I have never been a big fan about writing on Warren Buffet. Maybe it is my natural contrarian nature or the saturation of his coverage in the media, but recently I found myself reading his annual letter to shareholders for the first time for a specific reason: I am now a shareholder. This didn’t come along by purchasing the shares outright, Berkshire’s B-shares are $250 currently and with the ability to now purchase fractional shares, the ability to purchase A-shares is available to anyone as well. Rather, these were a transfer to me by a family member who wanted to gift some B-shares to me that they had purchased when originally issued in the mid 1990’s. This gives me a cost basis of about $20 a share compared to the current price of $250 per share. If taxes weren’t a concern I may consider selling the shares and just placing them in an ETF that tracks an index like small caps or the wider market.

Berkshire shares have beaten the market from the initial start date of the B-share issuance, generating a 10.5% return compared to that of the S&P 500 at 9.26%. However, more recently the shares have lagged the large cap benchmark which returned 13.5% annually over the past 10 years compared to about 12% annually for Berkshire shares. This shouldn’t be a surprise. Berkshire is so large at this point, the 7th largest company in the S&P by market cap, that it will be almost impossible to beat the market without taking oversized risks. Even it’s bet on Apple, which was a good call, isn’t enough to move the meter for the company to push it ahead of the market, which is now dominated by the high flying tech companies.

The funds that are beating the market in this environment also beat the market in terms of the risk they are taking. Cathie Woods is living her 15 minutes of fame through her ARK ETF’s but a look under the hood just shows she’s overexposed to tech and especially to overpriced names like Tesla. This outperformance won’t last in the long term and the long term investors know that.

So in addition to keeping my newly acquired Berkshire shares for tax reasons, I find that I agree with the fundamental philosophy of Buffet in terms of his buying companies at a reasonable price and having a long term mindset that largely ignores the day to day of the overall market. As soon as the letter is issued, media companies and bloggers jumó on the letter to see what Buffet has to say about current events but beyond the current events, I find that the gift of Buffet, besides being a genius investor, is to make complicated issues simple and explain them in layman’s terms. Here there are a few nuggets we can take away from the letter.

Bonds Are Too Expensive

Buffet notes that bonds are just not a good investment overall right now. The ultra low rates produce winners and losers. Winners are those that hold assets and issue debt. This could be a homeowner who has a mortgage (long housing, short bonds) or a tech company that has hold intellectual property through patents and also issues debt (long IP assets and short bonds). The losers are going to be pension funds, insurance companies and retirees who depend on the payout from fixed income assets to either value their own assets or live off of. Rates being lower requires bigger contributions from pensioners and massive purchases of fixed rate investments for insurance companies to keep the present value of assets stable. Buffet describes:

And bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.

Here he also cautions that low rates could end up getting many into trouble by seeking yield in riskier assets:

Some insurers, as well as other bond investors, may try to juice the pathetic returns now available by shifting their purchases to obligations backed by shaky borrowers. Risky loans, however, are not the answer to inadequate interest rates. Three decades ago, the once-mighty savings and loan industry destroyed itself, partly by ignoring that maxim.

The price swings of stocks are closely watched by the media but the swings in prices for long term bonds are largely ignored. Corporate long term bonds, represented by the Vanguard Long Term Corporate Bond ETF VCLT, has fallen 7.2% this year. The Vanguard Long Term Treasury ETF, VGLT has fallen 10.56% since the end of 2020 and 15.7% in the last year. This is in contrast to the period from December 2019 to March 2020, where long term treasuries shot up by 22% as investors sought the liquidity and safety of treasuries from the uncertainty of the pandemic. In retrospect the long trades of 2020 were long term treasuries in the first 3 months followed by long tech for the rest of the year. This hypothetical strategy would have yielded an 87% return.

On Why Conglomerates Usually Lose

Many market commentators focussed on the fact that Buffet announced in his letter that he had repurchased about 5% of the shares of Berkshire, this is an easy way to increase your earnings. As the number of shares dwindles, even this will push the earnings per share up, all other things being equal. Since Berkshire doesn’t believe in paying dividends, this is a phantom way of paying dividends to investors. Personally I prefer this way because it keeps me from having to pay taxes on dividends. Again here, Buffet shows why he is so lauded, he truly looks out for his shareholders and has their best interest in mind.

One aspect that may have been a bit overlooked however, was his simple yet intuitive defense of his firm’s conglomerate status.

Over time, conglomerates have generally limited themselves to buying businesses in their entirety. That strategy, however, came with two major problems. One was unsolvable: Most of the truly great businesses had no interest in having anyone take them over. Consequently, deal-hungry conglomerateurs had to focus on so-so companies that lacked important and durable competitive strengths. That was not a great pond in which to fish.

Beyond that, as conglomerateurs dipped into this universe of mediocre businesses, they often found themselves required to pay staggering “control” premiums to snare their quarry. Aspiring conglomerateurs knew the answer to this “overpayment” problem: They simply needed to manufacture a vastly overvalued stock of their own that could be used as a “currency” for pricey acquisitions. (“I’ll pay you $10,000 for your dog by giving you two of my $5,000 cats.”)

Basically, Buffet is saying that his firm differentiates itself in that it is perfectly happy taking minority stakes in great businesses and is content to let a great business get on with what they do best: making money for their shareholders.

I personally saw this happen with my own investments when my Monsanto shares were purchased for a huge premium a few years ago by Bayer. This was a win win for the shareholders because the all cash deal was closed right before Monsanto had to deal with a Roundup scandal that ended up costing Bayer $2 billion to settle. Investors in Monsanto received both cash at an inflated valuation as well as not having to deal with the downside that would have likely come of having to deal with the Roundup lawsuit.

On top of that, repurchasing his own shares has allowed Buffet to double up on Apple. How? He explains very simply that while he has repurchased 5% of Berkshire shares, Apple has been busy repurchasing about 5% of their own shares since Berkshire bought their stake in 2016. Owners of Berkshire now own 10% more of Apple’s profits than they did in 2018 without having to lift a finger, this shows the magic of having a sturdy investment philosophy and putting shareholders first even when you own minority stakes in some businesses.

Four Jewels

Finally Buffet simplifies his business. The term conglomerate is synonymous with complexity, something that is the antithesis of his philosophy. So to paint Berkshire in a simpler light he names the 4 businesses that make up what he calls the “Jewels” of his empire: Insurer GEICO, the railroad Burlington Norther (BNSF), Berkshire Hathaway Energy and his Apple shares. The former 3 being wholly owned by Berkshire while the stake in Apple being 5%. The minority stakes in other companies are also shown in a very simple table with the percentage ownership Berkshire has as well as the current market value. There is potentially a subtle hint as to why he is characterizing his company this way.

Buffet is 90 years old and there likely isn’t much time for him left. Although he has stepped away from the day to day of the company, his personality and market moving comments loom large. We’re he to pass, there would be a big question in many investors minds on how to value such a company which both owns huge companies as well as has minority stakes in others. This may be Buffet’s attempt to leave a simplified overview on what the company is and what drives the controlling versus minority run stakes in businesses. Potentially it could represent his wish to keep the company in tact should he pass as many have speculated it would need to be broken up into supérate parts were he to pass on. This will be at the discretion of Berkshire’s shareholders but given the reasonable return seen so far as well as a philosophy which saves investors on taxes, this investor would like to see it go at least a little longer than just the next few years.

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