Analysis of Berkshire Hathaway's 2020 Annual Letter

Analysis of Berkshire Hathaway's 2020 Annual Letter: Briefing Document

Source: Berkshire Hathaway 2020 Shareholder Letter

This briefing document summarizes the key themes, important ideas, and significant facts presented in Warren Buffett's 2020 annual letter to Berkshire Hathaway shareholders.

Overall Performance and Value Creation:

• Strong Long-Term Performance: The letter prominently features a table demonstrating Berkshire Hathaway's historical outperformance against the S&P 500, showcasing a compounded annual gain of 20.0% from 1965-2020 compared to the S&P 500's 10.2%. The overall gain over this period is a staggering 2,810,526% for Berkshire versus 23,454% for the S&P 500. This highlights the consistent, long-term value creation for shareholders.

• GAAP Earnings Components: Buffett breaks down Berkshire's $42.5 billion GAAP earnings in 2020 into four key components: operating earnings ($21.9 billion), realized capital gains ($4.9 billion), increase in net unrealized capital gains ($26.7 billion), and an $11 billion loss from a write-down of subsidiary/affiliate value.

• Focus on Operating Earnings: Despite the large contribution from unrealized capital gains, Buffett emphasizes that "Operating earnings are what count most, even during periods when they are not the largest item in our GAAP total." He notes that Berkshire made no sizable acquisitions and operating earnings fell 9% in 2020.

• Intrinsic Value Enhancement: While operating earnings declined, Berkshire increased its per-share intrinsic value by both retaining earnings and repurchasing about 5% of its shares. This underscores the commitment to enhancing shareholder value through various means.

• Future Capital Gains: Buffett and Munger "firmly believe that, over time, Berkshire’s capital gains from its investment holdings will be substantial." This indicates confidence in the long-term prospects of their investment portfolio.

• Untapped Value in Investee Earnings: A crucial point is made about the "huge sums that investees retain on our behalf become invisible" under GAAP. These unrecorded retained earnings are seen as "building value – lots of value – for Berkshire," and are expected to eventually deliver significant capital gains.

Investment Philosophy and Strategy:

• Businesses, Not Just Stocks: Buffett and Munger view their $281 billion marketable stock holdings as a "collection of businesses," even though they don't control their operations. They share proportionately in the long-term prosperity of these companies.

• Distinction from Conglomerates: Berkshire differentiates itself from traditional conglomerates by not limiting itself to buying businesses in their entirety. Buffett explains the historical problems of conglomerates, including their focus on mediocre businesses and reliance on overvalued stock for acquisitions, often leading to deceptive or fraudulent practices. As Buffett states, "Conglomerates earned their terrible reputation."

• Owning Wonderful Businesses (Controlled and Non-Controlled): Berkshire's strategy is to "own all or part of a diverse group of businesses with good economic characteristics and good managers." The level of control is deemed "unimportant." This highlights the shift in philosophy, with Buffett acknowledging that "owning a non-controlling portion of a wonderful business is more profitable, more enjoyable and far less work than struggling with 100% of a marginal enterprise."

• Key Investment Criteria: Investment decisions are based on "a company’s durable competitive strengths, the capabilities and character of its management, and price."

• Share Repurchases as a Value Driver: Berkshire actively repurchased shares in 2020, spending $24.7 billion to acquire the equivalent of 80,998 "A" shares. This increased existing shareholders' ownership in all of Berkshire's businesses by 5.2% at no cost to them. Share repurchases are undertaken when they "would both enhance the intrinsic value per share for continuing shareholders and would leave Berkshire with more than ample funds for any opportunities or problems it might encounter." Buffett contrasts Berkshire's approach with CEOs who repurchase more shares at higher prices.

• Apple as an Example of Repurchase Power: The investment in Apple is used to illustrate the power of repurchases. Despite selling a small portion of their Apple holdings, Berkshire's ownership percentage increased from 5.2% to 5.4% due to Apple's share buybacks. This, combined with Berkshire's own repurchases, resulted in existing Berkshire shareholders indirectly owning "a full 10% more of Apple’s assets and future earnings than you did in July 2018."

• Patient, Long-Term Investing: Buffett emphasizes the importance of patience, inner calm, ample diversification, and minimizing transactions and fees for successful investing. He contrasts this with Wall Street's focus on short-term trading and fees, famously stating, "Still, investors must never forget that their expenses are Wall Street’s income. And, unlike my monkey, Wall Streeters do not work for peanuts."

