This is the thirty-sixth 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 2012 letter weighs in at 13,580 words, a 0.7% increase from 13,480 words the prior year. Berkshire's $23 billion increase in net worth during the year was 14.4% of beginning 2012 net worth.
2012 was notable for Berkshire for Buffett's large investment in Heinz, a deal he orchestrated with 3G Capital. Buffett describes the deal as follows:
In February, we agreed to buy 50% of a holding company that will own all of H. J. Heinz. The other half will be owned by a small group of investors led by [3G Capital's] Jorge Paulo Lemann, a renowned Brazilian businessman and philanthropist.
We couldn’t be in better company. Jorge Paulo is a long-time friend of mine and an extraordinary manager. His group and Berkshire will each contribute about $4 billion for common equity in the holding company. Berkshire will also invest $8 billion in preferred shares that pay a 9% dividend. The preferred has two other features that materially increase its value: at some point it will be redeemed at a significant premium price and the preferred also comes with warrants permitting us to buy 5% of the holding company’s common stock for a nominal sum.
Berkshire subsequently invested an additional $5.2 billion in the company (source), for a total investment in the common stock equal to about $9.5 billion. It should be noted that, in addition to receiving 9% dividends on the preferred shares up until their redemption in 2016, Berkshire now owns 325.6 million shares of Kraft Heinz (ticker KHC), which have a market value of approximately $28 billion (or a 3X return in under 5 years, representing a 24% CAGR). Berkshire also receives $780 million in annual common dividends on its KHC shares--an amount that can purchase a serious number of 9-gram ketchup packets in a year (28,888,888,888 to be exact)!
RBS "SELL EVERYTHING (NOW)!!!!!" VERSUS BUFFETT "WHAT, ME WORRY?"
Back in January 2016, when China's economy appeared to be weakening and the price of oil was plummeting, a market analyst at RBS named Andrew Roberts generated massive worldwide (at least, in financial circles) headlines with his breathless exhortation to just "Sell Everything!", since according to him the sky was literally falling. Below is a sample of the news coverage of this call:
It is interesting to compare this to Buffett's message in the 2012 shareholder letter, which basically boils down to "Don't worry, be happy". Buffett states that attempting to time the markets (a la RBS) is a fool's game:
American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don’t forget that shareholders received substantial dividends throughout the century as well.)
Since the basic game is so favorable, Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.
Indeed, while periodically being significantly or totally "in cash" is considered a safe or conservative investment style by most, Buffett has the opposite message, saying that what is actually risky is being out of equities, because of the opportunity cost (anyone who has sat out of the market over the past 8 years has probably felt this intensely). This is because with equities the game is highly stacked in the investor's favor (equities are virtually certain to appreciate over time), whereas with cash the opposite is true (cash is virtually certain to depreciate over time). What matters, of course, is one's purchasing power--either it is going up or going down, and one should concentrate one's investments in assets likely to increase it over time.
No doubt the folks over at RBS will return with their doom-and-gloom prognostications the next time the future appears particularly ominous. The term "foolish consistency" springs to mind...
DID BUFFETT FALL FOR NON-GAAP NONSENSE FROM IBM?
In many of our prior blog posts on the Berkshire shareholder letters, we have noted Buffett's manifold criticisms of the games that management teams play with their GAAP financial numbers in order to make them look more palatable to investors (as Buffett has stated previously, "A CEO whose focus is centered on Wall Street [and 'making the numbers'] will be tempted to make up the numbers"). In light of these prior criticisms, it is interesting that in the 2012 letter he seems to forgive IBM for excluding certain charges from its GAAP earnings in order to arrive at its so-called "adjusted operating earnings". Here is Buffett's comment:
“Non-real” amortization expense also looms large at some of our major investees. IBM has made many small acquisitions in recent years and now regularly reports “adjusted operating earnings,” a non-GAAP figure that excludes certain purchase-accounting adjustments. Analysts focus on this number, as they should.
