This is the thirty-ninth 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 2015 letter weighs in at 16,200 words, a 21% decrease from 20,560 words the prior year (a lot less meat appears in this letter than in the prior year's letter, as it seems that Buffett tired himself out in 2014 celebrating his 50th anniversary in charge of Berkshire). Berkshire's $15.4 billion increase in net worth during the year was 6.4% of beginning 2015 net worth.
JOHN D. ROCKEFELLER HAD NOTHING ON TODAY'S UPPER MIDDLE CLASS
Well we're movin on up,
To the east side.
To a deluxe apartment in the sky.
Movin on up,
To the east side.
We finally got a piece of the pie...
--Movin' On Up [theme From The Jeffersons] Lyrics
Buffett includes in the 2015 letter the following commentary about how people live today versus John D. Rockefeller's lifestyle in 1930:
All families in my upper middle-class neighborhood regularly enjoy a living standard better than that achieved by John D. Rockefeller Sr. at the time of my birth. His unparalleled fortune couldn’t buy what we now take for granted, whether the field is – to name just a few – transportation, entertainment, communication or medical services. Rockefeller certainly had power and fame; he could not, however, live as well as my neighbors now do.
This viewpoint is interesting in light of recent social unrest and protests. While there will always be fighting over the size of the slices of the economic pie that individuals receive (i.e., how the pie is divvied up), fortunately the overall pie is vastly larger today than it was 80 or 90 years ago, even after adjusting for inflation and population growth. And the pie will just get larger and larger on a per capita basis over time. Buffet states that money and votes will be the weapons used to fight over the pie. Hopefully this will be the case--and not what was witnessed in Charlottesville, VA recently.
INTRINSIC BUSINESS VALUE
The concept of intrinsic business value (or IBV), Buffett explains, is very squishy. While it is relatively straightforward to find a range of IBV for most companies, it is very difficult to pinpoint with exactitude. With respect to Berkshire's IBV, Buffett states as follows:
As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). It is possible, however, to make a sensible estimate. In our 2010 annual report we laid out the three elements – one of them qualitative – that we believe are the keys to an estimation of Berkshire’s intrinsic value.
Here is an update of the two quantitative factors: In 2015 our per-share cash and investments increased 8.3% to $159,794 (with our Kraft Heinz shares stated at market value), and earnings from our many businesses – including insurance underwriting income – increased 2.1% to $12,304 per share. We exclude in the second factor the dividends and interest from the investments we hold because including them would produce a double-counting of value. In arriving at our earnings figure, we deduct all corporate overhead, interest, depreciation, amortization and minority interests. Income taxes, though, are not deducted. That is, the earnings are pre-tax.
Because companies have no definable specific intrinsic value, stock prices can wildly diverge from underlying fundamental values for extended periods. For example, consider Tesla Inc. (ticker TSLA), which has a market cap of approximately $60 billion, yet an intrinsic value that is anyone's guess. Bulls hold that intrinsic value is much greater than the market value, because the company will completely dominate the renewable energy sector for decades to come. Bears will counter that it is highly unlikely he that the company will ever be sufficiently profitable to justify the current market valuation, therefore intrinsic value must be far below the market quote.
The only thing that truly determines a company's intrinsic value is its actual financial performance over many years. By definition, intrinsic value for a company in its early stages will be much less clear than that for a company with an established operating history. This is why venture capitalists extensively diversify their investments, whereas an investor like Buffett can concentrate his investments to an extreme degree (since Buffett invests in stalwarts such as Wells Fargo, American Express, Coca-Cola, Apple, etc).
HOW TO LEGALLY MISLEAD INVESTORS: NON-GAAP FINANCIAL METRICS
Buffett includes in the 2015 letter the following discussion of GAAP versus non-GAAP financials, for example whether it is appropriate to count amortization charges as "real" expenses:
I suggest that you ignore a portion of GAAP amortization costs. But it is with some trepidation that I do that, knowing that it has become common for managers to tell their owners to ignore certain expense items that are all too real. “Stock-based compensation” is the most egregious example. The very name says it all: “compensation.” If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?
Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring “earnings” figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing “access” to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.
Depreciation charges are a more complicated subject but are almost always true costs. Certainly they are at Berkshire. I wish we could keep our businesses competitive while spending less than our depreciation charge, but in 51 years I’ve yet to figure out how to do so. Indeed, the depreciation charge we record in our railroad business falls far short of the capital outlays needed to merely keep the railroad running properly, a mismatch that leads to GAAP earnings that are higher than true economic earnings. (This overstatement of earnings exists at all railroads.) When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.
