Warren Buffett (Trades, Portfolio)’s annual shareholder letter came out over the weekend. We believe that the letters, which the Oracle of Omaha has penned for decades, offer numerous precious lessons to the business community (all for free, which is just another reminder to us that sometimes value does deviate far from price). Below are our top three takeaways from this year’s reading.
“In 1924, Edgar Lawrence Smith, an obscure economist and financial advisor, wrote Common Stocks as Long Term Investments, a slim book that changed the investment world. Indeed, writing the book changed Smith himself, forcing him to reassess his own investment beliefs.
For the crux of Smith’s insight, I will quote an early reviewer of his book, none other than John Maynard Keynes: ‘I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest operating in favor of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.’
Though investors were slow to wise up, the math of retaining and reinvesting earnings is now well understood. Today, school children learn what Keynes termed “novel”: combining savings with compound interest works wonders.”
Buffett started the letter with the vital concept of retained earnings, which is crucial to compounding shareholder wealth but is somehow underrated, at least among retail investors per our observation. Nowadays, the discussion of yield seems popular over a few investment forums, and it is evident that equity-oriented products with the word “income” in their names could lead to better sales results.
As discussed in a previous article, we think that yield-chasers are forgoing the unique advantage of stocks, which is the ability to reinvest a portion of profits in growth opportunities at the book value (instead of the market price). Looking at Berkshire’s top holdings, we see a 79% earnings retention rate at American Express (AXP, Financial), 76% at Apple (AAPL, Financial) and 76% at Bank of America (BAC, Financial). The future should look bright to shareholders, even without much cash payout at hand.
“Fortunately, the fallout from many of my errors has been reduced by a characteristic shared by most businesses that disappoint: As the years pass, the “poor” business tends to stagnate, thereupon entering a state in which its operations require an ever-smaller percentage of Berkshire’s capital. Meanwhile, our “good” businesses often tend to grow and find opportunities for investing additional capital at attractive rates. Because of these contrasting trajectories, the assets employed at Berkshire’s winners gradually become an expanding portion of our total capital.”
Any investor inevitably makes mistakes over time. Nonetheless, Buffett has his well-thought-out and simple “strategy” to minimize the lag from those “poor” businesses – that is, the leverage of his prudent, skillful capital allocation. Such an approach may not apply as much to stock investing at the portfolio level, as trades occur at the market price rather than the book value. But at least it reflects the significance of “keeping the winner and selling the loser.”
“Over the years, board ‘independence’ has become a new area of emphasis. One key point relating to this topic, though, is almost invariably overlooked: Director compensation has now soared to a level that inevitably makes pay a subconscious factor affecting the behavior of many non-wealthy members. Think, for a moment, of the director earning $250,000-300,000 for board meetings consuming a pleasant couple of days six or so times a year. Frequently, the possession of one such directorship bestows on its holder three to four times the annual median income of U.S. households.
Paid-with-my-own-money ownership, of course, does not create wisdom or ensure business smarts. Nevertheless, I feel better when directors of our portfolio companies have had the experience of purchasing shares with their savings, rather than simply having been the recipients of grants.”
Lastly, Buffett explained the problems with today’s U.S. corporate governance. Although acknowledging the improvement in light of regularly scheduled executive sessions at which the CEO is barred, he remains concerned about the independence of the board, given that director compensation has soared to a level that is “three to four times the annual median income of U.S. households.” One of the filters that may help is to look for directors who own shares purchased with their own savings, as Buffett indicated. However, this looks like a fairly rare type of insider transaction, per our real-life experiences with Corporate America today.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Berkshire Hathaway.
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