Two value investors I admire, Whitney Tilson (Trades, Portfolio) and Bill Ackman (Trades, Portfolio), have recommended that to learn about value investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we go over the 1980 letter.
Non-controlled ownership earnings
The letter has a very interesting and important section about non-controlled ownership earnings. This pertains to the appropriate accounting procedures when a company such as Berkshire Hathaway has ownership stakes in other companies. This is mostly based on the percentage owned and has important implications for financial statement analysis.
Buffett explained:
"Generally accepted accounting principles require (subject to exceptions, naturally, as with our former bank subsidiary) full consolidation of sales, expenses, taxes, and earnings of business holdings more than 50% owned. Blue Chip Stamps, 60% owned by Berkshire Hathaway Inc., falls into this category. Therefore, all Blue Chip income and expense items are included in full in Berkshire’s Consolidated Statement of Earnings, with the 40% ownership interest of others in Blue Chip’s net earnings reflected in the Statement as a deduction for “minority interest”.
Full inclusion of underlying earnings from another class of holdings, companies owned 20% to 50% (usually called “investees”), also normally occurs. Earnings from such companies - for example, Wesco Financial, controlled by Berkshire but only 48% owned - are included via a one-line entry in the owner’s Statement of Earnings. Unlike the over-50% category, all items of revenue and expense are omitted; just the proportional share of net income is included. Thus, if Corporation A owns one-third of Corporation B, one-third of B’s earnings, whether or not distributed by B, will end up in A’s earnings. There are some modifications, both in this and the over-50% category, for intercorporate taxes and purchase price adjustments, the explanation of which we will save for a later day.
Finally come holdings representing less than 20% ownership of another corporation’s voting securities. In these cases, accounting rules dictate that the owning companies include in their earnings only dividends received from such holdings. Undistributed earnings are ignored. Thus, 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 intercorporate dividends) either (a) $1 million if X declared the full $10 million in dividends; (b) $500,000 if X paid out 50%, or $5 million, in dividends; or (c) zero if X reinvested all earnings."
This is important to Berkshire because its insurance business owns multiple companies with less than 20% ownership. As lots of those companies pay only a small part of their net income out as dividends, then only a small part of these companies’ current earnings power are reflected in Berkshire’s current operating earnings. Investors only taking a surface level look at Berkshire’s earnings would see only what’s been earned by dividends, and not the overall “economic well-being,” which the underlying earnings would demonstrate.
Buffett wants to visit this issue because Berkshire’s investments in the under 20% ownership category had grown rapidly in the prior few years given Buffett’s view that equity markets had presented many attractive opportunities. The result, thanks to the growth in earnings from those companies Berkshire bought, was “an unusual result; the part of 'our' earnings that these companies retained last year (the part not paid to us in dividends) exceeded the total reported annual operating earnings of Berkshire Hathaway.” The accounting gives a misleading presentation, or an “earnings iceberg” as Buffett calls it, as less than half of the true earnings are presented by Berkshire. This is quite rare, but the guru realizes this is probably going to be a recurring issue for Berkshire and wants to provide to shareholders a truer picture of the economic situation. As he puts it, “earnings reality differs somewhat from generally accepted accounting principles.” In a sense, control is theoretical; what is important is what is the reinvestment returns of retained earnings (the portion of earnings not paid out to Berkshire in dividends). The point is, sometimes retained earnings destroy value and are worth less than 100 cents on the dollar, but in this case, Buffett believes much of the retained earnings not captured in Berkshire’s reporting have “an economic value to us far in excess of 100 cents on the dollar.”
The investor is saying that accounting rules distort the appearance of value of retained earnings because how they are reported depends on what percentage the investor, Berkshire, is holding in the portfolio company. Accounting rules are based on the concept of control, but Berkshire does not intervene in the operations of a portfolio company and, therefore, the control does not really matter. He wrote, “The value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage.”
He continued:
"Our view, we warn you, is non-conventional. But we would rather have earnings for which we did not get accounting credit put to good use in a 10%-owned company by a management we did not personally hire, than have earnings for which we did get credit put into projects of more dubious potential by another management - even if we are that management."
The lesson is that accounting rules and treatments can make a company look better or worse than the economic reality. So when a company is invested in another company or a group of companies, we should try to understand the difference between what we see and what we get.
Financing
In 1980, Berkshire raised $60 million in debt. Buffett's explanation made it sound like a wise decision. He wrote:
"Unlike most businesses, 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 to good use. The most attractive opportunities may present themselves at a time when credit is extremely expensive - or even unavailable. At such a time we want to have plenty of financial firepower."
The lesson is that debt is not always a bad thing. For patient investors, cash has a degree of optionality that is often forgotten about. However, debt needs to be done carefully. He wrote:
"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."
