Buffett: America's Economic Magic Is Alive and Well
America's golden goose of commerce and innovation will continue to lay more and larger eggs, writes the Berkshire chairman and CEO in his annual letter to shareholders.
Berkshire Hathaway (BRK.B) chairman and CEO Warren Buffett delivered a dose of optimism about America in his annual letter to shareholders, released Saturday morning along with the firm's 2015 results. The highly anticipated missive has long been required reading for Berkshire shareholders and value investors across the globe.
Morningstar's stock analysts will sift through the earnings release in a separate report. Beyond the business results, Buffett's annual letters also include key investing takeaways, observations, and quotable aphorisms to tide the faithful over until Berkshire's annual meeting--also known as the Woodstock for Capitalists--every spring (this year, on Saturday, April 30). Morningstar's Berkshire analyst, Gregg Warren, will be one of the three analysts, in addition to three financial journalists, asking questions at this year's meeting. And Morningstar markets editor Jeremy Glaser will be covering the event live with commentary on Morningstar.com (check out last year's coverage here). In a change to past protocol prohibiting video recording during the event, the 2016 meeting will also be webcast live on Yahoo Finance.
Don't Bet Against America
Near the top of his letter, Buffett laments the "negative drumbeat" of our presidential election year, which in his view is propagating the story line that, given our country's current trajectory, American children will not live as well as their parents.
"That view is dead wrong," Buffett counters. "The babies being born in America today are the luckiest crop in history."
Backing up his sunny assessment, Buffett offers a per-capita view of economic growth, accounts for productivity, and factors in quality-of-life improvements enabled by technology and innovation.
Considering America's growth per capita paints a different picture, in Buffett's view. "American GDP per capita is now about $56,000. … [T]hat--in real terms--is a staggering six times the amount in 1930, the year I was born, a leap far beyond the wildest dreams of my parents or their contemporaries. U.S. citizens are not intrinsically more intelligent today, nor do they work harder than did Americans in 1930. Rather, they work far more efficiently and thereby produce far more. This all-powerful trend is certain to continue: America's economic magic remains alive and well."
Looking ahead, even a lackluster 2% real GDP growth rate results in a per-capita growth rate of 1.2%, which, over 25 years, "leads to a gain of 34.4% in real GDP per capita. … In turn, that 34.4% gain will produce a staggering $19,000 increase in real GDP per capita for the next generation," Buffett writes. "Were that to be distributed equally, the gain would be $76,000 annually for a family of four."
American innovation and productivity gains are major ingredients in the secret sauce. Buffett points to the history of farming: "Huge increases in physical [crop] output have been accompanied by a dramatic reduction in the number of farm laborers ('human input'). Today about three million people work on farms, a tiny 2% of our 158-million-person work force [versus 40% of the work force in 1900, by Buffett's numbers]. Thus, improved farming methods have allowed tens of millions of present-day workers to utilize their time and talents in other endeavors … We would not have anything close to the America we now know had we stifled those improvements in productivity."
Those endeavors and innovations in turn enable dramatic improvements to quality of life, including advancements in technology, medicine, transportation, and entertainment. "Rockefeller certainly had power and fame," Buffett observes. "He could not, however, live as well as my neighbors now do." (When Buffett talks about "his neighbors," remember that he famously lives in the same Omaha, Neb., house that he bought in 1958.)
But such innovation also has a dark side, Buffett notes: "A long-employed worker faces a different equation. When innovation and the market system interact to produce efficiencies, many workers may be rendered unnecessary, their talents obsolete. Some can find decent employment elsewhere; for others, that is not an option."
Berkshire's own businesses have not been immune. "When low-cost competition drove shoe production to Asia, our once-prosperous Dexter operation folded, putting 1,600 employees in a small Maine town out of work," he recounts. "The same scenario unfolded in slow-motion at our original New England textile operation, which struggled for 20 years before expiring. Many older workers at our New Bedford plant, as a poignant example, spoke Portuguese and knew little, if any, English. They had no Plan B."
