Many across the financial industry look to Warren Buffett’s annual letter to shareholders of his company Berkshire Hathaway, which provides pearls of wisdom and insights into the thought process of one of the greatest investors. This year was no exception. Buffett stressed the importance of holding steady as the key to investing, and to “never bet against America.”
Below we provide some key takeaways from members of our investment committee. At Propel, we work together as a team, each member providing a different perspective. These differing perspectives serve to illustrate to our clients how each of our team members brings something unique to the table. We find that multiple perspectives benefit our clients when we evaluate investments and portfolio allocations.
The Buffett Factors: Amanda Vaught on the ESG of Berkshire Hathaway
“Berkshire is a Delaware corporation, and our directors must follow the state’s laws. Among them is a requirement that board members must act in the best interest of the corporation and its stockholders. Our directors embrace that doctrine.” (Berkshire Hathaway Annual Shareholder Letter 2020, page 10)
In this year’s letter, Buffet emphasizes the legal standard of shareholder primacy. He even calls his feelings for shareholders an “unusual attachment.” Why would he take the time to highlight this aspect of his business approach?
Recently, many corporations have been moving towards a “stakeholder” primacy in their operations driven, at least in part, by the increased popularity of considering ESG (environment social and governance) factors when making investing decisions. (See my primer blog post: Social Values Investing: A Propel Primer or watch the replay of our Sept. 30, 2020 webinar, Copilot vs Autopilot: Who is Navigating your Financial Plan?, where I outline various issues in social values investing.)
Traditionally, corporations follow the guidance of economist Milton Friedman: the shareholder’s best interest is to make as much money as possible. In contrast, ESG adherents advocate that when a company incorporates other interests into their decision-making process, specifically environmental, social and governance factors, the company achieves better performance over the long-term.
For example, the Clorox Corporation is often cited as having high ESG standards for itself. It releases a lot of information about its company’s operations beyond what the SEC requires in traditional financial disclosures. For instance, does it make more business sense for Clorox to dispose of chemical waste in the cheapest way possible so their shareholders can make more money now? Or is it wiser for Clorox to dispose of chemical waste in a more expensive, but environmentally-friendly way? The latter choice may cost shareholders in the short-term; but in the long-term, they may avoid expensive lawsuits, use the environmentally-friendly choice in marketing materials to attract new customers, improve employee morale by “doing the right thing”, etc. This type of corporate decision-making is not always apparent in the financial disclosures of corporate 10-K statements. ESG adherents have touted the benefits of this approach to investing, and recent stock market returns have shown that including an ESG factor in your investment products may provide you with better returns than those that don’t include ESG factors.
Most of the ESG ETFs for sale today require companies to be a signatory to the United Nations Principles for Responsible Investment. (More information about the six principles for responsible Investment can be found on the UN’s website.) If a company does not sign on, then they will be excluded from the ETF or fund. Berkshire Hathaway is one of the only major US companies who refuse to sign. Therefore, most ESG ETFs do not include Berkshire Hathaway in their holdings.
Therefore, the use of Buffet’s annual letter to stress his dedication to shareholder primacy implies that he may not be considering concerns like ESG factors when investing. On the contrary, he spends a considerable amount of time on ESG factors. He outlines various environmental, social and governance factors he considers when investing in various corporations.
1. Environmental Factor
“When seats open up at Berkshire – and we hope they are few – we want them to be occupied by newcomers who understand and desire what we offer. After decades of management, Charlie and I remain unable to promise results. We can and do, however, pledge to treat you as partners.” (page 13)
Buffet dedicates a large portion of his letter highlighting four major investments, one of them being Berkshire Hathaway Energy (BHE). He explains how most utility companies pay dividends rather than reinvesting their earnings back into the company. The electric industry no longer relies on coal and is shifting to more environmentally-friendly methods of energy production. BHE began upgrading its outdated grid in 2006 and does not expect to finish until 2030. That is a substantial capital outlay cutting into realized profits for investors. Buffet though states that the “advent of renewable energy made our project a societal necessity.” (page 14) If he was really concerned about shareholder profits, would he be delaying returns on this substantial infrastructure investment until 2030? I believe he would because he is looking at the big picture and what is best for the shareholder long-term.
He continues by writing: “We are today searching for other projects of similar size to take on. Whatever the obstacles, BHE will be a leader in delivering ever-cleaner energy”. This project was not a one-time whim for this company but a dedication to improving its environmental impact.
