, which at the time had appreciated substantially since the depths of the financial crisis (when it traded as low as the ~$80/share level). Of course, Buffett likely had to contend with financial regulatory rules regarding maximum allowable bank holding company stakes, etc., so perhaps he put the maximum permissible amount into BAC that he could.
Ironically, later in the 2011 letter Buffett uses IBM as a potential case study in share buybacks (aka financial engineering). His basic argument is that, all other things being equal, he would prefer that a company's shares remain stagnant after his purchase thereof so the company can repurchase the maximum amount of shares via its buyback program, thereby increasing Berkshire's ownership interest in the company:
Let’s use IBM as an example. As all business observers know, CEOs Lou Gerstner and Sam Palmisano did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their operational accomplishments were truly extraordinary.
But their financial management was equally brilliant, particularly in recent years as the company’s financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.
Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?
I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.
Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.
If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $11⁄2 billion more than if the “high-price” repurchase scenario had taken place.
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
Well, Buffett certainly got his wish on the "stagnant share price" part of the equation. Unfortunately, the financial alchemy of share buybacks only works if the shares are repurchased at below intrinsic value (in which case they increase the wealth of the remaining shareholders at the expense of the exiting shareholders); when the reverse is true (i.e., when shares are repurchased at a price above their intrinsic value), the exiting shareholders benefit financially at the expense of the remaining shareholders. Below is select financial information for IBM for the 2012-2016 period (the five calendar years after Buffett purchased the IBM stake); you be the judge as to whether IBM was repurchasing shares at levels above or below intrinsic value during this period (note that in Buffett's hypothetical 5-year example above he assumed that IBM would earn $20 billion in the fifth year out, which would equate to 2016 below; actual 2016 income from continuing operations was just $12 billion, down from $17 billion in 2012, which decline happened in the context of a steadily growing economy) (source - IBM 2016 Annual Report, page 155):
In stark contrast, set forth below is BAC's select financial information for the 2012-2016 period, in which we can see that net income rose from just under $4 billion in 2012 to nearly $18 billion last year (source - BAC 2016 10-K, page 26):
The moral of the story? (1) Share buybacks can be beneficial, but are no panacea (if earnings relentlessly shrink, buybacks may stem the rate of share price decline, but won't stop it); and (2) Earnings growth (or decline) is by far the more important determinant of future stock appreciation (or depreciation).
BUFFETT'S PERSISTENCE: ENERGY FUTURE HOLDINGS
In the 2011 letter, Buffett describes one of his investing "unforced errors", specifically the bonds of Energy Future Holdings (EFH):
A few years back, I spent about $2 billion buying several bond issues of Energy Future Holdings, an electric utility operation serving portions of Texas. That was a mistake – a big mistake. In large measure, the company’s prospects were tied to the price of natural gas, which tanked shortly after our purchase and remains depressed. Though we have annually received interest payments of about $102 million since our purchase, the company’s ability to pay will soon be exhausted unless gas prices rise substantially. We wrote down our investment by $1 billion in 2010 and by an additional $390 million last year.
At yearend, we carried the bonds at their market value of $878 million. If gas prices remain at present levels, we will likely face a further loss, perhaps in an amount that will virtually wipe out our current carrying value. Conversely, a substantial increase in gas prices might allow us to recoup some, or even all, of our write-down. However things turn out, I totally miscalculated the gain/loss probabilities when I purchased the bonds. In tennis parlance, this was a major unforced error by your chairman.
Berkshire eventually had to book a nearly $900 million loss on this particular bond investment. However, Buffett is nothing if not persistent, as Berkshire just a week ago announced it had put in a takeover offer for EFH at $9 billion and is now embroiled in a battle with Paul Singer's hedge fund Elliott Management over the company, which owns the largest utility in Texas:
There's a saying in the investment world that "You don't have to make it back the same way you lost it"--at least in the case of Energy Future Holdings, Buffetts seems to disagree.
IS BERKSHIRE TOO DIVERSE TO OUTPERFORM?
One thing that Buffett mentions in the 2011 letter leads to the following question: Are Berkshire's operations simply too diverse these days to outperform the broader market? First the quote:
The steady and substantial comeback in the U.S. economy since mid-2009 is clear from the earnings shown at the front of this section. This compilation includes 54 of our companies. But one of these, Marmon, is itself the owner of 140 operations in eleven distinct business sectors. In short, when you look at Berkshire, you are looking across corporate America.
With 54 separate operating companies (including one which itself is composed over over 100 operations), it's hard to see how the Berkshire behemoth has any definable "edge" over the broader S&P 500 index any longer. It's true that Buffett has carefully collected these operations over the decades, much in the way that a museum curator carefully selects paintings for an exhibition, and has also infused Berkshire with a certain ethos of frugality, ethics, etc. However, with a $420 billion market cap today, it's simply hard envision the conglomerate significantly outperforming domestic businesses in general going forward. If one assumes a total shareholder return of 6% per year over the next decade in the broader market, Berkshire's market cap will need to increase to $750 billion just to maintain pace; if we ratchet this up to 7.5%, then Berkshire's market cap would need to increase to $875 billion, or more than double today's capitalization. Meanwhile, Buffett is turning 87 at the end of next month--he'd better eat his...
INVESTING: SUMMARIZED IN 1900 WORDS
Buffett concludes the 2011 letter with a short essay on what investing actually is and the three types of investments one can choose from. We simply copy and paste this mini-essay below, as it requires no additional commentary from us:
The Basic Choices for Investors and the One We Strongly Prefer
Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.
From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.
Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.
• [The first major category of involves] investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments [including cash]. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.
Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.
Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”
For tax-paying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.
High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments – and indeed, rates in the early 1980s did that job nicely. Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label.
Under today’s conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety. At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be. Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.
Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain – either because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or because rates rise to a level that offers the possibility of realizing substantial capital gains on high-grade bonds when rates fall. Though we’ve exploited both opportunities in the past – and may do so again – we are now 180 degrees removed from such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”
• The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.
This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.
The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.
Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.
• Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.
My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test. Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.
Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.
Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.
One post-script: Any gold bugs out there will enjoy David Einhorn's rejoinder regarding category 2 above:
The debate around currencies, cash, and cash equivalents continues. Over the last few years, we have come to doubt whether cash will serve as a good store of value. If you wrapped up all the $100 bills in circulation, it would form a cube about 74 feet per side. If you stacked the money seven feet high, you could store it in a warehouse roughly the size of a football field. The value of all that cash would be about a trillion dollars. In a hundred years, that money will have produced nothing. In a thousand years, it is likely that the cash will either be worthless or worth very little. It will not pay you interest or dividends and it won’t grow earnings, though you could burn it for heat. You’d have to pay someone to guard it. You could fondle the money. Alternatively, you could take every US note in circulation, lay them end to end, and cover the entire 116 square miles of Omaha, Nebraska. Of course, if you managed to assemble all that money into your own private stash, the Federal Reserve could simply order more to be printed for the rest of us.
For the record, in 2011 Berkshire's stock declined 4.7%, trailing the S&P 500 by 7%, the Cardinals beat the Rangers 4-3 in the World Series and the Giants beat the Patriots 21-17 in Super Bowl XLVI. Next up, 2012, year 阴金兔年 in the Tibetan calendar (go on, check for yourself if you don't believe us).