The major source of Warren Buffett’s investment vehicle Berkshire Hathaway is likely to continue delivering gains for the best part of the next 100 years, the veteran investor believes. 
In his latest shareholder letter, the ‘Sage of Omaha’ – who runs Berkshire Hathaway with partner Charlie Munger – said the firm has benefited over several decades from ‘The American Tailwind’: a belief and optimism about the country’s potential.
“On 11 March, it will be 77 years since I first invested in an American business,” Buffett wrote (pictured). “The year was 1942, I was 11 and I went all in, investing $114.75 I had begun accumulating at age six.
“If my $114.75 had been invested in a no-fee S&P 500 index fund and all dividends had been reinvested, my stake would have grown to be worth – pre-taxes – $606,811 on 31 January 2019.”
He added: “Meanwhile, a $1m investment by a tax-free institution of that time – say, a pension fund or college endowment – would have grown to about $5.3bn.
However, there was a warning for those who use fund managers too.
“If that hypothetical institution had paid only 1 per cent of assets annually to various ‘helpers’, such as investment managers and consultants, its gain would have been cut in half, to $2.65bn,” he said.
“That’s what happens over 77 years when the 11.8 per cent annual return actually achieved by the S&P 500 is recalculated at a 10.8 per cent rate.”
US federal deficit since 11 March 1942
Source: St Louis Federal Reserve
Over that same period, Buffett said the US government budget deficit has risen by 40,000 per cent, but those of a more nervous disposition worried by currency devaluation who would have bought gold with $114.75 would now have asset worth just $4,200.
Instead, the US has contended with a number of challenges over the 77-year period – all of which had been overcome – while delivering vast living improvements.
“All engendered scary headlines; all are now history,” he noted. “Today, the Federal Reserve estimates our household wealth at $108trn, an amount almost impossible to comprehend.”
He added: “Charlie and I happily acknowledge that much of Berkshire’s success has simply been a product of what I think should be called ‘The American Tailwind’.
“It is beyond arrogance for American businesses or individuals to boast that they have ‘done it alone’. The tidy rows of simple white crosses at Normandy should shame those who make such claims.
“There are also many other countries around the world that have bright futures. About that, we should rejoice: Americans will be both more prosperous and safer if all nations thrive.”
He added: “Over the next 77 years, however, the major source of our gains will almost certainly be provided by ‘The American Tailwind’. We are lucky – gloriously lucky – to have that force at our back.”
As such, Buffett and Munger have built a portfolio of ‘economic trees’ that range “from twigs to redwoods”, some of which are diseased and unlikely to be around a decade from now while others are destined to grow in size and beauty.
The veteran investor said Berkshire Hathaway’s ‘forest’ consists of five ‘groves’, four of which are made up of the ably-managed businesses with favourable and durable economic characteristics it invests in. The fifth grove represents its property & casualty insurance business.
Performance of Berkshire Hathaway in 2018
Source: Yahoo Finance
The most valuable grove, according to Buffett, is made up of the “many dozens” of non-insurance companies it owns either outright or holds a majority stake in (minimum 80 per cent stake), which he said earned Berkshire $16.8bn last year.
“When we say ‘earned’, moreover, we are describing what remains after all income taxes, interest payments, managerial compensation – whether cash or stock-based – restructuring expenses, depreciation, amortisation and home-office overhead,” he said.
“That brand of earnings is a far cry from that frequently touted by Wall Street bankers and corporate chief executives,” said Buffett, who said so-called ‘adjusted EBITDA’ (earnings before interest, tax, depreciation amortisation) often excludes a variety of “all-too-real” costs.
The next grove is made up of its collection of stakes of 5-10 per cent in very large companies and worth almost $173bn at the end of 2018, including names such as American Express, Apple, Bank of America, Coca-Cola and Wells Fargo.
The third grove consists of four companies in which Berkshire Hathaway has shared control including Kraft Heinz, commercial mortgage lender Berkadia, infrastructure firm Electric Transmission Texas and truck stop operator Pilot Flying J.
Meanwhile, the fourth grove is made up of $112bn in US Treasuries and other cash equivalents as well as another $20bn in fixed-income instruments.
“We consider a portion of that stash to be untouchable, having pledged to always hold at least $20bn in cash equivalents to guard against external calamities,” he said. “We have also promised to avoid any activities that could threaten our maintaining that buffer.”
Buffett added: “We use debt sparingly. Many managers, it should be noted, will disagree with this policy, arguing that significant debt juices the returns for equity owners.
“And these more venturesome chief executives will be right most of the time.”
However, he warned that at “rare and unpredictable intervals” credit vanishes and debt on the balance sheet can be “financially fatal”.
“A Russian roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company’s upside but does not share in its downside,” he said. “But that strategy would be madness for Berkshire.”
He explained: “Rational people don’t risk what they have and need for what they don’t have and don’t need.”
As such, Berkshire Hathaway “will forever remain a financial fortress”, although he warned that it would sometime make mistakes.
While investors will often expect companies to return excess cash to shareholders, through payouts or equity buybacks, Buffett said his equity capital of $349bn was unmatched in corporate America. The Berkshire Hathaway chief only buys back stock when it trades at a discount to what it believes it its intrinsic value, arguing that blindly buying overprices stock is value-destructive.
“By retaining all earnings for a very long time, and allowing compound interest to work its magic, we have amassed funds that have enabled us to purchase and develop the valuable groves earlier described,” he said. “Had we instead followed a 100 per cent payout policy, we would still be working with the $22m with which we began fiscal 1965.”
Indeed, Buffett said he would never risk being caught short of cash and hopes to redeploy excess liquidly into business that it will own outright, although the immediate prospect “are not good”.
This, he said, is because valuations are “sky high” for businesses with good long-term prospects and, as such, the firm is likely to add to its portfolio of smaller holdings.
Performance of S&P 500 over 10yrs
Source: FE Analytics
However, he warned that any new purchases should not be interpreted by other investors as a market call.
“Charlie and I have no idea as to how stocks will behave next week or next year,” he said. “Predictions of that sort have never been a part of our activities. Our thinking, rather, is focused on calculating whether a portion of an attractive business is worth more than its market price.”