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An Important Lesson from Buffett’s 2011 Berkshire Letter

Warren Buffett writes an annual Chairman’s letter for Berkshire Hathaway shareholders, and he released the one for fiscal year 2011 a couple of days ago.

Consider reading the full letter here in PDF form, from the Berkshire site:
Chairman’s Letter 2011

Buffett himself is an interesting writer and one of the wealthiest billionaires in the world, so his Chairman’s letter differs significantly from the letters of other Chairmen. Generally, his letters are broad tutorials of investing mixed with an overview of his business. Even if someone else was in place of Buffett writing the letter, as the CEO and Chairman of this $200 billion conglomerate that owns businesses as diverse as railways, chemicals, candy sellers, energy holdings, dividend stock holdings, insurance, and home construction, the opinions contained within would be well-read by investors and the media. It’s basically a small snapshot of the American economy.

This article takes a brief look at what I view as some of the main points of the letter, but saves discussion of most of Berkshire Hathaway’s existing business operations for another day:

1. The compounded annual rate of return of Berkshire Hathaway’s book value per share has been 19.8% since 1964, which comes out to an increase of 513,055% in overall gain from the beginning. By more than doubling the annualized rate of return compared to that of the S&P 500, money invested in Berkshire Hathaway in the beginning of Buffett’s ownership of it would be nearly a hundred-fold larger than money invested in the S&P 500 over the same period. (And money invested in the S&P 500 was certainly no slacker either, so that’s saying something.)

2. Buffett explained far more definitive plans for a succession plan, despite stating he has no plans of leaving. There’s still a lot of secrecy, but he has stated that the process is ready to go. This is presumably to relax investor fears over potential issues for when he leaves the company he’s managed for a half century.

3. Major Berkshire/Buffett purchases for 2011 included:

A) The complete purchase of Lubrizol, a specialty chemicals and additives company, along with plans for a number of smaller bolt-on acquisitions for that company.

B) Over $8 billion in capital expenditures for property, plant, and equipment. This was a record for the company, primarily because Buffett has purposely added much more capital-intensive businesses.

C) An $11 billion purchase of International Business Machines (IBM) stock. It’s a fresh move for him, as he rarely does tech. I wrote previously on what I consider the maturation of the tech sector for long-term investors.

D) A $5 billion 6% preferred shares purchase of Bank of America (BAC). This came with unique options that allow Berkshire to buy up to 700 million shares of Bank of America for $7.14 per share, any time before September 2021. This, I believe, will be an incredibly lucrative investment. Buffett has been quite the opportunistic options-investor over the last several years.

4. Buffett pointed out that he was “dead wrong” in his statement last year about a housing recovery in one year. But he reiterates the certainty of an eventual housing recovery and explained the supply/demand surplus situation and how it’s working itself out.

The Important Lesson

The most useful piece of investment advice in the letter, in my opinion, is the part where he talks about stock valuation and share repurchases.

First, Buffett describes his current policy of being willing to aggressively repurchase Berkshire stock any time it trades below 110% book value. By his calculations, the stock is significantly undervalued at that level, and so it would be good for the remaining shareholders.

I think a company of that size should pay a dividend. But for any company that does do share repurchases, I think CEOs around the country would do much good for shareholders if they had similar share-repurchase policies in place for their own businesses, albeit with industry-appropriate metrics of estimation instead of the 1.1x book value metric. As it stands, a significant number of aristocrat dividend payers supplement their dividends with share repurchases when they have extra capital. Unfortunately, they tend to buy the most shares during periods of stock overvaluation, and the least shares during recessions. CEOs of dividend paying companies would likely do well for shareholders to consider setting quantitative limits on share repurchases, and using extra capital to buy back stock when it meets those requirements, and then using cash for other purposes, such as a special dividend, when the stock doesn’t meet those requirements.

But then, after this assessment, he gets into a far broader and fundamental concept:

Investors should desire for their holdings to fall in value.

This is a lesson that many value investors know, but that is often ignored or misunderstood. I’ll quote Buffett below:

This discussion of repurchases offers me the chance to address the irrational reaction of many investors to changes in stock prices. When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. A corollary to this second point: “Talking our book” about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume.

and

Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

That’s all I’ll quote, though I think the whole letter is generally worth reading for dividend or value investors, and the link is at the top of this article.

The important lesson is this: As a net buyer of stock, or as a holder of companies that repurchase their own shares (which, today, is probably the majority of blue-chip companies based on what I’ve seen from the stock reports I’ve published), and as reinvestors of dividends, we want our stock prices to perform poorly, and the company itself to perform well.

That’s the best case scenario. The better that the company performs in terms of revenue growth, earnings growth, cash flow growth, dividend growth, increase in book value, and other metrics, and the worse the stock price of that company performs, the better it is for investors. In the short term, irrational things can and do happen with stock prices. Over the very long term, prices must ultimately represent something close to the intrinsic value of the company, and the longer that they do not, the better it is for long-term shareholders.

