Notes on Warren Buffet’s 2016 shareholder letter

Warren Buffet released Berkshire’s annual shareholders letter last month. Here are the highlights of the letter.

  • Companies buying their own stock does not mean that the funds are being deployed for non productive uses. People should really only complain if the company is running out of cash but is still buying stock.
  • Berkshire’s intrinsic business value far exceeds its book value. This is largely due to its stakes in the insurance industries. Insurance industry has a benefit of collecting large amounts of premiums — “float” — before it is required to pay off the claims. If the underwriting of the risks of insurance is done carefully, which Berkshire places extreme emphasis across the board, then the float and its income would continue to increase providing that free cash for further investing. Buffet argues that, the entire float is accounted on its books as a liability, which is incorrect. As it is impossible to be in a situation that requires you to pay the entire float without replacing it. As a result the benefits of having this float on the books is never captured in its book value and hence the intrinsic value is higher than its book value.
  • The downside is that, because of the fact that insurance companies enjoy this cash influx before they are required to pay, it also leads to a lot competition resulting in buying other insurance companies very competitive. Also, because of the low interest rates in the current market, the new bonds which are the investment vehicle of choice for these insurance companies results in lower income. So, for the next 10 years there will be a downward pressure on the incomes coming in from the this float.
  • Apart from insurance, Berkshire has major investments in public utilities — both rail road and energy. Both of them are long term bets but also heavily regulated. Buffet’s bet is that governments in general favor capital inducing companies and hence regulation will always be on their side. As an aside, rail road is more efficient means of transporting commercial goods than trucks, at least by 3–4 times.
  • Berkshire is also getting into real estate. Today we see a lot of Berkshire realty companies around various cities in US. Buffet is bullish on their long term prospects of their real estate business.
  • Berkshire has investments in 44 companies in the manufacturing, retail and service operations. This doesn’t look like a home run but is still providing a decent return on investment. Buying these operations, Berkshire incurred heavy investment capital.
  • Companies should not focus on adjusted earnings (typically adjusted for restructuring or stock based compensation expenses). Typically many firms like to ignore the effect of restructuring on their earnings and focus on adjusted earnings. But buffet opines that, restructuring is part and parcel of the business and that needs to be taken into account. If you do not include these expenses, how is the market supposed predict what the future expenses would be. There is no logic in not including the compensation being paid to employees in your earnings.
  • In general, taxes on dividends is lesser than the taxes on capital gains. Therefore, buffet prefers to get dividends over capital gains.
  • Investors should stick with low cost index funds. Over a long period of time, passive investors investing in low cost index funds tend to outperform actively managed hedge funds. Also, what seems easy for a million dollar fund seems difficult for a billion dollar fund. Buffet tells his clients that as the fund size increases the returns are likely to decrease.