Although the goal of financial statements is to generally present a true economic picture of a business enterprise to investors for a given period of time, too often a public company's management will pervert them to legally deceive investors about the real state of the business. Usually the motive is to artificially inflate the stock price (and, hence, management's compensation). To cite one example, consider foreign exchange fluctuations. Management will often present non-GAAP currency-adjusted numbers to investors when foreign exchange rate movements have recently hampered growth in revenues or profitability. The rallying cry is "Everything would have been great if not for those pesky currency movements!" But will these same executives include currency-adjusted numbers in the non-GAAP financials in subsequent periods when these fluctuations go the other way and actually benefit revenues and earnings? Or will they attempt to quietly drop the entire concept and hope that nobody notices? We're guessing the latter is much more likely to occur.
DOWNSIZING AND LAYOFFS ARE GOOD FOR AMERICA(???)
Finally, Buffett includes in the 2015 letter a defense of layoffs and downsizing in American industry (take that POTUS!). In his discussion of 3G Capital and their business practices, for example at Kraft Heinz, Buffett more or less says that 3G are not evil, they are instead experts in achieving higher productivity. He describes this as the "secret sauce of America's remarkable gains in living standards since the nations founded in 1776". In other words, 3G acquires a company, fires a bunch of people who are considered dead weight and forces the remaining employees to achieve the same economic output with less people--and America is better off (says Buffett).
Below is Buffett's paean to downsizing--sorry, productivity:
Earlier, I told you how our partners at Kraft Heinz root out inefficiencies, thereby increasing output per hour of employment. That kind of improvement has been the secret sauce of America’s remarkable gains in living standards since the nation’s founding in 1776. Unfortunately, the label of “secret” is appropriate: Too few Americans fully grasp the linkage between productivity and prosperity. To see that connection, let’s look first at the country’s most dramatic example – farming – and later examine three Berkshire-specific areas.
In 1900, America’s civilian work force numbered 28 million. Of these, 11 million, a staggering 40% of the total, worked in farming. The leading crop then, as now, was corn. About 90 million acres [of corn in 1900] were devoted to its production and the yield per acre was 30 bushels, for a total output of 2.7 billion bushels annually.
Then came the tractor and one innovation after another that revolutionized such keys to farm productivity as planting, harvesting, irrigation, fertilization and seed quality. Today, we devote about 85 million acres to corn. Productivity, however, has improved yields to more than 150 bushels per acre, for an annual output of 13-14 billion bushels. Farmers have made similar gains with other products.
Increased yields, though, are only half the story: The huge increases in physical output have been accompanied by a dramatic reduction in the number of farm laborers (“human input”). Today about three million people work on farms, a tiny 2% of our 158-million-person work force. Thus, improved farming methods have allowed tens of millions of present-day workers to utilize their time and talents in other endeavors, a reallocation of human resources that enables Americans of today to enjoy huge quantities of non-farm goods and services they would otherwise lack.
It’s easy to look back over the 115-year span and realize how extraordinarily beneficial agricultural innovations have been – not just for farmers but, more broadly, for our entire society. We would not have anything close to the America we now know had we stifled those improvements in productivity. (It was fortunate that horses couldn’t vote.) On a day-to-day basis, however, talk of the “greater good” must have rung hollow to farm hands who lost their jobs to machines that performed routine tasks far more efficiently than humans ever could. We will examine this flip-side to productivity gains later in this section.
All of this "productivity" generation obviously creates a lot of hardship for those who get laid off. However Buffett says that the answer to this is not to prevent layoffs, rather it is to provide an adequate social safety net for such people. Interestingly, in his early days as an investment manager Buffett was accused of heartless business practices when he laid off employees at a windmill manufacturer in Beatrice, Nebraska that he had acquired control of, called Dempster Mill. After being publicly excoriated as an asset stripper, Buffett vowed that he would never again make investments involving "human problems" (meaning layoffs, etc.) (For further information on this particular investment (which turned out to be a financial bonzana for Buffett and his investors), see here.) It seems as though Buffett has found a way to achieve a similar goal today and avoid the negative press that came along with his Dempster investment--he just uses 3G to accomplish it.
For the record, in 2015 Berkshire's stock fell 12.5%, trailing the S&P 500 by 14% (post-50th anniversary hangover, perhaps), the Royals beat the Mets 4-1 in the World Series and the Broncos beat the Panthers 24-10 in Super Bowl 50. Next up, 2016, the year a team from the Windy City ended a serious drought (believe it or not, "next year" finally arrived) and the occurrence of the final Berkshire shareholder letter to be covered by this blog series (thank God!).