The release of Warren Buffett’s annual letter to shareholders is one of the most important events of the year for value investors. This year, the significance of the letter is accentuated by the fact that fifty years have passed since Mr. Buffett took control of Berkshire Hathaway. Mr. Buffett is effectively the “founder” of Berkshire in its current form as an investment holding company and conglomerate of operating subsidiaries.
Berkshire Hathaway’s annual report, scheduled to be released tomorrow morning, has long followed a format leading off with a table documenting Berkshire’s annual and cumulative performance followed by Mr. Buffett’s letter to investors and Berkshire’s financial results for the past year. This year, Mr. Buffett’s letter is expected to focus on his view of Berkshire’s potential evolution over the next fifty years. In addition, Charlie Munger has written a separate letter to shareholders outlining his view of Berkshire’s next fifty years. According to recent interviews, there has been no collaboration between Mr. Buffett and Mr. Munger when it comes to presenting their thoughts on Berkshire’s future.
Form Your Own Opinion
From the moment the report is posted online at 8 am eastern time tomorrow, social media and news outlets will be flooded with various opinions regarding the annual letter and Berkshire’s results. Sometimes one has to wonder how it is possible for anyone to form instant opinions but it is a virtual certainty that at 8:01 am, declarative judgments of the contents of the material will already be prevalent online. To immunize yourself against this intellectual assault, simply print the annual report on actual paper, turn off your computer, and disconnect from all social media and news until after finishing a review of the report. Failure to do so will inevitably pollute your own judgment regarding the contents of the report and, even worse, may do so in a subliminal manner as the opinions of others act in subtle ways to alter your own thinking.
First Things First
As a general rule, it is best to review the actual results of a business prior to reading management’s assessment of the results. In most cases, the reason behind doing so is to avoid being unduly influenced by management teams (or more frequently PR consultants) who are trying to spin results in some way. With Berkshire Hathaway, we do not have to worry about Mr. Buffett trying to mislead shareholders but if we read his letter prior to reading about Berkshire’s results, we will invariably be influenced by his conclusions anyway. Since it will be very difficult to read the entire financial report before peeking at Mr. Buffett’s letter, at least resolve to conduct a thirty minute review of Berkshire’s important business segments and overall financials before delving into the letter.
What to Look For in the Letter
Mr. Buffett’s letters typically follow a format where he presents his overview of Berkshire’s recent results and follows up with essays on various topics. Sometimes the topics are directly relevant to Berkshire’s business units but often they also involve much broader topics. It is likely that the letter will, to some degree, follow the format of prior years but we can perhaps expect a more lengthy review of how Berkshire’s fifty year record came about since this forms the foundation of what Berkshire is today. Once that foundation is well understood, we can look to the future and we can expect Mr. Buffett’s views on how Berkshire might evolve over the next fifty years.
There are a number of key topical areas that shareholders should look for:
Management Succession
There is no reason to believe that Mr. Buffett has changed his mind regarding continuing to lead Berkshire Hathaway as long as he is fit to do so and recent television interviews provide no reason to suspect any deterioration in his physical or mental condition. However, as the recent passing of Berkshire Hathaway Director Donald R. Keough at age 88 reminds us, the health of a man in his eighties can often change for the worse very quickly. Berkshire’s succession plan may not be needed for another ten or twenty years or it could be needed in the near future.
Mr. Buffett is nearly certain to not name the current frontrunner to be Berkshire’s next CEO but he could very well expand upon his thoughts regarding the necessary qualities and characteristics that will be needed. At this point, there are a number of Berkshire executives who are often named as potential future CEOs but, as time passes, many of these men are getting into their 60s or 70s. Mr. Buffett might drop clues regarding the desired duration of his successor’s tenure. He has previously hinted that the next CEO should have a long tenure and, if this is reinforced, one might tend to believe that the top candidate could be in his 50s rather than in his 60s or 70s.
Capital Allocation
Mr. Buffett’s prior letters have often gone into great detail regarding his views on the role of a CEO as capital allocator. This will be one of the most important roles for the next CEO in addition to maintaining Berkshire’s unique corporate culture. A key decision that the next CEO will face will involve whether to return capital to shareholders or to continue Mr. Buffett’s practice of retaining all earnings.
Shareholders who might otherwise agitate for a return of capital have long been content to allow Mr. Buffett to retain all earnings since having a large amount of cash on hand provides him with a great deal of optionality when it comes to future deals. Given Mr. Buffett’s long demonstrated mastery of the art of capital allocation, having long periods of near-zero returns on a pile of cash is viewed as an acceptable trade-off to preserve the optionality of a major deal that would be facilitated by the cash. No matter how accomplished Mr. Buffett’s successor will be, shareholders are unlikely to have the same patience. Some words of wisdom regarding how much flexibility Mr. Buffett’s successor should have in this regard might be useful.
It will be virtually impossible for Mr. Buffett to paint a picture of Berkshire in fifty years without at least implicitly rendering a verdict on Berkshire’s ability to continually deploy cash internally at attractive rates of return. If Berkshire retains all earnings for the next fifty years and is able to reinvest those earnings into attractive new subsidiaries and investments, the market capitalization of the company would be truly mind boggling. For example, if Berkshire can compound its market capitalization at 5 percent in real terms over the next five decades, its market capitalization would exceed $4 trillion in current dollars. At some point, Berkshire will clearly have to return capital to shareholders. Mr. Buffett might provide clues regarding when that day is likely to arrive.
Organizational Structure
Berkshire has a reporting structure where nearly all of the major subsidiary CEOs report directly to Mr. Buffett. This is partly due to the history behind many acquisitions and Mr. Buffett’s ability to inspire subsidiary managers to the point where they need hardly any “oversight” at all. Berkshire’s future CEO, regardless of accomplishment, is not going to be Mr. Buffett’s equal in terms of inherent capabilities or in terms of his ability to inspire unquestioned loyalty from his subordinates. However, it is critically important for Berkshire to retain a decentralized structure that empowers subsidiary managers. How should this balance be achieved? While the exact approach may be one that Berkshire’s next CEO will have to formulate, perhaps some clues will be provided in Mr. Buffett’s letter.
“What Would Warren Do?”
At some point, Berkshire’s next CEO is going to face a crisis or some event that leads shareholders and, perhaps even the Board, to start obsessing over “what Warren would do” under the same circumstances. While it is very important to take lessons from Mr. Buffett’s life and business track record, nothing could be more harmful for Berkshire’s next CEO than to be a slave to the inferred decisions of a past leader.
Apple’s current CEO, Tim Cook, had the seemingly impossible task of taking over for an ailing Steve Jobs in 2011. Mr. Jobs was adamant that Mr. Cook should not be haunted by constantly asking “what would Steve do?” but should simply do what he thought was right. Obviously, it would be foolish for Tim Cook to make decisions without considering the lessons he learned from Steve Jobs, but ultimately he has to make his own decisions. The same will be true for Mr. Buffett’s successor. Mr. Buffett might choose to paint a picture of how Berkshire shareholders should think about evaluating the next CEO in this light.
Conclusion
The best approach for reading Berkshire’s annual report, or the annual report of any company, is to make your own judgments and avoid being influenced by others until after you have first reached your own preliminary conclusions. On Saturday morning, the best approach is to print the report on actual paper and to go off-line to avoid even the temptation of considering the views of others prematurely. Spend the better part of the day reading the report and considering what Mr. Buffett and Mr. Munger have to say about Berkshire’s future and then, if you choose to, engage in discussions with other Berkshire shareholders or review what the professional pundits have to say.
Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.