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Berkshire Hathaway: Ironically, the Ultimate Speculation

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).


Buffett, the Teacher

When asked what he'd most like to be remembered for, Warren Buffett doesn't hesitate: a good teacher. Having read through all of Buffett's annual letters to shareholders for Berkshire Hathaway's company history, along with Berkshire's predecessor, BPL (Buffett Partnership Limited), I can personally vouch for the efficacy of Buffett's investment teaching wisdom. The way he distills seemingly complex concepts about investing into easily digestible quotes (here are 3 of my favorite Buffett quotes analyzed) is unmatched, and the clarity he's provided has helped guide my own personal investing practice, especially as I entered individual stock picking just before the coronavirus pandemic landed. Since then, I've been fortunate to have mentors and much additional guidance from other investment gurus, and while the market has changed a great deal over a short period of time, Buffett's principles remain cornerstones of my personal investing philosophy today. They have served me extremely well in both my businesses and my personal investing practice.

Berkshire Hathaway, the Ultimate Compounding Machine

Imagine a snowball rolling downhill, and oft-used analogy for the power of compounding. The snowball starts out as a little nugget, but as it rolls downward, it continues to pick up snow on the outside, and the next thing you know, it's the size of a softball... and then a basketball. By the time it gets to the bottom of the hill, it's an enormous beach ball of packed snow, ready to be the thorax of your next snowman. This is exactly how compounding works when you're running a business, or when you're reinvesting earnings anywhere. Instead of taking the earnings away, you let them do their work on the business or the investment, and they add to the principle, which yields even more earnings, and so on. Many businesses will pay out a distribution to owners on a quarterly or annual basis if there's extra cash in the bank account (usually preserving a preset minimum), and in stock investing, this is called a dividend.

Now, Buffett has spoken extensively about dividends and their implications. He cites two main reasons why Berkshire Hathaway has never paid out a dividend:

  1. There is a clear tax advantage to not paying dividends to owners, since the shareholder has to pay tax on that income as soon as it is distributed.
  2. There's nobody in the world better than Berkshire (and Buffett) at compounding money over time, with Berkshire yielding a stupefying compounded annual gain of 20% over more than 50 years of existence.

After all, if you had invested $1000 in the S&P 500 in 1965, that money would be worth some $200,000 today. The same $1000 invested in Berkshire would be worth would be worth more than $20 million today. There are many businesses and investments that have outdone Buffett over short stretches, but nothing and nobody comes close to this performance record, so why wouldn't the dividends just stay in Berkshire, where they can be intelligently reinvested under Buffett's watchful eye?

Investing vs Speculation

Over the years, Buffett has consistently made a sharp distinction between investing and speculating. Investing involves being as certain as possible that an underlying asset will pay you back over time. Buffett puts it succinctly here: "If you were all knowing about the future, and could predict all the cash that a business would give you between now and judgment day, discounted at the proper discount rate, that number is what the intrinsic value of a business is." Speculation, on the other hand, is the idea that someone else will pay more for what you own. You can buy a Ken Griffey Jr rookie card, or an X-men comic book, or (if you're in the 17th century Dutch republic) tulips, and then you can try to sell it for more than you paid for it at a later date.


Owner's Earnings and Dividends

Given that Berkshire Hathaway has famously never paid a single dividend to its shareholders, does that imply, then that Berkshire Hathaway is an investment, or does it enter the realm of speculation? If we take Buffett's definition literally, we just don't know if Berkshire will ever return any cash to shareholders. This means that the only way for us to make a profit is to sell a share of BRK.B (or BRK.A if you're fortunate enough to have them!).

In Berkshire's 1986 annual letter to shareholders, Buffett describes owner's earnings as such:

These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume...Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes...All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) - but do not subtract (c).

By these criteria, Berkshire is an amazing business, and as a person who is long Berkshire, I understand fully well that there's a really good chance that my money will be extremely well cared for under Buffett's stewardship, and will very likely provide an excellent return, should I decide to sell my shares of the company. However, I recognize the deep irony: I've made a very good speculation on a great company.

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