Buffett argues that the solution lies not in curbing the march of productivity, but instead helping those displaced workers. "Americans would not be living nearly as well as we do if we had mandated that 11 million people should forever be employed in farming," he argues. "The solution, rather, is a variety of safety nets aimed at providing a decent life for those who are willing to work but find their specific talents judged of small value because of market forces." Buffett specifically says he would favor a reformed and expanded Earned Income Tax Credit.
Near the end of his letter, Buffett adds a darker addendum to his generally optimistic outlook. "There is … one clear, present and enduring danger to Berkshire against which Charlie [Munger, Buffett's business parter] and I are powerless. That threat to Berkshire is also the major threat our citizenry faces: a 'successful' (as defined by the aggressor) cyber, biological, nuclear or chemical attack on the United States. That is a risk Berkshire shares with all of American business."
Buffett further notes that although the risk of such an event may be small in any given year, over time small, ever-present risks become much more certain to occur at some point. "There is no way for American corporations or their investors to shed this risk," Buffett writes. "If an event occurs in the U.S. that leads to mass devastation, the value of all equity investments will almost certainly be decimated."
But Buffett has previously written about another kind of risk: underestimating America. In the depths of the 2008 financial crisis, in a now-famous letter to The New York Times, he wrote, "In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497."
Today, more than seven years later, he echoes the same sentiment: "For 240 years it's been a terrible mistake to bet against America, and now is no time to start. America's golden goose of commerce and innovation will continue to lay more and larger eggs."
In addition to his take on the economy, Berkshire shareholders are also keen to hear about Buffett's acquisition and investment strategy. As Berkshire has grown, the size of its investments has needed to similarly expand in order to move the needle, a reality Buffett has likened to hunting for acquisition targets with an "elephant gun." Almost by definition, fewer opportunities may meet the selection criteria of Buffett and his longtime business partner, Berkshire vice chairman Charlie Munger. But that doesn't mean they're standing still. In addition to bagging an elephant in Precision Castparts Corp. in 2015, Berkshire also contracted for 29 bolt-on acquisitions to subsidiary businesses last year.
"Charlie and I encourage bolt-ons, if they are sensibly-priced. (Most deals offered us most definitely aren't.)," Buffett writes. "These purchases deploy capital in operations that fit with our existing businesses and that will be managed by our corps of expert managers. That means no additional work for us, yet more earnings for Berkshire."
Whether bagging an elephant or buying a bolt-on, Buffett and Munger are seeking a certain quality of company. Whereas some managers focus on turnarounds and buy businesses that can be quickly and dramatically improved, the Berkshire duo's strategy is different. "[W]e follow an approach emphasizing avoidance of bloat, buying businesses such as PCC that have long been run by cost-conscious and efficient managers," Buffett writes. "After the purchase, our role is simply to create an environment in which these CEOs … can maximize both their managerial effectiveness and the pleasure they derive from their jobs. (With this hands-off style, I am heeding a well-known Mungerism: 'If you want to guarantee yourself a lifetime of misery, be sure to marry someone with the intent of changing their behavior.')"
And in seeking quality, Berkshire is open to both buying companies whole or taking a meaningful stake, so long as the target is right: "At Berkshire, we much prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business," Buffett explains. "It's better to have a partial interest in the Hope Diamond than to own all of a rhinestone."
'Float' and Discipline in the Insurance Business
Buffett also devoted some ink to discussing the insurance business--and specifically the role of "float," or the money that is collected in premiums before claims are paid out.
"One reason we were attracted to the [property/casualty] business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later," Buffett writes. "This collect-now, pay-later model leaves P/C companies holding large sums--money we call 'float'--that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float."
How much has it grown? Buffett's data table shows a float value of $39 million in 1970 growing to $87.7 billion in 2015.
But the benefits of float don't occur in a vacuum. Underwriting discipline is required to activate the value. "Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous indeed that it sometimes causes the P/C industry as a whole to operate at a significant underwriting loss," Buffett writes. That means to make it work, insurers have to be willing to walk away if the appropriate market premium isn't sufficient to insure a given risk.
"Disciplined risk evaluation is the daily focus of all of our insurance managers, who know that while float is valuable, its benefits can be drowned by poor underwriting results," Buffett explains. "All insurers give that message lip service. At Berkshire it is a religion, Old Testament style."
Jason Stipp does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.