Key Businesses and Assets:

• The "Big Four" Assets: Most of Berkshire's value is concentrated in four "jewels":

• Property/Casualty Insurance: The core of Berkshire for 53 years, unique due to its large capital base and the leadership of Ajit Jain. This financial strength allows an "equity-heavy investment strategy not feasible for the overwhelming majority of insurers."

• BNSF (America's Largest Railroad): 100% owned, it carries about 15% of all non-local ton-miles of goods in the U.S. BNSF has invested significantly in its infrastructure ($41 billion since 2010) and has paid substantial dividends to Berkshire ($41.8 billion). Katie Farmer is the new CEO, succeeding Carl Ice.

• Apple (5.4% Ownership): A significant non-controlled holding that has benefited Berkshire through dividends and share repurchases by Apple.

• Berkshire Hathaway Energy (BHE) (91% Ownership): A "very unusual utility business" whose annual earnings have grown significantly. Unlike BNSF, BHE retains all its earnings for significant infrastructure investment, particularly in updating the grid for renewable energy. BHE is committed to an $18 billion project to rework the western U.S. grid, demonstrating trust in America's systems and a long-term vision.

• Significant Fixed Asset Ownership: Berkshire owns American-based property, plant, and equipment with a GAAP valuation exceeding any other U.S. company, totaling $154 billion. This reflects their investment in the country's "business infrastructure." While not necessarily a sign of investment triumph in terms of high-margin businesses, it highlights their significant physical presence.

• Success Stories in Middle America: Buffett highlights the entrepreneurial spirit and success found outside coastal areas, focusing on Omaha (See's Candy, GEICO, National Indemnity, Nebraska Furniture Mart) and Knoxville (Clayton Homes, Pilot Travel Centers). These stories emphasize the importance of dedicated management, strong values, and the opportunities provided by the American framework.

The Berkshire Partnership and Shareholder Relationship:

• Partnership Mentality: A central theme is the "partnership" attitude towards shareholders, dating back to Buffett's and Munger's early partnerships. The 1983 annual report explicitly stated, "Although our form is corporate, our attitude is partnership." This commitment means treating shareholders' money as their own and having an "extreme aversion to permanent loss of capital."

• Special Kinship with Individual Investors: Buffett expresses a "special kinship" with the "million-plus individual investors who simply trust us to represent their interests." These investors are seen as having "no intent to leave," mirroring the mindset of their original partners.

• Reluctance to Court Wall Street: Berkshire is not focused on courting Wall Street analysts and institutional investors, believing they already have the "investors we want" and that they would not be "upgraded by replacements."

• Consistent "Menu": Using Phil Fisher's restaurant analogy, Buffett states that Berkshire has been serving "hamburgers and Coke for 56 years," referring to their consistent investment approach. They cherish the clientele attracted by this approach and don't intend to capriciously change their "menu."

• Pledge to Treat as Partners: While results cannot be promised, Berkshire pledges to "treat you as partners," a commitment that will extend to their successors.

Challenges and Mistakes:

• PCC Acquisition Write-Down: Buffett frankly discusses the $11 billion write-down related to the 2016 acquisition of Precision Castparts (PCC), admitting that he "paid too much for the company." He takes full responsibility, stating he was "simply too optimistic about PCC’s normalized profit potential." Despite the error in price, he still believes PCC is a "fine company – the best in its business" with a passionate CEO.

Optimism about America:

• Incubator for Human Potential: Buffett remains strongly optimistic about America, stating that "In its brief 232 years of existence, however, there has been no incubator for unleashing human potential like America."

• Economic Progress and Future: Despite challenges, the country's economic progress has been "breathtaking," and he believes progress will continue towards a "more perfect union."

• "Never Bet Against America": The letter concludes with the unwavering conclusion: "Never bet against America."

Annual Meeting Information:

• Virtual Meeting in 2021: Due to COVID-19, the 2021 annual meeting will be held virtually in Los Angeles, streamed by Yahoo and CNBC. Charlie Munger will be on stage with Buffett to answer questions.

• Return to Omaha in 2022: Buffett expresses hope and expectation for a return to an in-person annual meeting in Omaha in 2022.