You can find Warren Buffett’s 2016 letter to shareholders at Berkshire Hathaway’s website. He always publishes the letter in late February for the prior year’s business. And it’s always a treat, packed with classic folksy wisdom only Buffett can hand down.

Buffett and his massive loyal following devour these letters as soon as they go live on the website. I kept hitting refresh in my browser the minutes leading up to the release. And finally, the Warren Buffett 2016 Shareholder Letter! I’m not even in the Buffett cult either – I simply enjoy reading his thought leadership on many issues. I by no means follow his every move like some investors.

As always, this letter was edited by Fortune magazine editor, Carol Loomis. Buffett writes this letter as if, as he says, a distant relative that hasn’t been following Berkshire Hathaway’s business (NYSE: BRK.B) and only comes around once a year picks it up.

Executive Summary of the Warren Buffett 2016 Shareholder Letter

Berkshire Hathaway’s Business

  • Berkshire’s Performance v.s the S&P 500 – The 1st page of the shareholder letter details changes in book value by year along with the cumulative average over the years. For 2016, Berkshire increased its book value by 10.7%, up from 6.4% from last year.

Berkshire's returns vs the S&P 500

Warren Buffett 2016 Shareholder Letter

  • Net Worth Gain – Berkshire increased its net worth in 2016 by $27.5 billion – a staggering amount.
  • Insurance Float / Profit – Berkshire’s insurance float is around $91.6 billion, up by about $30 billion since 2010. Underwriting profit increased 16%, or about $300 million from the prior year. The dynamic competition in the P/C space almost guarantees suboptimal returns, but Buffett likes his own prospects.

Berkshire insurance float

  • Wells’ Fargo – There was only one mention of Wells in the letter and that was as a line item in the investments breakdown (they own 10% of the bank). Not another mention and probably for good legal reasons. What advantage does Buffett have on commenting on the issue surrounding phony accounts? Zero. What Wells did was distrustful and unforgivable but Munger said they’ll be better in the long run.

Berkshire’s Investments

Berkshire's Investments

Macroeconomics

Buffett believes that you shouldn’t bet against America because of our capitalistic system along with our government. He believes that certain government programs like Social Security, Medicare, and the public education system all work to make America a great place.

If someone had come out of a long-term coma and the fist thing they read was the Warren Buffett 2016 Shareholder Letter, they’d think that America was doing great and the future was bright. If instead they turned on the news (any news outlet that I can think of), they’d likely think America’s best days

Folksy Wisdom

  • On fear (SL, p.6) – Buffett says that during scary periods, investors should remember 2 things: 1. Widespread fear is your friend. 2. Personal fear is your enemy.

Random Quotes I Like

“Starting from scratch, America has amassed wealth totaling $90 trillion.” – 2016 SL, page 5

“This economic creation will deliver increasing wealth to our progeny far into the future.” – 2016 SL, page 6

“American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead.” – 2016 SL, page 6

“Of course, a business with terrific economics can be a bad investment if it is bought at too high a price.” – 2016 SL, page 15

“There are many ways for practitioners to perform this legerdemain.” Buffett’s referencing how management distorts numbers. – 2016 SL, page 16

Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met.” – 2016 SL, page 16

Detailed Analysis of the Warren Buffett 2016 Shareholder Letter

On ‘Merica!

Buffett believes in the American system and the programs we’ve built. He remarks in page 6 that the market system is “primarily responsible for allocating rewards.” But he goes on to say that government has also had a heavy hand in distributing those rewards. He points out both old age entitlements (Social Security and Medicare) and the education system are financed by those people in their productive years. We don’t want granny living under a bridge eating dog food.

Buffet's 2016 Shareholder Letter

On Scary Markets

Further down on page 6 of the 2016 Warren Buffett Shareholder Letter, Buffett says that investors should remember 2 things during scary periods: 1. Widespread fear is your friend. 2. Personal fear is your enemy. He also advocates avoiding high and unnecessary costs. I AGREE! Of course, this seems like a no-brainer for many investors. Then why are people still buying mutual funds, certain annuity products, trading excessively, using a broker instead of a fee-only planner, etc. etc.? We’re all about indexing or certain buy-and-hold strategies here at Optimize Your Retirement. Along with proper allocation, you’ll be able to achieve a high return with the lowest acceptable risk.

fear is your friend

On the Fruitfulness of Share Buybacks

On share buybacks, Buffett points out that they for existing shareholders, share buybacks always make sense (see p.7). Though for those of us who like to buy additional shares in the future, share buybacks only make sense at below intrinsic value. That’s the only time Buffett repurchases Berkshire’s shares – they have to be trading at 120% of book value or below, which Buffett and team believe represent a damn good discount to intrinsic value.

