🦎 Warren Buffett's 10 investment secrets
Insights from Berkshire Hathaway's FY22 shareholder letter
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Berkshire Hathaway recently reported its FY22 performance.
I’ve received many requests from community members to cover Berkshire.
Every year, like clockwork, the investment community eagerly awaits the arrival of Berkshire Hathaway's annual report. And while the financial statements are important, the accompanying letter to shareholders from Warren Buffett (Chairman and CEO) steals the show.
In these letters, Buffett shares his insights and wisdom on investing, business, and life, offering a glimpse into the mind of one of the world's most successful and respected investors. For those in the know, these letters are like gold dust, a treasure trove of advice and guidance that can help even the most seasoned investors make better decisions.
But what is it about these letters that makes them so unique? Is it Buffett's folksy writing style, peppered with anecdotes and witticisms? Or is it the depth of knowledge and experience that he brings to bear, honed over decades of investing and business success?
In truth, it's a little bit of both. Buffett's letters are a masterclass in storytelling and copywriting, combining vivid language and compelling narratives with hard data and evidence. Whether discussing the benefits of investing in index funds, recounting the story of his first stock purchase, or sharing his thoughts on the broader economy, Buffett has a knack for distilling complex concepts into simple, memorable lessons.
And that's why, year after year, investors eagerly devour these letters, poring over every word and phrase in search of that next nugget of wisdom that could help them make better investment decisions. So whether you're a seasoned pro or just starting, there's always something to be learned from Buffett's letters to shareholders, making them an indispensable part of the investment community's collective knowledge base.
So today, we’ll cover the following:
How Berkshire Hathaway makes money.
Key insights from the latest shareholder letter.
At its core, Berkshire Hathaway is a holding company that owns many businesses across various industries, from insurance and finance to manufacturing and retail. The company's portfolio includes well-known brands such as GEICO, Dairy Queen, and Duracell and several lesser-known but highly profitable subsidiaries.
One of the keys to Berkshire Hathaway's success is its unique business model, which involves acquiring businesses with strong management teams and allowing them to operate largely independently. Rather than imposing strict cost-cutting measures or other changes, Berkshire Hathaway typically takes a hands-off approach, allowing its subsidiaries to continue doing what they do best.
Of course, this approach wouldn't work if the businesses themselves weren't profitable, and that's where Berkshire Hathaway's shrewd investment strategy comes in. Over the years, the company has amassed a staggering portfolio of stocks and other securities, including major positions in companies like Apple, Coca-Cola, and American Express.
The equity portfolio was worth $298 billion at the end of December 2022.
Six positions made 80% of the allocation:
Apple (AAPL) 39%.
Bank of America (BAC) 11%.
Chevron (CVX) 9%.
American Express (AXP) 9%
Coca-Cola (KO) 8%.
Kraft Heinz (KHC) 4%
But perhaps the most distinctive aspect of Berkshire Hathaway's investment strategy is its focus on value investing. This approach involves buying stocks undervalued by the market and holding onto them long-term. By focusing on companies with solid fundamentals and sustainable competitive advantages, Berkshire Hathaway has generated outsized returns for its shareholders.
In addition to its investment portfolio, Berkshire Hathaway also earns money through its insurance businesses, including GEICO and several other specialty insurers. The company can generate significant profits in this highly competitive industry by pooling risk and leveraging its financial resources.
All of these factors combine to make Berkshire Hathaway one of the world's most successful and highly respected companies, with a track record of consistent growth and profitability.
Revenue is broken down by segment:
🦎 Insurance (~27% of overall revenue): Including GEICO, Berkshire Hathaway Primary Group, Berkshire Hathaway Reinsurance Group, and Alleghany (acquired in October 2022 for $12 billion).
🚊 BNSF (~9% of overall revenue): Burlington Northern Santa Fe operates one of the largest railroad systems in North America.
⚡️ BHE (~9% of overall revenue): Berkshire Hathaway Energy, a global energy company with subsidiaries including utility companies.
🧑🏼🏭 Manufacturing (~25% of overall revenue): industrial (aerospace, chemicals), building (prefabricated and site-built homes, flooring, roofing), and consumer products (recreational vehicles, Duracell, various apparel, footwear, and more).
🍔 McLane (~18% of overall revenue): Wholesale distribution services to companies like Walmart and 7-Eleven.
🍫 Services & retailing (~13% of overall revenue): Dairy Queen, Borsheim Jewelry, See’s Candy, and more.
