What SWFs Can Learn From Buffett's Berkshire Letters

March 11, 2015 by Loch Adamson

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Berkshire Hathaway, by dint of its scale and investment returns, makes a great model for sovereign wealth funds. But can we expect managers to follow CEO Warren Buffett's advice?

Berkshire Hathaway
’s 2014 annual report hit the Internet on February 28 — big news for capitalists. For 50 years, shareholders and money managers have devoured CEO Warren Buffett’s shareholder letter to parse his insights and scour it for investment ideas. Buffett’s co-dependent enablers — pundits, journalists and me — mine it for stories. Some fogies even try to figure out how the business is doing these days.

Berkshire Hathaway’s 2014 annual report hit the Internet on February 28 — big news for capitalists. For 50 years, shareholders and money managers have devoured CEO Warren Buffett’s shareholder letter to parse his insights and scour it for investment ideas. Buffett’s co-dependent enablers — pundits, journalists and me — mine it for stories. Some fogies even try to figure out how the business is doing these days.

The answer is pretty well. Berkshire’s growth in shareholder equity — a proxy for the direction of so-called "intrinsic value", Buffett’s preferred gauge of corporate worth — was 8.3 percent. Four of the Omaha, Nebraska company’s five top non-insurance subsidiaries were doing well too, he tells us. Insurance is not faring badly either. Berkshire’s operating earnings per Class A share rose 9.3 percent to $10,071. That doesn’t include earnings of companies whose shares Berkshire holds as long-term investments.

The theme of this year’s letter is the underlying strength of Berkshire’s businesses — understandable given that Buffett is 84. "The message he is trying to reinforce is how resilient the company is," says Mark Curnin, co-founder of White River Capital, a Chappaqua, New York–based firm that invests in financial stocks. That idea seems to be getting through: Class A shares rose 27 percent in 2014, versus a 13.7 percent return for the S&P 500 Index.

Of course, one-year performance is the kind of short-termism Buffett inveighs against. Since 1964 Berkshire shares have returned 21.6 percent annualized through December versus 9.9 percent for the S&P 500.

Berkshire and sovereign wealth funds have plenty in common: scale, long-term outlook and the need to find businesses that can absorb large amounts of capital. Given Buffett’s legendary track record, sovereign wealth funds can certainly learn from Berkshire’s five decade run.

Insurance Float

Berkshire’s market capitalization hovered at $360 billion in March, making it the fourth largest company in the S&P 500, behind Apple, Google and Exxon Mobil. By that measure, it is bigger than the Qatar Investment Authority (QIA), with an estimated $304.4 billion in assets, the $72 billion Korea Investment Corp., and Singapore’s GIC, which Sovereign Wealth Center estimates to have over $315 billion of assets.

Market capitalization inevitably see-saws. It is Berkshire’s massive cash generation and buying power that makes it a model for growing sovereign wealth funds. The company’s insurers and other businesses it groups in with them for reporting purposes had $58 billion in cash on their balance sheet at year-end to put to work, adding to the $170.9 billion in often big name stocks, bonds and other investments they already hold. (Buffett has said he likes to keep at least $20 billion in pocket change for safety’s sake.)

This excludes cash holdings on the separate balance sheets of Berkshire’s other businesses like railroad, utilities, energy, finance and financial products, which include myriad leasing operations. That was worth a combined $5.3 billion. (This money, after all, could be necessary for financing.) A scrupulous tally of available Berkshire firepower, though, could arguably include the $7.3 billion of investments in the finance and financial products division.

Another prism through which to look at Berkshire’s investment strength is the so-called float generated by its insurance businesses: the premiums it controls that will eventually be paid out in claims but that Buffett and his minions can, in the meantime, invest, and reap profits from. Buffett in this year’s letter calls it a "revolving fund." The combined float of the company’s insurance businesses — Berkshire Hathaway Reinsurance, General Re, GEICO and a variety of others — totalled $83.9 billion at the end of 2014, up 8.7 percent from $77.2 billion a year ago. There’s a lot of money sloshing around.

Capital at Work

Lesson No.1: Berkshire has adeptly responded to that cash horde by buying the kinds of businesses that can soak up huge amounts of capital — and upon which the company can still earn what Buffett calls a "decent" return. That includes the regulated Berkshire Energy, the former MidAmerican Energy, which has grown, acquisition by acquisition, into a sprawling utility. In 2010 Berkshire bought Burlington Northern Santa Fe (BNSF), the giant U.S. railroad. Buffett in this year’s letter said he planned to spend $6 billion in plant and equipment improvements for BNSF in 2015 alone.

Buffett also wrote that last year Berkshire spent $15 billion on plant and equipment. And he is constantly on the lookout for capital intensive businesses to buy. Of the top five non-insurance businesses in the Berkshire portfolio — Berkshire Energy, Burlington Northern, lubricant maker Lubrizol, metal cutting tool manufacturer IMC, and the conglomerate Marmon — only Berkshire Hathaway Energy was held 10 years ago. Buffett knows companies that can put lots of capital to work in an efficient manner.

Sovereign wealth funds take note: This is a very different business than sharp-shooting technology high-fliers. It’s a lesson some state-owned investors would do well to understand, especially given the frothy venture capital markets. Some are already doing so.