Buffett doesn’t understand why, when corporations implement a share buyback plan, there isn’t an underlying price which management will not purchase shares. Would a company still repurchase their own shares if the stock is overvalued? Wouldn’t that destroy shareholder wealth?

On Low Energy Prices

Buffett sees Iowa as the “Saudi Arabia of America [when it comes to wind energy]” (p.12).  Because data centers need low energy prices, they come to places like Iowa which have them. Buffett’s thoughts are that since most tech CEOs like renewable energy, they’re building wind farms (and I would imagine solar too).

berkshire energy

On GAAP Depreciation Charges

Buffett thinks that GAAP depreciation charges don’t reflect the real amount the company needs to spend on it’s capital-intensive businesses to keep them going (pgs. 15-16). So GAAP expenses are lower for depreciation (because they’re based on historical cost) than the actual capital expenditures that are required to keep them from falling apart. This has the effect of overstating earnings, but is offset by the amortization of intangibles, which isn’t a true expense.

Capital Expenditures > GAAP Depreciation

Intangible Expense < GAAP Amortization of Intangibles

I like to use a real estate investing example for this. Let’s say you invested in a property 20 years ago and your initial depreciation schedule of 27.5 results in an allowable depreciation expense of $5,000. This is money you take away from your real estate income whether you actual put $5,000 into the property or not (sometimes referred to as phantom income). Now fast forward to present day and you have to put more than $5,000 into the property each year to maintain it, but your depreciation is based on historical costs so it’s only $5,000.

On Stock-based Comp

We all know Warren’s thoughts on the expensing (or not expensing) of stock based compensation. The bottom of page 16 sums it up:

Buffett on stock based compensation

I agree with Buffett. I don’t understand why companies don’t expense stock-based compensation. As a CPA, I’d like to see all companies use the same standards when accounting for stock-based comp (and restructuring costs for that matter).

On Investments

Buffett leaves some room open to sell his holdings at any given time. He’s clear in this letter that they will not hold stocks “forever” as he outlines on page 20:

Berkshire investment

I’m glad Buffett took the time to point out the difference between a market securities and controlled businesses. It can make regular investors think they should never sell stocks which is just plain wrong. If you have an opportunity that would yield a greater return on investment and the company your holding as achieved your investment goal, why not sell the puppy? Well, I understand it can be a bit more complicated than that but still good to understand Buffett’s viewpoint.

On The Long Bet

Now for the fun stuff: gambling (for charity though). Buffett is nine years into his bet that a passive index fund will beat any managed funds results over a 10 year period. The Fund of Funds A – E listed below are averaged out and then compared to the S&P Index Fund column. As you can clearly see, Buffett is winning his bet quite handily and will, with statistical certainty, win after the 10 year period.

buffett's long bet

To me, this is more than just a bet: it’s a case study of managed versus passive funds. And it’s one of the many examples of why I think that in the future:

1) Mutual funds will be either non-existent or have their scope reduced so that they make up an inconsequential segment of the market

2) Brokers and insurance-style investment products will be banned in participating in retirement accounts and hopefully much more.

3) All soon-to-be retirees will have clear choices to make with their investments. They’ll be empowered and educated as to what’s the “best” way to invest (e.g. passive indexing, low cost, diversification, etc.)

I’m glad Buffett champions this approach. Thanks bud!

The Bottom Line from page 24:

passive investing

And just one more tidbit on this from page 25, Buffett writes, “Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide.”

The Annual Meeting

Berkshire’s annual meeting will be held on May 6, 2017 and doors will open at the CenturyLink center at 7 AM and the shareholder movie starts at 8:30 AM.

The meeting will be webcast by Yahoo Finance starting at 9 AM at this address: https://finance.yahoo.com/brklivestream

Thoughts?

Let me know your thoughts on the Warren Buffett 2016 Shareholder Letter by commenting below. Did anything jump out at you? Is it more of the same? What you expected?