Two months in to the new year and the markets are experiencing some significant volatility, down over 20% from their recent highs. It is during these volatile times, that investors seemingly appreciate their dividend income even more - as it provides an opportunity to reinvest the income into equities that appear attractively valued for the long term. The question for many investors in the coming weeks and months is what if any companies in their portfolios will need to cut their dividends and which companies will be able to weather the storm and be able to increase the dividend in the next 12 mos? It will be interesting to see how things develop in the next 12 months to say the least.
February income is 13.0% higher than a year ago. A 2.6% increase occurred as a result of dividend increases during the past year, with both Abbott Laboratories and American Express experiencing double digit increases in the dividend rate, which is to be expected with companies with a relatively low average payout ratio. Other companies on the list, such as CVS and GIS, have foregone dividend increases in the near term to focus on debt reduction relates to recent acquisitions, yet still have current yields as management works on shoring up the balance sheet. The volume favorability contributed a 10.4% increase in dividend income, and was solely attributed to the CVS position which did not exist in February 2019.
The hotel lodging REITs and taken a hit along with the cruise ships and airlines as businesses and the population at large has paired back on travel as a result of the COVID-19 concerns. As such, my relatively small position in CLDT is not looking good at the moment. There was another company, PK, that I had my eye on prior to this latest scare and which has higher quality assets compared to CLDT and was selling at a steeper discount to book value as well. The price to book value of these companies look extremely attractive - however, liquidity is the concern as many hotels are experience very high vacancy rates and we know that REITs tend to be highly leveraged.
Warren Buffett's Annual Letter to Shareholders
Last year I shared some snippets from Warren Buffett's annual letter that he publishes towards the end of each February and I thought I'd do so again this year. Despite this year's letter being much shorter than years past, I've included a lengthy list of Buffett's comments below, particularly those having to do with Board of Directors. Kudos to Buffett is willing to agitate the current status quo among corporate boards and hopefully it provides an impetus for positive change as a result of the many discussions I'm sure his comments will instigate.
- Buffett references Edgar Lawrence Smith's 1924 book Common Stocks as Long Term Investments that changed the investment world. He goes on to quote an early review of the book by John Maynard Keynes: “I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest (Keynes’ italics) operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.” Prior to this "enlightenment" Buffett states that "gentlemen" preferred bonds and that the common perception of business ownership sliced into small pieces - "stocks" - were viewed as a short term gamble on the market movements. Even at their best, stocks were considered speculations. Today, school children learn what Keynes termed "novel": combining savings with compound interest works wonders.
- In deployment of the funds Berkshire retains, the company first seeks to invest in the many and diverse businesses it already owns. Reinvestment in productive operations assets will forever remain Berkshire's top priority.
- In addition, Berkshire constantly seeks to buy new businesses that meet three criteria. First, they must earn good returns on the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price.
- Tom Murphy, an all time great among business managers, long ago gave Buffett some important advice about acquisitions: "To achieve a reputation as a good manager, just be sure you buy good businesses." Buffett has concluded that acquisitions are similar to marriage: They start, of course, with a joyful wedding - but then reality tends to diverge from pre-nuptial expectations. Sometimes, wonderfully, the new union delivers bliss beyond either party's hopes. In other cases, disillusionment is swift. Applying those images to corporate acquisitions, it is usually the buyer who encounters unpleasant surprises. It's easy to get dreamy-eyed during corporate courtships. Fortunately, the fallout from many of Berkshire's errors has been reduced by a characteristic shared by most businesses that disappoint: As the years pass, the “poor” business tends to stagnate, thereupon entering a state in which its operations require an ever-smaller percentage of Berkshire’s capital. Meanwhile, our “good” businesses often tend to grow and find opportunities for investing additional capital at attractive rates. Because of these contrasting trajectories, the assets employed at Berkshire’s winners gradually become an expanding portion of our total capital.
- Insurance is a business of promises, and Berkshire's ability to honor its commitments is unmatched.
- Forecasting interest rates has never been our game, and Charlie and I have no idea what rates will average over the next year, or ten or thirty years. Our perhaps jaundiced view is that the pundits who opine on these subjects reveal, by that very behavior, far more about themselves than they reveal about the future. What we can say is that if something close to current rates should prevail over the coming decades and if corporate tax rates also remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term, fixed-rate debt instruments. That rosy prediction comes with a warning: Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater. But the combination of The American Tailwind, about which I wrote last year, and the compounding wonders described by Mr. Smith, will make equities the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions. Others? Beware!
- In the last part of his letter, Buffett lambastes common themes/trends in corporate governance, specifically related to the oversight that the Boards of Directors are expected to provide (Buffett has sat on 21 publicly owned companies in the last 62 years)
- The bedrock challenge for directors remains constant: Find and retain a talented CEO - possessing integrity, for sure - who will be devoted to the company for his/her business lifetime. Often, that task is hard. When directors get it right, though, they need to do little else. But when they mess it up,.....
