The debacle at the Academy Awards Ceremony reminds us that even the best laid plans can go horribly wrong. Over the previous 89 years of the Oscars and 85 presentation ceremonies, the famous envelopes were correctly inserted with the names of the verified winners. The envelopes had probably been checked many times before they arrived at the venue. Then they were held in tight security that prevented tampering. However, on this occasion the process went haywire. In a further cruel twist, the mistake wasn’t made for the “Best Costume Design” or the “Best Animation” but for the ultimate award of “Best Picture of 2017”.
The chances of a mistake were probably not even contemplated by the Academy of Arts and Sciences. The chance that Warren Beatty and Faye Dunaway would announce the wrong winner would have been regarded as highly improbable and probably impossible – something like a 1000 to 1 chance. Anyone betting on that possibility and subsequently collecting would have been charged with fraud – the type of fraudster epitomised in the Academy Award winning picture “The Sting”. Any insurance company, including those owned by Warren Buffett, would not pay out on that claim. They would take the premium, surmise that a claim would most likely have to be fraudulent and so they would not be liable. However, in this case, there was no fraud and there was no insurance. Unpredictable human error is common but regarded as a low risk event by markets!
That brings us to this point: when considering investments, remember that things can go wrong and they will – no matter how many checks and balances are in place. Therefore when we consider the price of an investment, we should always consider what can go wrong. The risk of a mistake, outright failure or changed circumstances should be factored into the price that we are prepared to pay for an investment asset. A margin of safety and/or an appropriate discount rate should be adopted as a mechanism to mitigate the risk of capital loss caused by an unpredictable risk or outcome. In particular, we should avoid any investment (and in particular shares) that are priced for perfection because no investment is perfect.
“Of course, a business with terrific economics can be a bad investment if it is bought at too high a price.” Warren Buffett, 2017 Letter to Shareholders
Similarly, a business that trades well above its valuation needs to be reviewed. Unlike popular folklore, Berkshire Hathaway does not own marketable securities (listed shares) forever.
“Sometimes the comments of shareholders or media imply that we will own certain stocks “forever” … It is true that we own some stocks that I have no intention of selling for as far as the eye can see (and we’re talking 20/20 vision). But we have made no commitment that Berkshire will hold any of its marketable securities forever”.
BUFFETT’S LETTER TO SHAREHOLDERS
Apart from the Academy Awards and President Trump’s much anticipated “Address to a Joint Sitting of Congress,” this week saw the publication of the annual letter to Berkshire Hathaway shareholders penned by its chairman, Warren Buffett. In it, there was a flow of common sense antidotes for investors to reflect upon. Many of these had been previously made over prior years, but both shareholders and investors alike relish their repetition. A feature was Buffett’s honest acknowledgement (again) that he has and does make investment mistakes. But he clearly doesn’t make many, and he openly declares that his erstwhile partner Charlie Munger has been responsible for stopping many more mistakes. Buffett presents as an optimistic funds manager who is checked by Munger’s hard-nosed logic.
“I will commit more errors; you can count on that. Fortunately, Charlie – never bashful – is around to say “no” to my worst ideas.”
We do not propose to re-publish the investment lessons from the letter, but we will focus on commentary that may help us draw conclusions on a few sectors, some listed companies and corporate behaviour.
The letter from Buffett was published after the market closed last Friday in the US. Whether the letter was market sensitive or not, the following statement should send a message to Australian listed companies, the ASX and ASIC regarding market disclosures. The Australian system is simply unfair and needs to be fixed.
“While I’m on the subject of our owners’ gaining knowledge, let me remind you that Charlie and I believe all shareholders should simultaneously have access to new information that Berkshire releases and, if possible, should also have adequate time to digest and analyse it before any trading takes place. That’s why we try to issue financial data late on Fridays or early on Saturdays and why our annual meeting is always held on a Saturday (a day that also eases traffic and parking problems).
We do not follow the common practice of talking one-on-one with large institutional investors or analysts, treating them instead as we do all other shareholders. There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his or her savings. As I run the company day-to-day – and as I write this letter – that is the shareholder whose image is in my mind.”
In a potent commentary on stockbroking investment analysts and the behaviour of listed company executives that smooth profit expectations, Buffett wrote the following:
“Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centred on Wall Street will be tempted to make up the numbers.”
This is another reason why listed companies should not be allowed to present their profit results just before or during trading hours. The market needs time to analyse results and shareholders deserve the right to review their company’s results before hyperactive traders and computers flip prices in an information vacuum.
In the letter, Buffett spends some time detailing the features of Berkshire’s insurance companies. These have become the power houses that supply investment capital to the Berkshire Group. With complete ownership of their cash (the “free float”), and with the knowledge that this float is stable and growing (with the economy), the Berkshire Group is empowered to strategically invest. The compounding returns are clear to see.
What some commentators misunderstand is that Berkshire Hathaway is a type of listed mutual. By not paying dividends to shareholders, and therefore not servicing capital (they do notionally but not actually), the insurance group is able to maintain highly efficient and low priced insurance to its policyholders. It can meet any market conditions and any catastrophe through its bountiful and ballooning capital.
Australia’s great mutual insurance entities (AMP, National Mutual and NRMA) all disappeared in the 1990’s. We can reflect on this and ask whether the conversion from mutual and member focus to shareholder focus has been for the better. A mutual enterprise (and Berkshire is an example) has a tremendous investment advantage over listed investment companies or insurers. It can provide stable investment capital to their investors and if the investment management overseeing that capital is clever and has integrity, then substantial compounding investment returns can be made. The returns on investment ultimately dwarf the returns on insurance.
