A great way to learn about investing is to read Berkshire Hathaway Inc.'s (BRK.A, Financial) (BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, I cover the 2009 letter.
Applying Munger’s thinking at Berkshire
Charlie Munger (Trades, Portfolio) and Buffett avoid businesses whose futures they cannot evaluate, no matter how exciting their products may be. Berkshire will never become dependent on the kindness of strangers. When the financial system "went into cardiac arrest in September 2008," Berkshire was a supplier of liquidity and capital to the system, not a supplicant.
Berkshire tends to let its many subsidiaries operate on their own, without Munger and Buffett supervising and monitoring them to any degree. “We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly – or not at all – because of a stifling bureaucracy.”
The conglomerate makes no attempt to woo Wall Street. Investors who buy and sell based upon media or analyst commentary are not for them. Buffett wrote, “If Charlie and I were to go into a small venture with a few partners, we would seek individuals in sync with us, knowing that common goals and a shared destiny make for a happy business 'marriage' between owners and managers.”
Insights into the regulated utility business
Buffett provided some detail on Berkshire’s near 90% holding in MidAmerican Energy Holdings. He noted that since Berkshire purchased MidAmerican 10 years prior, it has never paid a dividend. That is because Berkshire is happy for high levels of capital expenditure in order to “not only prepare for the future, but also make these operations more environmentally friendly.” Berkshire used MidAmerican’s earnings to improve and expand its properties in each of the territories it served.
One example was that in the prior three years to 2009, its Iowa and Western utilities earned $2.5 billion, while in this same period spending $3 billion on wind generation facilities. While many investors are obsessed with dividends, Buffett is not. He said what is important are the high returns on capital available.
Since MidAmerican “has consistently kept its end of the bargain with society” Buffett said, “to society’s credit, it has reciprocated.” What he meant is that because MidAmerican had been a good corporate citizen, its regulators allowed it to earn a fair return on the ever-increasing sums of capital it must invest. Buffett noted, “Going forward, we will do whatever it takes to serve our territories in the manner they expect. We believe that, in turn, we will be allowed the return we deserve on the funds we invest.”
Portfolio considerations and diversification
In earlier days, Berkshire shunned capital-intensive businesses such as public utilities, as Buffett looks for capital-light businesses that do not require much capital expenditure in order to grow. Buffett said those are still the best businesses for owners to own, but now that Berkshire has a number of those types of company and its size has become very large, he is now willing to enter businesses that regularly require large capital expenditures, so long as those businesses have reasonable expectations of earning decent returns on the incremental sums they invest.
If these expectations are met, Buffett predicted, “Berkshire’s ever-growing collection of good to great businesses should produce above-average, though certainly not spectacular, returns in the decades ahead.” This is partly a question of diversification, but also a solution to Berkshire’s size problem. With limited time and a lot of spare cash, he could not be expected to make hundreds of small investments just to meet his original investment criteria.
Responsible investment and social compact
But Buffett has been wise to build up a strong reputation. By buying utilities, including the large BNSF operation, the stable returns these businesses generate are also dependent on wise regulators providing certainty about allowable returns. As Buffett said, his companies “provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation” by running them in a responsible way, which means regulators are less likely to kick up trouble. Buffett is happy to make huge capex provided that allowable returns provide a fair return. He wrote:
"We see a 'social compact' existing between the public and our railroad business, just as is the case with our utilities. If either side shirks its obligations, both sides will inevitably suffer. Therefore, both parties to the compact should – and we believe will – understand the benefit of behaving in a way that encourages good behavior by the other. It is inconceivable that our country will realize anything close to its full economic potential without its possessing first-class electricity and railroad systems. We will do our part to see that they exist."
Risk control at financial institutions
Buffett and Munger believe that a CEO must not delegate risk control because it is simply too important. That is why Buffett said he both initiates and monitors every derivatives contract on Berkshire’s books, save for a few contracts at a few of its subsidiaries, such as MidAmerican and General Re. Buffett said he will not pass the blame to any risk committee or chief risk officer. He said:
"In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.
It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been 'bailed-out' is to make a mockery of the term."
Buffett lambasted the performance of financial sector CEOs following the global financial crisis. He said it was the behavior of these CEOs and directors that needed to be changed and that if their institutions and the country were harmed by their recklessness, they personally should pay a heavy price. He is asking for some symmetry: CEOs and directors benefit from the upside via “oversized financial carrots,” so it was time for “some meaningful sticks” to be employed too.
It is no wonder that Buffett was frustrated, as he has always sought to run Berkshire with high liquidity to avoid blowing up when the perfect storm hits, such as it did in the global financial crisis. He makes a good point in that because financial institutions at heart are about risk transformation, the top leadership should understand all the risks and the sizes of the risks and ultimately call the shots in managing those risks. The lesson I learn then is when analyzing a bank or insurance company, it is worth checking if the backgrounds of top leadership involve risk taking and risk management, or more sales and marketing. In my opinion, financial risk will always be around, just transferred between different parties. We want to invest in companies that understand those risks, manage them and take them in a smart way.