Keep this in mind when investing, and when everyone else is distraught over market drops, you won’t be.

Other Weekend Reading

Here are some other good reads for the weekend.

Those Responsible for Millionaire Teacher’s Success
I’ve got to mention Andrew Hallam first here, as he has been one of the value investors pointing out that net buyers of stock should hope for low stock prices consistently on his blog. He’s also the author of the book, Millionaire Teacher, which is definitely worth the read.

TSX 60 Dividend Yield Ex-Dividend Date
Every month, the Dividend Guy provides an extremely helpful list for Canadian dividend investors.

8 Dividend Stocks to Consider While Waiting on Apple to Pay its First Dividend
D4L points out Apple’s enormous cash/investment position. In addition to the $30 billion in cash that he mentions, and no debt, Apple has put some cash into longer-term investments, so the “true” cash position is more like $100 billion. (To put that in perspective, it’s larger than Amazon Inc.’s market cap.) The stock has obviously done quite well for investors, but as it stands, the growth brought in huge amounts of free cash flow from innovation of Steve Jobs and his employees, rather than from capital reinvestment. Apple’s got to eventually do something with this money, and as a company with a half-trillion-dollar market cap, paying a dividend would probably be the best use of cash.

Define Your Emergency Fund Road Map
It’s important to have cash available for unexpected things. Passive Income Earner discusses emergency funds.

Dividend Dynamos
Need more stock ideas? Dynamic Dividends has you covered with a highly organized list of the top companies that have paid long stretches of consecutively annually raised dividends.

 Dividend Insights Newsletter

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Comments

  1. “we want our stock prices to perform poorly, and the company itself to perform well.”

    I feel the same way, which is why I would prefer a bear market over a bull market while I’m in the accumulation phase of my investing. As long as the companies are doing well (and continuing to increase their dividends each year), I would be fine with little or no capital appreciation, which would allow me to put new capital to work and reinvest dividends at lower cost.

  2. Fantastic synopsis of Buffett’s letter and the points about value investing.

    I completely concur about rooting for the prices of shares I own to decline in value, or stay static, over an extended period of time while the underlying business continues to do well. This is the optimal situation as a value investor.

    However, with that said, some of that viewpoint depends on what phase you are in as an investor. As Deedubs pointed out in his comment, he is in the accumulation phase (as am I) so as a net buyer of stocks it’s imperative that I buy them at a discount or at the very least at a fair price. Limited downside, and a margin of safety are important to preserve and grow my capital as I continue to grow my assets. If I was already living off my dividends then the price of shares would no longer matter, as the dividends those shares are throwing off would be all that would matter to me, unless I was allocating a certain percentage of the dividends toward reinvestment.

    Great article as always, and I also received the newsletter today. Read it all and completely agree with you on every front, especially the sectors that hold the most value right now.

    Best wishes, and hope you’re having a great weekend!

    • Thanks Mantra, and I do appreciate the newsletter feedback.

      You are correct that the stage of life matters. Buffett was specifically referring to net buyers.

      However, I’d point out that more people are net buyers than they may realize, and that’s a point Buffett made as well. If a retiree, for instance, is holding Procter and Gamble, and is living off the dividends (neither buying nor selling shares), then the retiree is a net buyer because Procter and Gamble is buying $5 billion or so worth of its own shares every year. The lower the price of PG stock over this period, the more shares they can buy for their money, the fewer shares there will be at the end of the year, and the higher the dividend growth per share, all else being equal.

      The retiree would have to actively sell shares not to be a net buyer. Many blue-chip companies repurchase shares, so the default position in a given dividend growth stock is often that of a net buyer.

      Glad you enjoyed the newsletter, and thanks for remembering my comment request to give feedback.

  3. I also enjoyed the newsletter. Regarding valuation of overall market, have you considered Schillers PE10? I think its a very good measure, see link below.
    http://www.econ.yale.edu/~shiller/data.htm

    • Hi Defensiven,

      Schillers PE is another good ratio to be aware of.

      The three main ratios I have utilized are:
      -Market/GDP: Pretty good overall, but a flaw is that it doesn’t take into account a shift from private to publicly traded companies.
      -Average P/E of S&P: Also good, but a flaw is that during market downturns, some cyclical companies may have temporary low earnings and therefore increase the P/E on their stock.
      -Average dividend yield of the S&P: Still good. It deals with the cyclical problem, at least for companies that don’t cut their dividend in recessions. But it doesn’t take into account any potential long-term trends of payout ratio differences.

      Following any one of those three ratios is a fairly good way of keeping track of market valuation.

      I wrote a computer program once that explores different stock/bond rebalancing scenarios based on some of these ratios, or algorithms combining more than one ratio.

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