- Audit committees remain no match for managers who wish to game the numbers, an offense that has been encouraged by the scourge of earnings "guidance" and the diers of CEOs to "hit the numbers." In Buffett's limited experience with such managers, those who have played the game were more often prompted by ego than by a desire for financial gain.
- Compensation committees rely much more heavily upon consultants than they used to. Consequently, compensation arrangements have become more complicated - what committee member wants to explain paying large fees year after year for a simple plan? - and the reading of proxy material has become a mind-numbing experience.
- One improvement has been mandated - a regularly scheduled "executive session" of directors at which the CEO is barred. Prior to that change, truly frank discussions of a CEO's skills, acquisition decisions and compensation were rare.
- Buffett has yet to see a CEO who craves an acquisition bring in an informed and articulate critic to argue against it (Buffett includes himself among the guilty).
- Overall, the deck is stacked in favor of the deal that’s coveted by the CEO and his/her obliging staff. It would be an interesting exercise for a company to hire two “expert” acquisition advisors, one pro and one con, to deliver his or her views on a proposed deal to the board – with the winning advisor to receive, say, ten times a token sum paid to the loser. A venerable caution will forever be true when advice from Wall Street is contemplated: Don’t ask the barber whether you need a haircut.
- Over the years, board “independence” has become a new area of emphasis. One key point relating to this topic, though, is almost invariably overlooked: Director compensation has now soared to a level that inevitably makes pay a subconscious factor affecting the behavior of many non-wealthy members. Think, for a moment, of the director earning $250,000-300,000 for board meetings consuming a pleasant couple of days six or so times a year. Frequently, the possession of one such directorship bestows on its holder three to four times the annual median income of U.S. households. (I missed much of this gravy train: As a director of Portland Gas Light in the early 1960s, I received $100 annually for my service. To earn this princely sum, I commuted to Maine four times a year.)
- And job security now? It’s fabulous. Board members may get politely ignored, but they seldom get fired. Instead, generous age limits – usually 70 or higher – act as the standard method for the genteel ejection of directors.
- Is it any wonder that a non-wealthy director (“NWD”) now hopes – or even yearns – to be asked to join a second board, thereby vaulting into the $500,000-600,000 class? To achieve this goal, the NWD will need help. The CEO of a company searching for board members will almost certainly check with the NWD’s current CEO as to whether NWD is a “good” director. “Good,” of course, is a code word. If the NWD has seriously challenged his/her present CEO’s compensation or acquisition dreams, his or her candidacy will silently die. When seeking directors, CEOs don’t look for pit bulls. It’s the cocker spaniel that gets taken home.
- Despite the illogic of it all, the director for whom fees are important – indeed, craved – is almost universally classified as “independent” while many directors possessing fortunes very substantially linked to the welfare of the corporation are deemed lacking in independence. Not long ago, I looked at the proxy material of a large American company and found that eight directors had never purchased a share of the company’s stock using their own money. (They, of course, had received grants of stock as a supplement to their generous cash compensation.) This particular company had long been a laggard, but the directors were doing wonderfully.
- Paid-with-my-own-money ownership, of course, does not create wisdom or ensure business smarts. Nevertheless, I feel better when directors of our portfolio companies have had the experience of purchasing shares with their savings, rather than simply having been the recipients of grants.
- Here, a pause is due: I’d like you to know that almost all of the directors I have met over the years have been decent, likable and intelligent...nevertheless, many of these good souls are people whom I would never have chosen to handle money or business matters. It simply was not their game. They, in turn, would never have asked me for help in removing a tooth, decorating their home or improving their golf swing. Moreover, if I were ever scheduled to appear on Dancing With the Stars, I would immediately seek refuge in the Witness Protection Program. We are all duds at one thing or another. For most of us, the list is long. The important point to recognize is that if you are Bobby Fischer, you must play only chess for money.
- At Berkshire, we will continue to look for business-savvy directors who are owner-oriented and arrive with a strong specific interest in our company. Thought and principles, not robot-like “process,” will guide their actions. In representing your interests, they will, of course, seek managers whose goals include delighting their customers, cherishing their associates and acting as good citizens of both their communities and our country. Those objectives are not new. They were the goals of able CEOs sixty years ago and remain so. Who would have it otherwise?
- In 2019, Berkshire sent $3.6 billion to the U.S. Treasury to pay its current income tax. The U.S. government collected $243 billion from corporate income tax payments during the same period. From these statistics, you can take pride that your company delivered 1 1⁄2% of the federal income taxes paid by all of corporate America.
Books mentioned in the shareholder letter:
Common Stocks as Long Term Investments (Edgar Lawrence Smith, 1924)
Margin of Trust (Larry Cunningham and Stephanie Cuba, 2020)