Risk and Volatility

Lesson No. 2 — to my mind the most important — appears on page 18 of this year’s letter. It should be required reading for any long-term investor contemplating conventional asset allocation — but especially sovereign wealth funds.

Buffett’s point is a simple one — since the end of 1964, the year he assumed control of Berkshire, the U.S. dollar has lost 87 percent of its purchasing power. He points out the S&P 500 returned 11,196 percent over that time.

For Buffett, that’s proof that traditional diversification strategies are flawed. "The unconventional but inescapable conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities —Treasuries for example — whose values have been tied to American currency," Buffett writes.

The Oracle’s logic upends conventional thinking about asset allocation. "Stock prices will always be far more volatile than cash-equivalent holdings," he writes. "Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions."

In short, investors who believe in 60-40 stock to bond allocations know a lot about volatility but nothing about risk. "Volatility is far from synonymous with risk," Buffett writes. "Popular formulas that equate the two terms lead students, investors and CEOs astray."

It bears repeating that this applies only to investors with reasonable time horizons, like sovereign wealth funds. But it’s a timely insight especially now, with U.S. rates likely to rise. "Cash has proven to be a poor investment and bonds are likely to be disastrous from here," says White River Capital’s Curnin. "People like talking about volatility because they can measure it, but volatility only matters to investors that are leveraged or have short-term time horizons. Sovereign wealth funds don’t fill either bucket."


Lesson No. 3: Think long term. "Our favorite holding period is forever," Buffett wrote in his 1988 shareholder letter, and he has lived by that credo and repeated it often. Sovereign wealth funds have generally adhered to that shibboleth.

Berkshire has never willingly sold a subsidiary company and has closed or disposed of only a handful over the years — Berkshire Hathaway’s original namesake textile business in 1982 and Dexter Shoe Co., described by Buffett as one of his worst purchases ever, which was folded into another subsidiary after shuttering U.S. production in 2001. "Gin rummy managerial behavior (discard your least promising business at each turn) is not our style," he wrote in Berkshire’s Owner’s Manual, reprinted each year in the annual report.

Non-tradeable holdings, like whole companies, can and do generate excess returns. "Sovereign wealth funds can afford to invest in highly illiquid assets," says professor Colin Blaydon of the Tuck School of Business at Dartmouth College. "The market seems to say you can get a premium return for that."

Lesson No. 4 dovetails with the stance of most state investors — the benefits of passive investing. While not an indexer himself, last year Buffett wrote that he has advised that his wife’s inheritance, should he die before her, be allocated to 10 percent in short term Treasuries and 90 percent in a Vanguard Group index fund that tracks the S&P 500. "I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers," he wrote.

While the vast majority of publicly traded securities held by state-owned investors is indexed, according to some industry experts, it does raise the question of why the rest is not, given the allocations of funds like the $21.5 billion New Zealand Superannuation Fund to domestic stock-picking.

Lesson No. 5: Buffett diverges meaningfully from sovereign wealth funds like Singapore’s GIC, Temasek Holdings and QIA on another front. These state-owned investors, to one degree or another, emphasize higher-growth emerging markets to benefit from, among other things, demographics and an expanding middle class. Berkshire is firmly focusing on the U.S. "The motherlode of opportunities runs through America," Buffett writes in this year’s letter. "The dynamism embedded in our market economy will continue to work its magic." He points out that about 90 percent of Berkshire’s money spent in 2014 on plant and equipment was in the U.S.

Stars and Stripes

Reality check. Following Berkshire’s first big foreign corporate acquisition, Israel-based IMC in 2006, Buffett toured the globe to drum up acquisition candidates. No big ones surfaced, at least at the right price. It certainly behoves those sovereign wealth funds emphasizing emerging markets and other non-U.S. markets to reconsider a serious rebalancing, particularly given the strengthening dollar.

Berkshire hasn’t always shot the lights out when venturing abroad. He began buying shares in U.K. retailer Tesco before the financial crisis, and by 2012 held 415 million shares at a cost of $2.3 billion. As the supermarket chain’s myriad problems worsened in 2014, Berkshire slowly sold out of its position, booking an after-tax loss of $444 million. He blames his own "dawdling" for the red ink in the 2014 letter. French drugmaker Sanofi was down more than 11 percent in 2014, though Berkshire was still in the black on that investment at year-end. No mention at all is made in the 2014 letter of Chinese electric automaker BYD, in which Berkshire bought a 10 percent interest in 2008 for $232 million, and whose shares have gyrated wildly since.

Certainly, sticking Stateside would have benefited investors lately. Since the nadir of the financial crisis in March 2009, the MSCI Emerging Markets Index has returned just 0.7 percent annualized, and the EUROSTOXX 50 Index 12.4 percent through 2014. By contrast, the S&P 500 Index has returned 20.4 percent annualized over that time and Berkshire’s Class A shares 18.5 percent.

Buffett-watchers say he is not just waving the stars and stripes. "In the U.S. you get the stable political environment and regulatory structures and it doesn’t have the demographic challenges of Japan and Europe," says Matt Coffina, editor of the Morningstar StockInvestor newsletter. "The U.S. does have the best of both worlds."

Buffett agrees. "America’s best days lie ahead," he writes.

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