Berkshire’s major equity portfolio drives a significant part of the company’s earnings. As a result, the analysis of net earnings is misguiding because it depends heavily on short-term portfolio performance.
In 2022 (a bear market for US equities), the investment losses more than offset the profits from the business segments. But it doesn’t say much about the long-term potential of the business.
Let’s look at the numbers from the past year.
1. Berkshire Hathaway FY22
Here is the bird’s-eye view of the income statement.
Revenue grew +9% Y/Y to $302 billion.
🦎 Insurance grew +10% Y/Y to $82 billion, with a 9% margin.
🚊 BNSF grew +11% Y/Y to $26 billion, with a 30% margin.
⚡️ BHE grew +5% Y/Y to $26 billion, with a 12% margin.
🧑🏼🏭 Manufacturing grew +10% Y/Y to $76 billion, with a 15% margin.
🍔 McLane grew +8% Y/Y to $53 billion, with a 1% margin.
🍫 Services & retailing grew +10% Y/Y to $38 billion, with a 12% margin.
Overall segment operating margin was 11% (-0.2% Y/Y).
Investment and derivative losses were ($68) billion.
Net loss before tax was ($31) billion.
Operating cash flow: $37 billion (12% margin, -2pp Y/Y).
Cash and short-term investments: $129 billion.
Long-term debt: $128 billion.
So what are the big takeaways?
The operating business had a slight margin compression, driven by the railroad businesses.
Capital expenditures grew +16% to $15 billion.
Excluding the significant investment losses caused primarily by a bear market for US equities, the operating portion of the business was pretty uneventful, except for the acquisition of Alleghany in Q4.
The company bought back $7.9 billion of its common stock during FY22, illustrating that management found the stock attractive enough to continue buybacks.
Is the business sustainable?
Berkshire Hathaway has a huge cash pile on its balance sheet, and it’s by design. An insurance company needs to keep a lot of cash on its balance sheet to ensure it can pay out claims to its policyholders.
Insurance companies make money by charging premiums and investing that money until they need to pay out claims. However, they also need to keep a significant amount of cash on hand in case of a sudden surge in claims (such as natural disasters).
If an insurance company doesn't have enough cash, it may be forced to sell off investments at a loss or borrow money, which could hurt its financial stability. By keeping a lot of cash on its balance sheet, Berkshire Hathaway is balancing risks and opportunities.
2. Key insights from the shareholder letter
Here are ten lessons from Warren Buffett’s letter this year that remain elusive to many investors. That’s why I like to call them “secrets.”
The power law governs returns
About his 58-year track record as an investor, Buffett explains:
“At this point, a report card from me is appropriate: In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. […] Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years – and a sometimes-forgotten advantage that favors long-term investors such as Berkshire.”
You may have heard of it as the power law, Pareto or 80/20 rule. In short, 20% of our actions impact 80% of our results. The same is true in investing. If you let your investment enough time to deliver on their premise, you only need a few home runs to win the game.
Water the flowers, cut the weeds
If you let a portfolio evolve organically, the winners and losers take care of themselves. Winners overtake the portfolio, while losers become infinitely small (as long as you don’t add to them). Buffett explains:
“The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders. And, yes, it helps to start early and live into your 90s as well.”
The power of compounding
“In August 1994 – yes, 1994 – Berkshire completed its seven-year purchase of the 400 million shares of Coca-Cola we now own. The total cost was $1.3 billion – then a very meaningful sum at Berkshire.
The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow.”
Take it easy, my brother Charlie
Buffett’s lifelong friend Charlie Munger (vice-Chairman of Berkshire) greatly influenced his mindset. So Buffett brought some of Charlie’s classic quotes in the letter. You might already know them all. But if you don’t, enjoy these nuggets of wisdom:
The world is full of foolish gamblers, and they will not do as well as the patient investor.
If you don’t see the world the way it is, it’s like judging something through a distorted lens.
All I want to know is where I’m going to die, so I’ll never go there. And a related thought: Early on, write your desired obituary – and then behave accordingly.
If you don’t care whether you are rational or not, you won’t work on it. Then you will stay irrational and get lousy results.
Patience can be learned. Having a long attention span and the ability to concentrate on one thing for a long time is a huge advantage.
You can learn a lot from dead people. Read of the deceased you admire and detest.
Don’t bail away in a sinking boat if you can swim to one that is seaworthy.
A great company keeps working after you are not; a mediocre company won’t do that.
