Buffett’s 2015 annual letter to shareholders
Warren Buffett has released his 2015 annual letter to Berkshire Hathaway shareholders, with points of interest including the operating results from the ‘Powerhouse Five’, succession planning, and the prospects for more big deals.
The Powerhouse Five
As Buffett has invested in more capital-intensive businesses to help absorb Berkshire’s $18bn of annual free cash flow, Berkshire now owns what Buffett calls the Powerhouse Five, consisting of BNSF Railway, Berkshire Hathaway Energy, Marmon, Lubrizol and IMC. Combined, these companies earned US$13bn in 2015, an increase of US$650m over 2014. This is double the profits produced by the insurance business.
In 2015 BNSF Railway spent US$6bn to upgrade its rail network after shipping delays due to record grain harvests and oil production caused it to lose market share. The investment paid off, with BNSF producing a record US$6.8bn pre-tax profit (a US$606m increase from the prior year).
This represented almost all of the growth in the Powerhouse Five’s earnings. Amazingly, BNSF moves about 17% of America’s intercity freight. That’s not just rail cargo, but all freight transported by rail, truck, air, water or pipeline. And due to its on-going investment requirements, it will make the job of capital allocation easier for Buffett’s eventual replacement.
At 85 years young, Buffett is letting his key investing appointments Ted Weschler and Todd Combs run their own race. At the recent Daily Journal meeting, Charlie Munger said that Buffett didn’t like getting told what to do when he was young, so he doesn’t interfere with Ted and Todd’s choices.
Buffett praised Combs for bringing Precision Castparts (an ex holding of our Global Fund) to his attention, which ended up being Berkshire’s largest acquisition ever at US$37bn.
Buffett was quiet as usual about his potential replacement(s). We don’t expect them to create as much value as Buffett has (in percentage terms at least), but as long as they don’t waste the company’s prodigious cash flows, maintain the company’s culture and leave the company in a better position than when they found it, shareholders can’t ask for too much more.
Buffett doesn’t share other’s concerns with 3G’s aggressive management style, and expects Berkshire will do many more deals with 3G over time. While 3G targets companies with bloated cost structures and ruthlessly cuts costs, Buffett stated "we follow an approach emphasizing avoidance of bloat, buying businesses such as PCC that have long been run by cost-conscious and efficient managers".
Like the Powerhouse Five, 3G is another outlet for large amounts of cash that Berkshire is struggling to find an attractive home for – a problem that will only increase over time.
Size does matter
As mentioned in Berkshire’s 2014 letter, the next 10-20 years will see Berkshire’s earnings reach a level where management will not be able to reinvest at attractive rates of return.
Over the past decade, Berkshire has achieved an average of 10% growth on its book value, which now stands at an Everest-sized US$250bn. If it achieved this growth rate over the next decade, book value would reach US$650bn. As the sums become this large, the company will face more pressure to pay a dividend.
Buffett said that Berkshire would be ‘delighted’ to buy back shares with excess cash flow when they trade at or below 120% of book value. The share price almost got there recently, and we agree the company is worth much more.
Is Berkshire a bargain?
Unlike other CEOs, Buffett provides everything you need to value the business. Interestingly, Buffett recommended including insurance underwriting income in business earnings for the first time.
If you simply use the oft-quoted ‘two column’ approach to valuing Berkshire (where you add the per-share investments with a multiple of pre-tax operating earnings), adding the insurance profits on a multiple of 8-15 times pre-tax profits increases Berkshire’s value by 3-5%.
Overall, if you add cash and investments of US$159,794 per share with pre-tax earnings from the operating businesses (including insurance underwriting income) of US$12,304 on a multiple of eight, you get a value for the Class A shares of US$258,226 some 30% higher than the current market price of US$198,190. With best of breed management, Berkshire is likely to do much better for investors than many of the risky ETFs we see out there.
About the author
Nathan has over 20 years’ investment experience. Before joining Peters MacGregor, Nathan worked for nine years at Intelligent Investor including four years as Research Director. He contributes regularly to Australia’s financial press and appears on Sky Business, CNBC and the ABC. He graduated from Flinders University with a Bachelor of Economics degree and subsequently completed a Graduate Diploma of Applied Investment and Management. Nathan is a CFA Charterholder.
About Peters MacGregor
Peters MacGregor is a value-focused investment manager based in Sydney, Australia. For the past 15 years we proudly set ourselves apart, through our disciplined investment philosophy and in-depth analytical methods. Some call us contrarian; we certainly spend our time seeking out of favour companies. When you’re building long-term capital appreciation you need a patient and methodical approach.
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Disclosure: Peters MacGregor Capital Management Limited holds a financial interest in Berkshire Hathaway Inc. through various mandates where it acts as investment manager.