Warren Buffett (Trades, Portfolio) published his 2019 letter to investors of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) over the weekend, and it was once again full of informative insights on the stock market and nuggets of information that could be of benefit to investors of any experience.
The power of retained earnings
Buffett devoted a large percentage of his letter to a discussion on the power of retained earnings. "At Berkshire, Charlie and I have long focused on using retained earnings advantageously," the Oracle of Omaha wrote.
Berkshire has never paid out a dividend to investors and has only just started repurchasing its own stock in sizable amounts.
Instead of returning cash to investors, Buffett has always favored reinvesting capital and retained earnings back into the conglomerate, either by buying new companies, acquiring public equities or capital investments.
On the topic of the latter, in his 2019 letter, Buffett points out that over the past decade, Berkshire has recorded $65 billion in depreciation. In contrast, internal investments in property, plant and equipment have totaled $121 billion. "Reinvestment in productive operational assets will forever remain in our top priority," he said.
This approach comes straight out of the capital allocation playbook. Capital allocation is one of the most important but misunderstood strategies among company CEOs. Many managers prioritize acquisitions and cash returns to shareholders over investments back into their businesses, which makes little to no sense.
Reinvestment should always come first if a manager can find attractive reinvestment opportunities. The next option is value-creating acquisitions. Not vanity acquisitions, which often result in value destruction.
Only when there are no opportunities for reinvestment or value-creating opportunities should cash returns to investors be considered. And this is the strategy Buffett appears to be using today.
He continues to invest billions in Berkshire's wholly-owned businesses, but has run out of attractive acquisition targets. Instead, he has started returning modest amounts of capital to shareholders while bulking up on public equities.
As Buffett went on to detail in his letter:
"We constantly seek to buy new businesses that meet three criteria. First, they must earn good returns on the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price.
When we spot such businesses, our preference would be to buy 100% of them. But the opportunities to make major acquisitions possessing our required attributes are rare. Far more often, a fickle stock market serves up opportunities for us to buy large, but non-controlling, positions in publicly-traded companies that meet our standards."
It seems as if the Oracle of Omaha will have to continue on this path for some time. Private market valuations remain elevated and it doesn't look as if private equity is going to start taking a more cautious approach to valuation anytime soon. The PE industry is still sitting on record amounts of capital, and cheap debt means it's easier to complete leveraged buyouts.
Still, even with publicly traded equities, Berkshire and its investors will profit from retained earnings of the companies it invests in. As Buffett explains in his letter:
"Both logic and our past experience indicate that from the group, we will realize capital gains at least equal to – and probably better than – the earnings of ours that they retained."
This is something investors need to consider when evaluating any investment. Retained earnings can be a great indicator of company quality, and what management chooses to do with these funds can provide insight into capital allocation skills.
There are only a few capital allocators out there that are as skilled as the Oracle of Omaha when it comes to deciding what to do with shareholder funds.
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
- Carl Icahn Has Outperformed Buffett Over the Past 20 Years
- 5 of Warren Buffett's Most Important Investment Lessons
- What Mohnish Pabrai Has Been Buying in India
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