Basically Buffett is saying that these charges simply aren't "real" expenses for IBM, which is convenient if one wants to justify a higher valuation for the company (based upon a multiple of "adjusted", rather than GAAP, earnings). Color us skeptical. In its Q4 2012 earnings press release, IBM announced that 2013 operating income was expected to come in at least $15.53 on a GAAP basis, but at least $16.70 on a non-GAAP "adjusted" basis (or 7.5% higher on a non-GAAP basis). IBM helpfully explained that "[t]he 2013 operating (non-GAAP) earnings exclude $1.17 per share of charges for amortization of purchased intangible assets, other acquisition-related charges, and retirement-related items driven by changes to plan assets and liabilities primarily related to market performance." So, despite Buffett's earlier statement, IBM was excluding more than just amortization expense, it was also excluding acquisition- and retirement-related charges.
The problem with "adjusted" earnings is that there are no firm rules governing what expenses are acceptable to exclude; rather, it is up to management's judgment. Management, however, is often subject to internal and external pressure to "get the stock price up" (in order to appease existing shareholders, receive higher compensation, use stock as an acquisition currency, etc.)--and what better way to artificially levitate the stock price than through the alchemy of "adjusted" earnings? After all, if a stock trades at a 20 P/E multiple, every dollar management can "adjust" earnings higher through legitimate or illegitimate add-backs tacks on $20 per share to the share price. Just like magic...
It's uncertain whether Buffett's willing excuse of IBM's earnings legerdemain was a sign that the investment was unsound at the time made (note that Buffett also effusively praised the company's "financial management" skills in the 2011 letter). However, in retrospect these very talents may have been a sign to be wary, rather than eager, to buy IBM stock. Speaking of which, IBM just a few days ago delivered another dud of an earnings report, with its stock dropping 4% (and now down 11% on the year, underperforming the S&P 500 by over 20%):
DISSERTATION ON DIVIDENDS
Buffett includes an interesting (at least, to us) discussion of dividends in the 2012 letter, the gist of which is follows:
(1) Cash generated from operations should first be reinvested in the business (in order to "widen the moat"); only then should remaining funds be paid out as dividends (or, alternatively, used to repurchase shares or to make acquisitions); and
(2) An investor owning stock in a company that retains all of its earnings can "create their own dividend" by simply selling off a percentage of their holdings every year (i.e., if they want a 5% "dividend", just sell off 5 out of every 100 shares owned on an annual basis). This approach is actually more tax efficient than if the company paid out a 5% dividend (since the investor will only pay taxes on the amount of the capital gain with respect to the shares sold, whereas with dividends the entire amount distributed is taxed).
Buffett's discussion of the topic is as follows:
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. So let’s examine when dividends do and don’t make sense for shareholders.
A profitable company can allocate its earnings in various ways (which are not mutually exclusive). A company’s management should first examine reinvestment possibilities offered by its current business – projects to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors....
Even after we deploy hefty amounts of capital in our current operations, Berkshire will regularly generate a lot of additional cash. Our [second] 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? I have made plenty of mistakes in acquisitions and will make more. Overall, however, our record is satisfactory, which means that our shareholders are far wealthier today than they would be if the funds we used for acquisitions had instead been devoted to share repurchases or dividends.
But, to use the standard disclaimer, past performance is no guarantee of future results. That’s particularly true at Berkshire: Because of our present size, making acquisitions that are both meaningful and sensible is now more difficult than it has been during most of our years....
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... But never forget: In repurchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value....
And [fourth] that brings us to dividends. Here we have to make a few assumptions and use some math. The numbers will require careful reading, but they are essential to understanding the case for and against dividends. So bear with me.
We’ll start by assuming that you and I are the equal owners of a business with $2 million of net worth. The business earns 12% on tangible net worth – $240,000 – and can reasonably expect to earn the same 12% on reinvested earnings. Furthermore, there are outsiders who always wish to buy into our business at 125% of net worth. Therefore, the value of what we each own is now $1.25 million.