2. Social Factor
“Always bet on America”
Buffett stresses repeatedly the benefits of investing in his own backyard and in the United States in general. He points out how Mrs. See’s candy company provides “life-long employment for thousands of women and men.” (page 8) In typical Wall Street wisdom, having more employees is a drain on a corporation’s bottom line and to a shareholder’s returns. If Buffett wanted the best returns possible, why would he highlight how great it was that the company offers life-long employment? He also dedicates considerable space to the businesses he’s purchased in his hometown of Omaha, Nebraska. Among them is Nebraska Furniture Mart. He didn’t say he considered multiple furniture stores to find the best value investment based on their fundamental financial returns. Instead, he stressed the fact that they were in his own community of Omaha. (page 9)
3. Governance Factor
“Charlie and I want our conglomerate to own all or part of a diverse group of businesses with good economic characteristics and good managers.” (page 5)
Buffett continually highlights the importance of a strong manager or management team throughout his letter.
He tells the story of purchasing National Indemnity Company from Jack Ringwalt in 1967. He seemingly made this investment decision purely on the basis of the manager, since he states that he “never asked for an audit”. (page 8-9) Regarding his purchase of Nebraska Furniture Mart, he stresses the “one invaluable asset” that was “unrecorded in the 1946 figures” was Louie Blumkin joining with his mother to create a “retailing miracle”. (page 9) Nowhere does he mention the company’s financial valuations.
Even when discussing a failed investment (purchasing PCC), he praises the CEO, calling Mark Donegan a “passionate manager” and states “we are lucky to have him running things.” (page 4)
In summary, while Berkshire Hathaway may be excluded from most ESG ETFs, I do not think that means that Berkshire is not an ESG-friendly corporation. At Propel we always stress the importance of knowing what you own – here is a great example of how looking under the hood of an investment helps to better understand where your money is really going.
David: Doesn’t Buffet emphasize his long-term record of making money on his introductory page that shows the from inception results of Berkshire’s share prices compared to the S&P 500?
Amanda: Yes, I think it goes without saying that Buffett is one of the most successful investors of the 20th century. You don’t get that without considering the financials.
One thing to keep in mind is that ESG factors are not an investing thesis in and of itself, but rather factors to consider after already determining that the company or stock is a sound investment based on the financials. You can have the best ESG scores in the world; but if no one is buying what you’re selling, then the company will ultimately fail.
Another point your question brings up is on disclosures. The SEC requires the publication of corporate financial information (both positive and negative). In contrast, the “soft” factors like ESG are released at the discretion of each company - what they choose to disclose and how they want to spin their story. That is also in play here – we don’t know what, if any, anti-ESG factors that Berkshire has chosen to withhold.
The Importance of Who: Danielle Woods on Qualitative Analysis
The fact that I could sit and read all 14 pages of this letter says something about Mr. Buffet's ability to tell a story. Above all, I'm a student of history. I prefer to hear about the people behind the numbers rather than treat investments as magical digits and letters that just popped into existence on a computer screen. If you consider your own life, it's the people in it who often determine what kind of a day you have (i.e. a supportive boss, lousy drivers on the road, a happy child) not the number of hours you spend doing something. For that matter, it’s why people hire our team at Propel. Why then do so many of us focus on the short-term statistics?
Our team knows we spend a lot more time learning about the "who" than other firms might. We aren't guaranteeing that this qualitative focus is going to make you richer than someone else, but it sure does make it easier to swallow temporary bad news (which impacts everyone, by the way) or feel more confident in where your money is invested on a long-term basis.
The paragraph that stood out the most to me in Mr. Buffet's letter was at the top of page 12:
"Productive assets such as farms, real estate and, yes, business ownership produce wealth - lots of it. Most owners of such properties will be rewarded. All that's required is the passage of time, an inner calm, ample diversification and a minimization of transactions and fees."
It's a good reminder that you don't just own "stocks." You own pieces of living, breathing companies comprised of real people. The question then becomes: Is this company led by good leaders who hire good employees; and do all of these folks make a positive and productive impact on their communities and environments? If the answer is yes to all of these questions, then doesn't it make sense that the bottom line will be positively impacted for those smart enough to invest in that company? I think it does. In my opinion, that "inner calm" that Warren Buffet alludes to comes from treating your investments like the positive byproducts of real people versus focusing on a bottom line that magically appears without your interest or understanding.
David: The quote you include is very consistent with what I was trying to say in a recent webinar about the compounding of reinvested earnings. That’s the math part, but you are talking about how those earnings are created in the real world.
Amanda: I think Danielle’s focus on the human side not just helps with investments, but also allows her to excel when helping clients with their personal finances.
Danielle: Thank you! I definitely enjoy the human part of it. There is a lot of satisfaction in helping people with some of their largest resources. Of course, I also enjoy the math puzzles inherent in our business; and I benefit from the work we do too. My personal investments look an awful lot like our clients’ portfolios.
