Many great investors have cited Warren Buffett (Trades, Portfolio)'s letters as a core component of their investment education. Everyone can learn so much from reading his annual shareholder letters for Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial). There is a lot to read, so this series is designed to highlight the most interesting aspects of each letter. This disucssion covers the 2010 missive.
Life and debt
Buffett said, “The fundamental principle of auto racing is that to finish first, you must first finish.” What he is saying is that you must not get wiped out. One way to get wiped out is through borrowing money. While that can make you rich when you are right, it can wipe you out if you are wrong.
The guru noted that leverage is addictive and that very few people who have benefited from it will retreat to more conservative practices. Buffett reminded readers that any large number multiplied by a single zero becomes zero. “History tells us that leverage all too often produces zeroes, even when it is employed by very smart people,” he wrote.
September 2008
This rule about leverage applies to both individuals and businesses. Buffett noted that companies with large debts often assume these obligations can be refinanced as they mature. That assumption is usually valid. However, sometimes, either because of company-specific problems or a worldwide shortage of credit – as in the global financial crisis of 2007 to 2009, maturities must be met by payment. For debt repayment “only cash will do the job.”
He continued:
"Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees."
Buffett noted that he and Munger, because of their age, and because of the fiduciary duties to Berkshire Hathaway shareholders and insurance beneficiaries, have no interest in putting even slightly at risk its well-being. He noted it would be irresponsible for Berkshire to risk what “all these constituencies need just to pursue a few points of extra return.”
Buffett’s grandfather Ernest
Interestingly, both Buffett and Munger worked in Omaha, Nebraska for Buffett’s grandfather, Ernest Buffett, at his grocery store, though not at the same time. Buffett said of his grandfather, “perhaps no man was more aptly named” and that the experience for working for him helped shape both investors. Ernest emphasized to his family that they must always have a cash reserve.
Even though he never went to business school,he understood the importance of liquidity as a condition for assured survival.
Buffett took this idea to heart and noted that Berkshire Hathaway has pledged that it will hold at least $10 billion of cash, excluding that held at its regulated utility and railroad businesses. He wrote:
"Because of that commitment, we customarily keep at least $20 billion on hand so that we can both withstand unprecedented insurance losses (our largest to date having been about $3 billion from Katrina, the insurance industry’s most expensive catastrophe) and quickly seize acquisition or investment opportunities, even during times of financial turmoil."
Don’t reach for yield
Buffett noted that Berkshire Hathaway's cash reserve is held in very safe U.S. Treasury bills and that it has had a long-standing policy to avoid short-term securities which yield a fraction of a percentage point extra in return. This helped the company avoid the money market fund turbulence that happened in the global financial crisis.
He quoted investment writer Ray DeVoe’s observation: “More money has been lost reaching for yield than at the point of a gun.” Buffett also stated that Berkshire does not rely on bank lines and does not enter contracts that could require postings of collateral except for amounts that are tiny in relation to its liquid assets.
Buffett also reminded readers that Berkshire Hathaway has not paid a dividend or executed a share buyback in the past 40 years because retained earnings have allowed the business to be strengthened. This has caused immense compounding of cash generation and equity value. “No other American corporation has come close to building up its financial strength in this unrelenting way,” he said.
"By being so cautious in respect to leverage, we penalize our returns by a minor amount," Buffett said. "Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008."
Memo to Berkshire Hathaway managers
In the 2010 shareholder letter, Buffett attached a memo he wrote to Berkshire Hathaway's managers, who he called The All-Stars. He reminded staff that Berkshire “can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.”
He said that Berkshire must act not just in accordance with the law, but in a way that everybody would be fine with the behavior being reported “the on front page of a national newspaper in an article written by an unfriendly but intelligent reporter.”
He advised his managers:
"Sometimes your associates will say 'Everybody else is doing it.' This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision. Whenever somebody offers that phrase as a rationale, in effect they are saying that they can’t come up with a good reason. If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them."
He also asked the managers to raise issues promptly as “I can handle bad news, but I don’t like to deal with it after it has festered for awhile.”
Buffett also said, "Your attitude on such matters, expressed by behavior as well as words, will be the most important factor in how the culture of your business develops. Culture, more than rule books, determines how an organization behaves."
