Berkshire Hathaway Inc. (BRK.A, Financial)(BRK.B, Financial) released its 2022 annual letter to shareholders on Feb. 25. While many investors look forward to reading Warren Buffett (Trades, Portfolio)'s insights each year, they were surprised to see he did not write much about his equity investments or the current market situation.
In this two-part series, I will highlight some of the key takeaways from this year’s letter and share my thoughts on them.
Takeaway 1
According to Buffett, “Capitalism has two sides: the system creates an ever-growing pile of losers while concurrently delivering a gusher of improved goods and services.”
Investors should realize that capitalism creates and destroys at the same time. We are living in an age of technological revolution and the world around us is constantly changing. This is why Berkshire has somewhat started to embrace technology stocks after avoiding them for years. For example, Berkshire held a large stake in International Business Machines Corp. (IBM, Financial) for several years before selling out in 2019, and its investment in Apple (AAPL, Financial) is currently its largest equity holding. Although Apple is a tech company, Buffett considers it a consumer business to a large extent because it produces electronics like the iPhone, iPad, MacBook and other software and apps.
Further, with a seemingly limitless amount of information available online, along with the ability to live stream content and even hold video conferences via Zoom (ZM, Financial), Skype or Google Meet, the tech space has a lot of growth potential as it moves into other areas. Therefore, in my opinion, Buffett and Charlie Munger (Trades, Portfolio) are slowly embracing tech stocks because they have a long runway for expansion.
Takeaway 2
The guru wrote, “Efficient markets exist only in textbooks. In truth, marketable stocks and bonds are baffling, their behavior usually understandable only in retrospect.”
Buffet is saying the efficient market theory is not realistic. In my opinion, this is because the markets become volatile and inefficient due to short-term trading and speculation. This creates anomalies in the capital markets, which are then used as opportunities by value investors.
The markets, to a large degree, are also driven by investor sentiment. When the sentiment is low, like the market experienced during the recession of 2007-08, it pulls stocks down to sell far below their fair value. On the other hand, in a bull market, when sentiment is high like in the 1990s, shares trade well above their intrinsic value.
Takeaway 3
In his annual missive, the Oracle of Omaha admitted, “In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. In some cases, also, bad moves by me have been rescued by very large doses of luck.”
“Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years – and a sometimes-forgotten advantage that favors long-term-investors such as Berkshire,” he continued.
Buffett provides justification for some of his mistakes by discussing his investments in Coca-Cola (KO, Financial) and American Express (AXP, Financial) in the 1990s. In my opinion, he is alluding to the magic of compounding and share buybacks that, according to him, have worked out pretty well for Berkshire over a long period of time. For example, the investment of $1.3 billion in Coca-Cola to buy 400 million shares in 1994 for a cash dividend of $75 million achieved the best outcome. This is because the dividends grew every year, reaching $704 million in 2022, and are expected to grow further.
The investment in American Express, which also cost about $1.3 billion in 1995, also worked out well for Berkshire. The company's dividends grew from $41 million at that time to $302 million in 2022. They are also expected to continue growing.
The value of these marketable stocks also increased significantly. For example, the market value of Coca-Cola increased to $25 billion, while American Express is valued at $22 billion, with each investment representing 5% of Berkshire’s net worth.
The guru continued, “Assume, for a moment, I had made a similarly-sized investment mistake in the 1990s, one that flat-lined and simply retained its $1.3 billion value in 2022. (An example would be a high-grade 30-year bond.) That disappointing investment would now represent an insignificant 0.3% of Berkshire’s net worth and would be delivered to us an unchanged $80 million or so of annual income.”
Essentially, Buffett is saying if the same amount was invested in marketable bonds for the same period, the outcome would have been very different. In this scenario, the value of bonds stayed at the same level and their coupons remained consistent for the same period. This, in my opinion, indicates stocks are a better investment than bonds.
Furthermore, I think what Buffett is trying to imply here is that investors need to pay special attention to retained earnings, dividends and the long-term time horizon when investing in equities. The dividends for a good company with good management in place will keep increasing, especially when the retained earnings of the business are used to buy back its own shares. These buybacks will increase the shareholder’s ownership in the business by reducing the number of outstanding shares. This is one of the reasons why Berkshire, in the last three years, has been aggressively buying back its own stock as a way to give back to its shareholders instead of paying out dividends that incur tax.
Takeaway 4
The billionaire investor noted: “Berkshire had a good year in 2022. The company’s operating earnings – our term for income calculated using Generally Accepted Accounting Principles (“GAAP”), exclusive of capital gains or losses from equity holdings – set a record at $30.8 billion. Charlie and I focus on this operational figure and urge you to do so as well. The GAAP figure, absent our adjustment, fluctuates wildly and capriciously at every reporting date. Note its acrobatic behavior in 2022, which is in no way unusual... The GAAP earnings are 100% misleading when viewed quarterly or even annually."
Regular readers of Buffett's letters will realize that he, for the first time, did not discuss Berkshire's equity investments. This could be because of the new GAAP reporting requirements that mandate reporting of its unrealized capital gains and losses for its equity investment holdings on a quarterly basis. In my opinion, Buffett appears to be criticizing the new GAAP reporting requirements for marketable securities, which he thinks are meaningless and misleading to shareholders and investors. His viewpoint, however, is debatable for some shareholders and investors like myself since short-term unrealized losses are arguably as important as unrealized gains.
If Berkshire decides to sell its marketable securities today, it will have to sell at its current market price, which might be higher or lower than the cost of acquiring these stocks. For example, Apple today might be trading at a price well below Berkshire’s purchase price, and if Berkshire decides to sell the stock, it will have no choice but to sell at a loss, which is as realistic as selling any other operating business.
Arguably, the new GAAP reporting requirements help analysts, shareholders and investors to realistically value Berkshire and its assets based on the current market value. Let’s assume that if Berkshire decides to file for bankruptcy today, it will have no choice but to receive a price for its assets (including stocks) marked to market and valued based on the current price.
Therefore, in my opinion, when the value of Berkshire’s non-operating businesses is down, it affects its stock price and its shareholders, who have no choice but to sell at a loss if they wish to exit. This is what makes the new GAAP reporting more relevant, which is contrary to Buffett's viewpoint.
Takeaway 5
Buffett said, "Aided by Alleghany (Y, Financial), our insurance float increased during 2022 from $147 billion to $164 billion.”
It is the insurance float, which is used as leverage, that has helped Buffett and Berkshire achieve superior results to the S&P 500 over the years. Although this reserve capital is a liability, in my opinion, Buffett treats this cash as an asset to buy operating and non-operating businesses to achieve above-average returns. This is the money collected today by Berkshire and its insurance subsidiaries to pay for any future claims tomorrow which can arise from any unforeseen circumstances.
While the float has grown significantly over the years, it has been affected in 2022 by unexpected insurance claims and underwriting losses. Therefore, in my opinion, this free cash (float), which has served as a catalyst for Berkshire all these years, is now becoming a cause for concern due to its abysmal performance and losses in 2022.
