Warren Buffett’s 2015 letter to Berkshire Hathaway shareholders was released last Saturday. Here are three things that investors can learn from it. 1. Berkshire’s low-cost advantage In the letter, Buffett had deftly tied together the cost advantages that many of Berkshire’s wholly owned business units share. The low cost model of Berkshire Hathaway Energy, one of Berkshire’s five most profitable noninsurance subsidiaries, charges an average US$0.068 per kilowatt hour to customers in the state of Iowa in the U.S. The other major electric utility in Iowa charges US$0.095 per kilowatt hour. And the rates charged by utilities in adjacent states are…
Warren Buffett’s 2015 letter to Berkshire Hathaway shareholders was released last Saturday. Here are three things that investors can learn from it.
1. Berkshire’s low-cost advantage
In the letter, Buffett had deftly tied together the cost advantages that many of Berkshire’s wholly owned business units share.
The low cost model of Berkshire Hathaway Energy, one of Berkshire’s five most profitable noninsurance subsidiaries, charges an average US$0.068 per kilowatt hour to customers in the state of Iowa in the U.S. The other major electric utility in Iowa charges US$0.095 per kilowatt hour. And the rates charged by utilities in adjacent states are equally high.
“Those outstanding performances explain why [Berkshire Hathaway Energy] is welcomed by regulators when it proposes to buy a utility in their jurisdiction,” Buffett wrote. “The regulators know the company will run an efficient, safe and reliable operation and also arrive with unlimited capital to fund whatever projects make sense.”
The same thing is true at Burlington Northern Santa Fe (BNSF), the U.S.’s largest railroad which was purchased by Berkshire in 2009. While price comparisons between railroads is difficult because of differences in both their mix of cargo and the distance over which it’s carried, Buffett’s admittedly “crude” analysis estimates that BNSF’s cost advantages allow it to charge 40% less per ton-mile than its competitors.
And, of course, there’s Geico insurance, the longtime low-cost U.S.-based insurance provider. Geico’s promise that new customers can save at least 15% in 15 minutes or less is grounded in a model that eschews an expensive and cumbersome network of agents in exchange for direct-to-consumer sales. Its underwriting expenses in 2015, for instance, were 14.7% of its premiums, which is second in the American insurance industry only to USAA when it comes to efficiency.
In all of these cases, Berkshire’s low-cost advantage creates a moat – “an enduring one,” says Buffett – that its competitors are unable to cross. It allows Berkshire to not only underprice competitors while still generating wide margins, but it also builds goodwill among both customers and industry regulators.
2. Important points about risk
Risk management is critical to Berkshire Hathaway, which is made up in no small part of insurance companies. Berkshire’s success in this regard can be summed up by Buffett’s observation that the Omaha-based conglomerate is “far more conservative in avoiding risk than most large insurers.”
One key is that Berkshire never overextends itself. “The nature of our insurance contracts is such that we can never be subject to immediate or near-term demands for sums that are of significance to our cash resources,” Buffett wrote. “This structure is by design and is a key component in the strength of Berkshire’s economic fortress.”
Buffett goes on to explain that among the biggest shortcomings of most insurance companies is that they’re unwilling to walk away from business even if they can’t charge high enough premiums to adequately offset their risk. “They simply can’t turn their back on business that is being eagerly written by their competitors,” wrote Buffett. “That old line, ‘The other guy is doing it, so we must as well,’ spells trouble in any business, but none more so than insurance.”
Regardless of how conservative Berkshire is, however, Buffett recognizes that some events will cause trouble for even it — namely, an attack on the U.S.. He explains:
“There is, however, one clear, present and enduring danger to Berkshire against which Charlie 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.
The probability of such mass destruction in any given year is likely very small. It’s been more than 70 years since I delivered a Washington Post newspaper headlining the fact that the United States had dropped the first atomic bomb. Subsequently, we’ve had a few close calls but avoided catastrophic destruction. We can thank our government — and luck! — for this result.
Nevertheless, what’s a small probability in a short period approaches certainty in the longer run. (If there is only one chance in thirty of an event occurring in a given year, the likelihood of it occurring at least once in a century is 96.6%.) The added bad news is that there will forever be people and organizations and perhaps even nations that would like to inflict maximum damage on our country. Their means of doing so have increased exponentially during my lifetime.”
3. Berkshire’s partnership with 3G Capital
Buffett also spent time in his letter addressing 3G Capital, a Brazil-based investment firm that Berkshire has teamed up with to invest in Kraft Heinz and Tim Hortons. As Buffett explained, the two companies employ different strategies when identifying investments:
“Their method, at which they have been extraordinarily successful, is to buy companies that offer an opportunity for eliminating many unnecessary costs and then — very promptly — to make the moves that will get the job done.
… At Berkshire, we, too, crave efficiency and detest bureaucracy. To achieve our goals, however, we follow an approach emphasizing avoidance of bloat, buying businesses such as PCC that have long been run by cost-conscious and efficient managers. After the purchase, our role is simply to create an environment in which these CEOs — and their eventual successors, who typically are like-minded — can maximize both their managerial effectiveness and the pleasure they derive from their jobs.”
Despite their different approaches, Buffett noted that Berkshire “share[s] with [3G Capital] a passion to buy, build and hold large businesses that satisfy basic needs and desires.” As Berkshire continues to grow, it’s likely to come across fewer acquisitions that will meet its stringent criteria. One way to get around this increasingly sparse landscape, in turn, is to team up with other investors that come at it from a different angle.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. This article was written by John Maxfield and first published on fool.com. It has been edited for fool.sg.