SAT, FEB 22, 2020

WARREN BUFFETT WATCH
Shareholder letter special edition

Hold on to those earnings

Warren Buffett's annual letter to Berkshire Hathaway shareholders, released this morning, features an in-depth explanation of the "power of retained earnings."

Buffett cites a 1924 book that "changed the investment world" by showing that companies reinvesting some of their profits in the business ... instead of paying dividends to shareholders ... benefited from "an element of compound interest."

By reinvesting profits now, companies could generate even more money later.

He writes that he and partner Charlie Munger have "long focused on using retained earnings advantageously" by putting a priority on reinvesting in productive operation assets for the companies Berkshire owns.

But even for Berkshire's stock portfolio, they expect that as a group the companies "will realize capital gains at least equal to -- and probably better than -- the earnings of ours that they retained."

As a result, "Overall, the retained earnings of our investees are certain to be of major importance in the growth of Berkshire's value."

It's not explicit in the letter, but Buffett's seminar on retained earnings may also be read as a defense of Berkshire's own rejection of calls by some of its shareholders to pay a dividend from its big $128 billion in cash. (Low interest rates mean those retained earnings aren't contributing very much to profit growth or the stock's price, which has lagged the overall stock market.)

And while a "modestly favorable" price/value equation prompted Berkshire to repurchase $5 billion of its stock in 2019, he and Munger won't be more aggressive about buybacks unless that price-to-value discount widens.

Stocks vs bonds: If, but, and, even so, Beware!

Buffett restated his belief that “if something close to current rates should prevail over the coming decades and if corporate tax rates also remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term, fixed-rate debt instruments.”

But, "Charlie and I have no idea what rates will average over the next year, or ten or thirty years."

And, "Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater."

Even so, stocks are "the much better long-term choice (over bonds) for the individual who does not use borrowed money and who can control his or her emotions."

"Others? Beware!"

"The Road Ahead"

Two of the top candidates to eventually succeed Buffett as Berkshire's CEO, Ajit Jain and Greg Abel, will be "given more exposure" at May's annual meeting.

Buffett writes that questions may be specifically posed to them. "They are outstanding individuals, both as managers and as human beings, and you should hear more from them."

The letter doesn't say if Jain and Abel will be sitting with Buffett and Munger at the main table.

Buffett also writes (again) that due to its strong structure and corporate culture, Berkshire is "100% percent prepared" for his and Munger's eventual departure.

He notes that his will explicitly forbids the sale of any Berkshire stock ahead of its gradual distribution to charitable foundations. He's even absolved executors and trustees from any liability for failure to diversify, which would be the standard course of action.

"I believe ... there is a high probability that my directive will deliver substantially greater resources to society that would result from a conventional course of action."

The problems with boards and barbers

Buffett says that one reason he's so confident about Berkshire's future is the "judgment and fidelity" of its directors, even as they're "tested by Wall Streeters bearing fees."

For other companies, though, he's much more pessimistic.

Even though audit committees are working harder, they're still "no match for managers who wish to game numbers ... often prompted (more) by ego than by a desire for financial gain."

Compensation committees are relying on consultants who justify their high fees by coming up with increasingly complicated compensation packages.

Director pay has grown to the point that the money "inevitably" becomes a "subconscious factor affecting the behavior of many non-wealthy members."

Chief executives want a "good" board member who doesn't challenge compensation or acquisitions. "CEOs don't look for pit bulls. It's the cocker spaniel that gets taken home."

Many board members Buffett has met are "good souls," but money and business are just not what they're good at doing. Conversely, if Buffett was ever scheduled on Dancing with the Stars, he would "immediately seek refuge in the Witness Protection Program."

Buffett offers an idea to stop boards from being stampeded into ill-advised acquisitions "coveted" by a CEO: hire two experts, one to present to "pro" case and the other to argue the "con" side.

But "don't hold your breath," he concludes. While the current system hurts shareholders, it's great for CEOs and the bankers, advisors, and other professionals who "feast" on deals.

"A venerable caution will forever be true when advice from Wall Street is contemplated: Don't ask the barber whether you need a haircut."

Three more things

Buffett notes that when Berkshire subsidiary Lubrizol suffered a major loss from a fire at one of its big plants in France, insurance covered a lot of the damage. Unfortunately, one of Lubrizol's biggest insurers was "a company owned by ... uh, Berkshire."
Berkshire paid $3.6 billion in federal income tax last year, about 1 1/2% of taxes paid by all corporations.
Buffett had a book recommendation as part of his praise for Berkshire directors' focus on shareholders. Margin of Trust: The Berkshire Business Model by Larry Cunningham and Stephanie Cuba will be available at the annual meeting.

Any questions?

Buffett will be live with Becky Quick on "Squawk Box" this Monday from 6a to 9a ET for our annual "Ask Warren" program.

Use the hashtag #AskWarren on Twitter, Facebook, or Instagram to make your own suggestions. You can also use email: askwarren@cnbc.com.

Questions about a topic included in Buffett's letter get special attention from the people selecting what to use on the air.

I'll have another special edition of the newsletter on Monday with highlights.

Also, the "Squawk Pod" podcast is planning a "super-sized" edition Monday, with additional Buffett segments through the week. Listen for free wherever you get your podcasts, including Apple, Stitcher, and Spotify.

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