Wait for the Formal Annual Meeting: David Vaught Wants to Hear More from the Successor Managers
The Berkshire Hathaway letter always sets up the annual meeting (taking place on May 1), where Warren Buffet, along with Charlie Munger, Ajit Jain and Greg Abel, elaborate from the center stage in response to hours of questions at the annual meeting itself.
One of the recent pressing questions revolves around Berkshire’s large accumulations of profits remaining in low yielding cash. In the past, Warren Buffet has been credited with wisely using this cash for acquisitions that have built the Berkshire structure of diversified companies and corporate shares that have built a huge profit making company. In what sounds a bit like throwing in the towel, Warren admits that one of those large multi-billion dollar acquisitions was a mistake. In that transaction he bought a private company, Precision Castparts from a family that built it up and owned it all without public shareholders. Precision Castparts is a major supplier of the structural framework of nearly every airliner manufactured in the world, along with many military aircraft. The company is under stress as airlines face steep losses due to covid-related shutdowns and are unrelated to the structural integrity of modern airliners. Buffet admitted in the letter not that it is a bad company; it’s just that he paid too much for it. Buffet’s candor has long impressed his admirers, but his reputation as an investment guru with expertise at reinvesting profits is questioned with humility in this letter by his own words.
In contrast, he continued his explanation of Berkshire’s continuing substantial investment in improving the electric grid with huge investments in renewable energy. At the 2020 annual meeting, he elaborated on this long range plan in the utility companies owned and managed internally by Greg Abel. He called on Greg at the meeting and had him stand in the spotlight among the directors on the floor for long detailed explanations of the merits of this idea. Now he emphasizes it more in his annual letter to shareholders, indicating he wants to do even more. This year he also promises that Greg will be at the head table to have more to say, not just standing on the floor. For a ninety year old CEO, highlighting the successor managers of Berkshire on the stage only he and Charlie have shared in the past is a major step.
Berkshire’s major insurance component collects huge premiums from policy holders prior to any claims they may later make. This is a key to his huge cash hoard. Ajit Jain will be on stage this year to comment on this aspect of Berkshire’s investment strategy. Insurance companies are known for large investments in safer bonds that match those huge potential claims with safe and sound investments that provide a certainty that the claims can be paid. The Federal Reserve Bank’s low interest rate policy to stimulate the economy puts a major clink in that strategy. Buffet acknowledges this and warns that bonds are no longer the sound investment they once were. This is a recognition of a major realignment of investment strategies that affect, not just Berkshire Hathaway and its central insurance holdings, but all investors. Take heed of Warren Buffet’s warning on this.
Amanda: Yes, it will be interesting to see how the Berkshire team expands on all of these points at the upcoming annual meeting. I also thought his assessment of the bond market and its impact on his insurance holdings was an important take-away from this letter. Do you see any other areas where the anticipated bear market in bonds will impact their corporate holdings? Do you think the warning about bonds should apply to individual’s portfolios as well as to Berkshire’s holdings?
Danielle: Definitely. Those investors who rely on bonds to protect their hard-earned wages and realized gains over the years as well as to provide some income (think retirees, pension plans, trust funds) are getting hurt in this low-interest rate environment. There is always a cost to buying investments and using custodian accounts. When your interest rate is nearly nothing, then those costs will chip away even more. That’s why we’ve had countless meetings internally at Propel over the past 18 months. We decided that we needed to reevaluate our definition of “fixed income” to include income-producing assets like infrastructure investments, Real Estate Investment Trusts (REITS), and even stocks of dividend-paying companies. The investment world is changing faster and faster, and we have to keep up.
David: Yes, it will affect their other corporate holdings, and yes, it should apply to individuals’ portfolios.
As Warren Buffet shifts his reserve holdings from bonds to equities, he is also adding a justification to keep holding large amounts of cash. Both cash and bonds are low-yielding now, but bonds also suffer interest rate risk, causing their market values to decline as interest rates increase. Cash avoids these losses while still providing a safety net to pay insurance claims.
Bonds in individual portfolios are also a safety net. They insure cash is available for withdrawals in retirement or for other withdrawals. This prevents the necessity for untimely sales of equities in weak markets to satisfy cash needs. They also contribute to sound sleep at night and less worry about down markets in equities.
Bonds have traditionally also provided interest payments to fund cash needs. With lower coupons and returns on cash, this doesn’t work as well as it once did. Because of that, we have been implementing for the more conservative part of portfolios the use of safer dividend paying stocks, real estate, infrastructure and other alternative ballast to the portfolio that provides cash flow to help meet cash needs.
As in 2020, there will be no in-person annual meeting in Omaha for 2021, but it will be broadcast to the world on May 1, 2021, via live-stream on Yahoo! Finance. We hope to attend in person in 2022 and look forward to seeing you there.