On Buffett’s letter to shareholders
Berkshire Hathaway founder Warren Buffett is not in favour of using company shares to buy assets. Simon Brown explains why he agrees with this investment guru.
the last Saturday of February is eagerly awaited by investors around the world as it’s the day on which Warren Buffett publishes his annual letter to Berkshire Hathaway shareholders. (You can find it at berkshirehathaway.com, remember you are looking for the 2016 letter as it is for their 2016 financial year-end.)
Further, the annual general meeting is being webcast on 7 May, so we can watch live without the long trek to visit Buffett’s hometown of Omaha, Nebraska.
This latest letter included an update on his nearly decade-long bet that an S&P 500 index tracker would beat a basket of hedge funds. With just a year to go, the index is miles ahead of the basket of hedge funds, proving his point about excessive fees that kill returns, but also his point that active management is very difficult and return after costs are often modest and below the market average.
He also disclosed large holdings in Apple and several US airlines. Since the yearend, Berkshire has also further increased its stake in Apple. What is important here is that Buffett has not been the one buying either Apple or the airlines. He has two deputies (Todd Combs and Ted Weschler) who each manage $10bn, and they have been buying these stocks. Buffett further says that most times he only learns about the purchases when he reads the trades sheets at the end of the month. This is real trust and one of either Ted or Todd is likely to be his replacement when he finally leaves the CEO seat.
For me what stood out in this year’s letter were his comments on buying assets using shares instead of cash. His view is that if they buy assets using Berkshire shares, they end up paying far more than the actual price, as the new shares have a permanent claim on profits. Put more crudely – if you issue a share at, say, R100 to buy another company, but the share price moves to R150, you have effectively paid R150 for the company and so it goes. Forward say a decade or more, when the share is now worth R2 000 and Warren Buffett, chairman and chief executive officer of Berkshire Hathaway, plays table tennis on the sidelines of the Berkshire Hathaway annual shareholders’ meeting in Omaha, Nebraska. paying a dividend of R100 per share. You’re now paying full price for the company you bought, but you’re paying it every year in dividends! (Buffett’s take on it: “Today, I would rather prep for a colonoscopy than issue Berkshire shares.”) I always favour a company using debt to acquire other assets or businesses, as debt is repaid and there is no further obligation. Now sure, some deals may simply be too large to do exclusively with debt, but it seems almost too easy for management to run to the market for another rights issue or book build to raise the cash that dilutes existing shareholders. The one exception is perhaps if the company’s share price is absurdly overvalued, then using it to buy may not be the worst idea. But I remain sceptical and always prefer management using debt or even maybe starting by buying, say, a 51% controlling stake for cash that they can increase over time. Buffett also criticises companies that publish “adjusted” earnings that are better than the generally accepted accounting principles (GAAP) earnings. (GAAP is the US equivalent of our International Financial Reporting Standards (IFRS), and refers to generally accepted accounting principles. This is a bugbear of mine as well. With headline earnings per share (HEPS), only HEPS and diluted HEPS are IFRS terms and hence I ignore any other HEPS number that management trots out that always looks better than straightforward HEPS. As soon as I see normalised or whatever HEPS, I have no real understanding of what they mean, so I ignore them. So, mark the last Saturday of February 2018 for Buffett’s next letter, and the first Saturday in May for the webcast AGM. While you wait, start reading this year’s letter.