Warren and I don’t focus on the froth of the market. We seek out good long-term investments and stubbornly hold them for a long time.
Ben Graham said, “Day to day, the stock market is a voting machine; in the long term it’s a weighing machine.” If you keep making something more valuable, then some wise person is going to notice it and start buying.
There is no such thing as a 100% sure thing when investing. Thus, the use of leverage is dangerous. A string of wonderful numbers times zero will always equal zero. Don’t count on getting rich twice.
You don’t, however, need to own a lot of things in order to get rich.
You have to keep learning if you want to become a great investor. When the world changes, you must change.
Warren and I hated railroad stocks for decades, but the world changed and finally the country had four huge railroads of vital importance to the American economy. We were slow to recognize the change, but better late than never.
Finally, I will add two short sentences by Charlie that have been his decision-clinchers for decades: “Warren, think more about it. You’re smart and I’m right.”
Focus on the business, not the stock
Investing like a business owner goes a long way to keeping a long-term mindset:
“Please note particularly that we own publicly-traded stocks based on our expectations about their long-term business performance, not because we view them as vehicles for adroit purchases and sales. That point is crucial: Charlie and I are not stock-pickers; we are business-pickers.”
Why Berkshire has been a “cannibal”
I covered the benefit of stock buybacks in How To Analyze a Balance Sheet. Berkshire has been returning capital to shareholders through buybacks, including in FY22. Buffett explains:
“The math isn’t complicated: When the share count goes down, your interest in our many businesses goes up. Every small bit helps if repurchases are made at value-accretive prices. Just as surely, when a company overpays for repurchases, the continuing shareholders lose. At such times, gains flow only to the selling shareholders and to the friendly, but expensive, investment banker who recommended the foolish purchases.”
Losers are part of investing
Over the years, I have made many mistakes. Consequently, our extensive collection of businesses currently consists of a few enterprises that have truly extraordinary economics, many that enjoy very good economic characteristics, and a large group that are marginal. Along the way, other businesses in which I have invested have died, their products unwanted by the public. Capitalism has two sides: The system creates an ever-growing pile of losers while concurrently delivering a gusher of improved goods and services. Schumpeter called this phenomenon “creative destruction.”
About 2 out of every 5 stocks are money-losing investments. They are unavoidable in an investing process. It’s critical to keep a holistic view.
The not-so-efficient market hypothesis
There are moments when stocks present excellent opportunities for long-term investors. Buffett continues:
“One advantage of our publicly-traded segment is that – episodically – it becomes easy to buy pieces of wonderful businesses at wonderful prices. It’s crucial to understand that stocks often trade at truly foolish prices, both high and low. “Efficient” markets exist only in textbooks. In truth, marketable stocks and bonds are baffling, their behavior usually understandable only in retrospect.”
Market forecasts are worse than useless
It’s well-documented that trying to forecast market movements is a waste of time.
As someone writing regularly about investing for more than five years, it still baffles me that this reality remains elusive to most market participants.
Much of the content consumed in the financial world is about predicting near-term market movements. Why? Probably because it’s seducing and entertaining to listen to someone reading a crystal ball. Unfortunately, it’s a waste of time and doesn’t fuel personal growth. Reading about what may happen next week is obviously useless a week later.
Buffett explains about the US economy:
“During the decade ending in 2021, the United States Treasury received about $32.3 trillion in taxes while it spent $43.9 trillion.
Though economists, politicians and many of the public have opinions about the consequences of that huge imbalance, Charlie and I plead ignorance and firmly believe that near-term economic and market forecasts are worse than useless.”
As you know, this newsletter is business-focused, and I don’t opine on what will happen next in the economy. If you wondered why, now you know.
Skin in the game
I first came across the concept of skin in the game via Nassim Taleb. His thesis is that having a measurable risk when making a significant decision is necessary for fairness, commercial efficiency, and risk management.
Buffett also applies this principle at Berkshire:
“Our CEO will always be the Chief Risk Officer – a task it is irresponsible to delegate. Additionally, our future CEOs will have a significant part of their net worth in Berkshire shares, bought with their own money. And yes, our shareholders will continue to save and prosper by retaining earnings. At Berkshire, there will be no finish line”
Berkshire Hathaway has built a legacy of value investing and long-term thinking. While its iconic leaders, Buffett and Munger, won’t be at the helm forever, the company has established a strong foundation and a culture of excellence that is likely to endure.
That’s it for today!
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