In his letter, Buffett made this interesting observation about the insurance sector: he suggested that many insurance companies have not managed their capital (free float) appropriately and their outlook is clouded.
“As these high-yielding legacy investments mature and are replaced by bonds yielding a pittance, earnings from float will steadily fall. For that reason, and others as well, it’s a good bet that industry results over the next ten years will fall short of those recorded in the past decade, particularly in the case of companies that specialize in reinsurance.”
Another potent comment was Buffett’s remarks concerning the liquidity of the Berkshire Group. Readers may recall that at our End of Year Investment Briefing we noted that an estimated US$2 trillion was held by listed US companies in non-US bank accounts in low tax jurisdictions.
“It’s important for you to understand that 95% of the $86 billion of “cash and equivalents” (which in my mind includes U.S. Treasury Bills) shown on our balance sheet are held by entities in the United States and, consequently, is not subject to any repatriation tax. Moreover, repatriation of the remaining funds would trigger only minor taxes because much of that money has been earned in countries that themselves impose meaningful corporate taxes. Those payments become an offset to U.S. tax when money is brought home.
These explanations are important because many cash-rich American companies hold a large portion of their funds in jurisdictions imposing very low taxes. Such companies hope – and may well be proved right – that the tax levied for bringing these funds to America will soon be materially reduced. In the meantime, these companies are limited as to how they can use that cash. In other words, off-shore cash is simply not worth as much as cash held at home.”
So it is Buffett’s view that US companies that hold vast amounts of capital in tax havens for long periods of time are deluding both themselves and their shareholders. While the minimisation of tax is a legitimate objective, it is not sensible if it drives down return on equity and shareholders forgo dividends.
Remember that any decision by the Trump Administration to lower the repatriation tax charged on US corporations will be in breach of established principles of free trade. It will also directly challenge resolutions of the G20 to crack down on international tax avoidance. There may be a flood of capital returning to the US when Trump changes the corporate tax laws, but the consequences of this may be serious. From an Australian perspective, one positive consequence should be a weakening $A.
In Buffett’s letter was a table of major listed investments of Berkshire Hathaway. It is an interesting list but absent from it was the investment in Bank of America (“BA”) made when that bank was in desperate need for capital in 2011 following the GFC.
Readers may recall that Buffett did a range of smart investment deals that included placements from Goldman Sachs and General Electric. These involved redeemable preference shares (at high yields) and warrants (options to invest in ordinary shares). In those desperate days, Berkshire had the liquidity available (some of it via the free float from insurance noted above), while most of the financial system was cash constrained. Those deals were extraordinary examples of powerful investment structures which provided unlimited upside with virtually no downside. Investors should contrast them to the capital structures that are designed by investment bankers structured to benefit the issuer and not the investor.
Noting the BA investment Buffett explains how a US5 billion investment is now valued at over US$16 billion
“Excluded from the table – but important – is our ownership of $5 billion of preferred stock issued by Bank of America. This stock, which pays us $300 million per year, also carries with it a valuable warrant allowing Berkshire to purchase 700 million common shares of Bank of America for $5 billion at any time before September 2, 2021. At year end, that privilege would have delivered us a profit of $10.5 billion. If it wishes, Berkshire can use its preferred shares to satisfy the $5 billion cost of exercising the warrant.
If the dividend rate on Bank of America common stock – now 30 cents annually – should rise above 44 cents before 2021, we would anticipate making a cashless exchange of our preferred into common. If the common dividend remains below 44 cents, it is highly probable that we will exercise the warrant immediately before it expires.”
Today BA is trading at circa US$24 per share and we note that Buffett has 700 million warrants exercisable at US$7.20 per share by 2021. In recent years, the bank has been buying back shares at significant premiums to the price paid by Berkshire. It is interesting to realise that BA in 2011 had no option but to issue preferred equity to Berkshire at an astronomical cost to its shareholders (ex Berkshire). Clearly it was in a mess at that time.
WE SHOULD NOT FORGET CHARLIE MUNGER
The long term working partnership between Warren Buffett and Charlie Munger is well documented. Bill Gates said of Munger “He is truly the broadest thinker I have ever encountered.”
The influence of Munger is constantly referred to by Buffett. They are a formidable team and the ethical backbone of Berkshire Hathaway. They are the managerial and directional link between Berkshire the mutual, and Berkshire the capitalist enterprise.
Think about it this way. Berkshire Hathaway does not pay a dividend to shareholders. It retains and partly reinvests its free cash flow. Despite this, its shareholders and the broad investment community have amazing trust in the integrity of Berkshire’s management and this is represented by its share price.
It is our view that Berkshire has the keys to good corporate governance. This is similar to the keys of good government. When commenting on good government, Munger says:
“In a democracy, everyone takes turns. But if you really want a lot of wisdom, it’s better to concentrate decisions and process in one person. It’s no accident that Singapore has a much better record, given where it started, than the United States. There, power was concentrated in an enormously talented person, Lee Kuan Yew, who was the Warren Buffett of Singapore.”
Lee Kuan Yew put it this way himself: “With few exceptions, democracy has not brought good government to new developing countries . . . What Asians value may not necessarily be what Americans or Europeans value. Westerners value the freedoms and liberties of the individual. As an Asian of Chinese cultural background, my values are for a government which is honest, effective, and efficient.”
In our view Berkshire Hathaway conducts its operations with honesty, effectiveness and efficiency. Such businesses are very hard to find.