You would like to have the two of us shareholders receive one-third of our company’s annual earnings and have two-thirds be reinvested. That plan, you feel, will nicely balance your needs for both current income and capital growth. So you suggest that we pay out $80,000 of current earnings and retain $160,000 to increase the future earnings of the business. In the first year, your dividend would be $40,000, and as earnings grew and the one-third payout was maintained, so too would your dividend. In total, dividends and stock value would increase 8% each year (12% earned on net worth less 4% of net worth paid out).
After ten years our company would have a net worth of $4,317,850 (the original $2 million compounded at 8%) and your dividend in the upcoming year would be $86,357. Each of us would have shares worth $2,698,656 (125% of our half of the company’s net worth). And we would live happily ever after – with dividends and the value of our stock continuing to grow at 8% annually.
There is an alternative approach, however, that would leave us even happier. Under this scenario, we would leave all earnings in the company and each sell 3.2% of our shares annually. Since the shares would be sold at 125% of book value, this approach would produce the same $40,000 of cash initially, a sum that would grow annually. Call this option the “sell-off” approach.
Under this “sell-off” scenario, the net worth of our company increases to $6,211,696 after ten years ($2 million compounded at 12%). Because we would be selling shares each year, our percentage ownership would have declined, and, after ten years, we would each own 36.12% of the business. Even so, your share of the net worth of the company at that time would be $2,243,540. And, remember, every dollar of net worth attributable to each of us can be sold for $1.25. Therefore, the market value of your remaining shares would be $2,804,425, about 4% greater than the value of your shares if we had followed the dividend approach.
Moreover, your annual cash receipts from the sell-off policy would now be running 4% more than you would have received under the dividend scenario. Voila! – you would have both more cash to spend annually and more capital value.
This calculation, of course, assumes that our hypothetical company can earn an average of 12% annually on net worth and that its shareholders can sell their shares for an average of 125% of book value. To that point, the S&P 500 earns considerably more than 12% on net worth and sells at a price far above 125% of that net worth. Both assumptions also seem reasonable for Berkshire, though certainly not assured.
Moreover, on the plus side, there also is a possibility that the assumptions will be exceeded. If they are, the argument for the sell-off policy becomes even stronger. Over Berkshire’s history – admittedly one that won’t come close to being repeated – the sell-off policy would have produced results for shareholders dramatically superior to the dividend policy.
Aside from the favorable math, there are two further--and important--arguments for a sell-off policy. First, dividends impose a specific cash-out policy upon all shareholders. If, say, 40% of earnings is the policy, those who wish 30% or 50% will be thwarted. Our 600,000 shareholders cover the waterfront in their desires for cash. It is safe to say, however, that a great many of them--perhaps even most of them--are in a net-savings mode and logically should prefer no payment at all.
The sell-off alternative, on the other hand, lets each shareholder make his own choice between cash receipts and capital build-up. One shareholder can elect to cash out, say, 60% of annual earnings while other shareholders elect 20% or nothing at all. Of course, a shareholder in our dividend-paying scenario could turn around and use his dividends to purchase more shares. But he would take a beating in doing so: He would both incur taxes and also pay a 25% premium to get his dividend reinvested. (Keep remembering, open-market purchases of the stock take place at 125% of book value.)
The second disadvantage of the dividend approach is of equal importance: The tax consequences for all taxpaying shareholders are inferior – usually far inferior – to those under the sell-off program. Under the dividend program, all of the cash received by shareholders each year is taxed whereas the sell-off program results in tax on only the gain portion of the cash receipts....
For the record, in 2012 Berkshire's stock appreciated 16%, beating the S&P 500 by 17.6%, the Giants swept the Tigers 4-0 in the World Series and the Ravens beat the 49ers 34-31 in Super Bowl XLVII. Next up, 2013, the year the world said goodbye to Nelson Mandela, Margaret Thatcher and Hugo Chavez (how's that for a threesome?).