Lost in the hoopla over Berkshire Hathaway chairman and CEO Warren Buffett's latest annual shareholder letter this past weekend was an implicit warning to the finance executives and managers who run corporate America: Now is the time to be investing profits in the business, while inflation is low.
It may not have the glamour of speculating about the Oracle of Omaha's next big deals, or even his thoughts about adding more diversity to corporate boards, but Buffett led off his annual letter with a lesson aimed at his fellow titans —explaining why conventional wisdom about retrenchment during periods of low inflation (often accompanied by tepid economic growth) is wrong.
If the lesson from Buffett was new, like many of his market lessons over the years, it was borrowed from the investors of previous eras whom he adored. He began by telling a story about the economist and financial advisor Edgar Lawrence Smith, whose 1924 book "Common Stocks as Long Term Investments" was the first to debunk the pre-Depression conventional wisdom about being more conservative with investments in weaker times. Quoting John Maynard Keynes' review of Smith's book, Buffett argues that investing in leaner times is a form of compound interest for an operating company, generating more returns over the long run than simply paying out dividends and stock buybacks.
"Though investors were slow to wise up, the math of retaining and reinvesting earnings is now well understood," Buffett wrote. "Today, schoolchildren learn what Keynes termed 'novel': combining savings with compound interest works wonders."
The challenge is that corporate America hasn't done a good job lately of reinvesting for growth,' says Michael Mandel, chief economist at the Washington-based Progressive Policy Institute. After President Donald Trump's 2017 tax cut, which was designed partly to revive flagging investment levels, corporate investment in equipment, facilities and technology never moved as high as it was in the 1990s, when net domestic business investment was 5% of gross domestic product. It has even moved back below the 2.8% level that prevailed right before the tax cut passed.
"There's nothing wrong with paying out dividends," Mandel said on Monday.
In fact, Buffett has been a big backer of dividends in the stocks Berkshire owns. While he has refused to offer a Berkshire shareholder dividend, his company earned close to $4 billion in dividends from stock portfolio holdings in 2019, according to the Berkshire annual report.
The lesson on corporate reinvestment also comes at a time when Buffett has been unable to make the type of large acquisitions that he has said should be required of a balance sheet that is throwing off so much cash — roughly $128 billion at the end of 2019.
But Mandel said that in the latest letter, "Buffett hit the nail on the head. ... Corporate investments are the real force for long-run growth and prosperity."
The institute publishes an annual list of nonfinancial Fortune 150 companies that invest the most, part of a report last issued in December that calls out the biggest businesses for investing too little. The top performers are leaders in industries where the U.S. tends to be the leader, with the latest list topped by mobile telecom and cloud computing companies, utilities and energy distribution companies, energy producers and transportation firms, followed only distantly by industrial companies.
Specifically, the companies that invest the most in the U.S. are led by Alphabet, AT&T, Amazon, Verizon and Microsoft, according to the PPI report, which uses a proprietary method to estimate domestic investment when most companies report their worldwide investment without geographic breakdowns. The next best: Comcast, Facebook, Charter Communications, Walmart, Intel, Apple, automakers Ford and General Motors, FedEx and Delta Air Lines.
Included in retained earnings are not just true business investments but stock buybacks. "Normally, those companies use retained earnings to expand their business and increase its efficiency. Or sometimes they use those funds to repurchase significant portions of their own stock, an act that enlarges Berkshire's share of the company's future earnings," Buffett wrote in the annual letter.
According to some Berkshire analysts, Buffett has been conservative with stock buybacks — $5 billion in 2019 — given the cash on hand. Buffett has argued for decades about the benefits he and Berkshire shareholders receive from owning stocks that buy back their shares, but in the new annual letter he said he does not feel "urgency" to buy back shares unless "the price-to-value discount (as we estimate it) widens." And he made it clear that Berkshire "will not, however, prop the stock at any level."
Buffett's Berkshire Hathaway didn't make the top 25, but Buffett's company is harder to measure because of the company's highly decentralized form of organization.
Berkshire's corporate office in Omaha, Nebraska, leaves ongoing investment decisions mostly to heads of the company's operating businesses, whether they are the Burlington Northern Railroad, industrial and retail operations that collectively provide the largest share of Berkshire's operating profits, or its electric-utility unit and insurance operations, said Lawrence Cunningham, a George Washington University law professor who has written several books on Berkshire and Buffett.
"In the Berkshire structure, no single decision maker decides whether to invest more in GEICO or less in BHE [Berkshire Hathaway Energy]," Cunningham said. "Each company makes its own reinvestment decisions. The reason is they have the greatest incentives, and greatest knowledge, to get it right. Neither Buffett nor external critics have any advantage over the unit managers.''
A big acquisition will always be the expectation among Buffett watchers, but the billionaire investor noted in this year's letter that "reinvestment in productive operational assets will forever remain our top priority."
The company's annual report and letter to shareholders shows some businesses with big investments ahead, while others have been cost-cutting, according to Cathy Seifert, who follows Berkshire for New York-based CFRA Research. She cited insurance giant Geico, for example, which is spending less on driver-monitoring technology than rivals like Allstate and Progressive.
"I think they are building a cash hoard, and when the market is right, they will make a big [acquisition] deal," Seifert said.
If so, Buffett gave no hint in this year's letter that the M&A market has changed to his short-term advantage. He has been saying for some time that the "fickle" market is valued too high for outright acquisitions and continuing to build mega stakes in a select group of stocks — he referred to Apple as Berkshire's "third business" — is a better use of his cash.
Even though Buffett does not make the investing decisions for Berkshire affiliates, he did make a few notable comments about the utility business in explaining the value of reinvesting through thick and thin.
In Iowa, Berkshire's Mid-American Energy unit has deployed wind power much faster than its nearest rival, Buffett wrote. After years of investment in wind, aided by federal tax credits Buffett has said made the investment more palatable, residential power rates at Berkshire have risen less than 1% a year, trailing general inflation, while the unnamed rival now charges residential rates 61% higher than Mid-American.
"In 2000, [Berkshire Hathaway Energy] was serving an agricultural-based economy; today, three of its five largest customers are high-tech giants," Buffett wrote. "I believe their decisions to site plants in Iowa were in part based upon BHE's ability to deliver renewable, low-cost energy."
And Buffett expects his utility management team to pour a lot more cash into the future of the business: "Today BHE has the operating talent and experience to manage truly huge utility projects — requiring investments of $100 billion or more — that could support infrastructure benefiting our country, our communities and our shareholders. We stand ready, willing and able to take on such opportunities."