You can’t argue with Buffett’s investment success: Berkshire’s book value has compounded at nearly 20% annually since he took over operations in 1965. One share worth $19 then is almost $100,000 now.
Below are some of the most useful insights from the report, followed by some investment ideas based on his current portfolio:
Buffett urges investors to think long term; he’s adamant that “fixed currency” investments are not where you want to be. There’s been an 86% decline in the value of the dollar since 1965, when Buffett took control of Berkshire; inevitable inflation corrodes the purchasing power of our currency.
While bonds yield income, taxes reduced the payout to significantly less than inflation. Since 1965, bonds have returned on average 5.7% annually, offsetting the 4.3% average yearly inflation. But, after taxes, the net return is well short. So, Buffett sees bonds and other fixed currency investments as inevitable long term losers.
However, he does appreciate the need for liquidity; Berkshire seeks to maintain $20 billion in cash for opportunities and business needs.
Gold is even worse than bonds because it pays no income. Buffett gives us a great graphic image of the world’s gold supply, indicating it could all fit into a baseball infield! He poses a great rhetorical question, asking us if we’d rather have that gold-filled field or productive assets worth the same, namely all US farmland, “sixteen Exxon Mobils” (each of which would generate $40 billion plus annually in profits), plus $1 trillion in cash!
For Buffett, because gold produces nothing, its investors can only hope that someone else will eventually pay more for it. Meanwhile, new gold production of close to $160 billion annually must be absorbed by the market just for the price to stay constant.
Buy Stocks, Real Estate, Farmland Now!
Buffett endorses investments in stocks, businesses, real estate, and farmland, or for that matter any asset that can generate income and be put to a productive use. According to Buffett, the best businesses are those whose sales can keep up with inflation with a minimum of additional capital investment.
Avoid the Over Loved
Although Buffett urges investments in productive assets, you must not overpay. He cites internet stocks and residential real estate as two situations where what started as an “initially sensible thesis” became a dangerous bubble. A similar theme comes up when Buffett discusses the wisdom of a company buying back its own stock; value is destroyed if you pay too much.
The corollary to avoiding overpaying is simply to pay as little as possible. At a minimum, you want to pay less than intrinsic value, which of course may or may not be the current quote: “The first law of capital allocation—whether the money is slated for acquisitions or share repurchases—is that what is smart at one price is dumb at another.”
Determining intrinsic value is an imprecise science; consensus has it as the amount of income generated by an investment over time, discounted to present value by some interest rate. That interest rate is probably the long term rate on US Government bonds, increased by a margin to reflect the chance that that the anticipated cash flows fall short.
Embrace Stock Buybacks
Buffett is a big fan of stock buybacks to augment shareholder value. Cash not needed for a business should be used to buy and retire its shares, with the caveat being the price paid for the shares should not exceed their intrinsic value.
Remaining shareholders benefit since there’ll be fewer shares outstanding after the buyback; each remaining share will have a larger portion of the company’s earnings. This is such a powerful tool to increase shareholder value that he’d be content to see his newly bought shares in IBM “languish” while it conducts buybacks.
Of course, Warren Buffett is not one to give a market outlook, save for his belief that over the long term solid companies bought at attractive prices will provide generous investment returns.
However, he does believe that the US economy has turned the corner, citing a 10% revenue improvement (overstated a bit due to a late 2011 acquisition) last year from his array of financial, rail, energy distribution, industrial, and retail businesses. However, he has seen no recovery in housing based on his housing related portfolio companies. Longer term, he’s bullish even for housing, as the inevitable demand based on new family formation will ultimately exceed the available housing stock.
Bank Stocks Buffett is bullish on bank stocks, believing that they have emerged from the financial crisis and are ready to roll. His favorite is Wells Fargo (WFC); indeed it’s the third largest position in Berkshire’s portfolio, just after Coca-Cola (KO) and IBM: “The banking industry is back on its feet, and Wells Fargo is prospering. Its earnings are strong, its assets solid and its capital at record levels.”
He sings the praises of Bank of America (BAC), following his $5 billion investment in it last August. Brian Moynihan, its CEO, is making all the right moves to restructure and turn around the business: “Concurrently, [Brian] is nurturing a huge and attractive underlying business that will endure long after today’s problems are forgotten.”
In addition to his preferred stock in the bank, he invested in Bank of America warrants, which entitle him to buy the common stock at $7.14 per share. With BAC shares currently trading at just over $8/share, buying BAC shares now looks like a tremendous investment if Buffett is right that the warrants will “be of great value before they expire.” Given that Buffett views favorably stock purchases at a discount to book value, BAC’s current below book value quote must make the stock particularly attractive.
While not mentioned specifically in the letter, Berkshire has a significant stake in US Bancorp (USB). This well run institution must be considered if Buffett’s rosy outlook for banks materializes. Buffett also had kind words for Jamie Dimon of JP Morgan (JPM), which Buffett has indicated he owns in his personal account.
Finally, Buffett is a long term major investor in American Express (AXP). Conditions positive for banks will provide a tail wind for this credit card issuer, while Amex’s success will have positive implications for banks generally.
Railroads For good reason, Buffett waxes enthusiastic on railroads and in particular his 2009 purchase of Burlington Northern. While historically he’s not been a big fan of capital intensive industries, the railroads enjoy a “moat,” a natural monopoly, which gives them unusual certainty of earnings power: “It is no exaggeration to characterize railroads as the circulatory system of our economy.”
Moreover, the rails are well positioned to ship coal; given that we are the Saudi Arabia of coal, and Asia, particularly China, must import as much as possible, the rails are a great way to take advantage of a booming China.
Unfortunately, Burlington no longer trades publicly, as it’s wholly owned by Berkshire. However, CSX (CSX) appears attractively priced, and we think it, too, has investment appeal for similar reasons.
For that matter, given the steep recent price declines in coal stocks, while Buffett didn’t mention this possibility, it certainly follows from the China coal demand thesis that coal stocks are worth considering. We like Peabody Coal (BTU) and CONSOL Energy (CNX).
Berkshire Hathaway Itself
There’s no question that Buffett finds his own stock, Berkshire Hathaway (BRKA), attractive. He believes the best objective measure of its value is its book value. Currently, Berkshire is trading at close to 120% of book value. But, according to Warren, at just 110% of book value Berkshire will buy back its own stock.
Are there other conglomerates run by investment savvy managers who espouse the same value orientation? Actually, there are several, but one we find particularly attractive is Loews (L). Run by the Tisch family for over 50 years, its stock has compounded at a 17.6% rate over that time period. Like Berkshire, the centerpiece of its portfolio is insurance, in Loews’ case publicly traded insurer CNA, of which Loews owns over 90%. Loews also has valuable stakes in energy and pipelines, as well as an array of smaller holdings.
If Buffett is right that the most objective value of a company, particularly a financial services oriented conglomerate, is book value, then Loews is a screaming buy, particularly compared to Berkshire. Loews book value is nearly $50, but the stock trades at more than a 20% discount to book value.
Bottom line, while the Tisch family would be the first to concede they are not Warren Buffetts, an application of Warren’s valuation metrics may make Loews a better investment than Berkshire today.