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Accounting
Three types of ownership were discussed (mainly based on voting): more than 50%, from 20% to 50% and less than 20%. (Nowadays, it is mainly based on the level of influence. So if the holding company takes less than 20% profit of the company but can decide everything in the company, it has to consolidate its holding).
Ø More than 50% category: full consolidation of sales, expenses, taxes and earnings of business holdings.
Ø 20-50% category: one-line entry of earnings. Unlike the over 50% category, all items of revenue and expenses are omitted; just the proportional share of net income is included. It is called “equity method.”
Ø Less than 20%: owning companies include in their earnings only the dividends received from such holdings. Undistributed earnings are ignored. This would distort Berkshire’s true earnings: “Should we own 10% of Corporation X with earnings of $10 million in 1980, we would report in our earnings (ignoring relatively minor taxes on inter-corporate dividends) either (a) $ 1million if X declared the full $10 million in dividends; (b) $500,000 if X paid out 50%, or $5 millions, in dividends; or (c)zero if X reinvested all earnings.”
Buffett continues “Our own analysis of earnings reality differs somewhat from generally accepted accounting principles, particularly when those principles must be applied in a world of high and uncertain rates of inflation… We have also owned small fractions of businesses with extraordinary reinvestment possibilities whose retained earnings had an economic value to us far in excess of 100 cents on the dollar”
The Use of retained earnings
Warren Buffett stated that the value to Berkshire Hathaway (BRK.A)(BRK.B) of retained earnings was determined by the use to which they are put and the subsequent level of earnings produced by that usage. “If a tree grows in a forest partially owned by us, but we don’t record the growth in our financial statements, we still own part of the tree.”
The best usage of retained earnings is repurchase of their own shares if the selling price is less than its intrinsic value: “If a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of interest of all owners at that bargain price?”
Long term results
The single year performance versus the long-term appraisal should be measured differently. “We evaluate single-year performance by comparing operating earnings to shareholders’ equity with securities valued at cost. Our long-term yardstick of performance, however, includes all capital gains or losses, realized or unrealized. We continue to achieve a long-term return on equity that considerably exceeds the average of our yearly return. The major factor causing this pleasant result is a simple one: the retained earnings of those non-controlled holdings we discussed earlier have been translated into gains in market value.”
Of course, the timing can’t be determined correctly and it involves probability, not a fully certainty. “The translation of retained earnings into price appreciation is highly uneven (it goes in reverse some years), unpredictable as to timing, and unlikely to materialize on a precise dollar-for-dollar basis. And a silly puerchase price for a block of stock in a corporation can negate the effects of a decade of earnings retention by that corporation. But when the purchase prices are sensible, some long-term market recognition of the accumulation of retained earnings almost certainly will occur.”
And he came to discuss the investment criteria made by Berkshire’s insurance companies: “well-run, favorably-situated, non-controlled companies that very often will pay out in dividends only small proportions of their earnings. Following this policy, we would expect our long-term returns to continue to exceed the returns derived annually from reported operating earnings.”
Inflation
Buffett related inflation to tax on capital that makes much of corporate investment unwise; it was like the “hurdle” rate of return on equity that should be achieved by corporations to produce real return for shareholders. He gave the example: “In a world of 12% inflation, a business earning 20% on equity (which very few manage consistently to do) and distributing it all to individuals in the 50% bracket is chewing up their real capital, not enhancing it. (Half of the 20% will go for income tax; the remaining 10% leaves the owners of the business with only 98% of the purchasing power they possessed at the start of the year – eve thought they have not spent a penny of their “earnings.”
Berkshire Hathaway didn’t have the corporate solution to the problem. Inflation does not improve the return on equity. And it eats up the real value of the reinvested earnings. “Earnings and dividends per share usually will rise if significant earnings are “saved” by a corporation; i.e, reinvested instead of paid as dividends. But that would be true without inflation. A thrifty wage earner, likewise, could achieve regular annual increases in his total income without ever getting a pay increase – if he were willing to take only half of his pay check in cash (his wage “dividend”) ad consistently add the other half (his “retained earnings”) to a savings account.”
Buffett said the insulation that all seek against inflation is indexing. And for capital to be truly indexed, the return on equity has to increase: “Business earnings consistently must increase in proportion to the business in the price level without any need for the business to add capital – including working capital – employed. (Increased earnings produced by increased investment don’t count.)
Financing
Buffett discussed the new notes that Berkshire had recently issued with the sinking fund and told the shareholders about the reason of financing. “Berkshire did not finance because of any specific immediate needs. Rather, we borrowed because we think that, over a period far shorter than the life of the loan, we will have many opportunities to put the money into good use. The most attractive opportunities may present themselves at a time when credit is extremely expensive – or even unavailable.”
Near the end of the letter, he summarized the key factors in Berkshire’s operating system: “Under all circumstances, we plan to operate with plenty of liquidity, with debt that is moderate in size and properly structured, and with an abundance of capital strength. Our return on equity is penalized somewhat by this conservative approach, but it is the only one with which we feel comfortable.”
Accounting and bond investment of insurers
A large part in 1980 letter Buffett spent to discuss on accounting issue and how it affected the investment decision in bonds of insurers. The details of the discussion are in this link.
The highlights of previous Berkshire shareholders’ letters can be found here:
1977
1978
1979
About the author:
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam Visit Anh Hoang's Website
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