The power of Retained earnings

In 1924, Edgar Lawrence Smith, a little-known economic scientist and Finance consultant, wrote the book "Common Stocks as Long Term Investments", a thin book, But it changed the investment world. Indeed, writing this book changed Smith himself, forcing him to re-evaluate his investment beliefs.

He intends to point out in the book that during the period of inflation, stock will perform better than Bond, and during the period of deflation, Bond's return will be higher. This seems wise enough. But Smith was startling.

His book begins with a confession: "These studies are a record of failure-the fact that failure cannot support a preconceived theory." Fortunately for investors, this failure prompted Smith to think more deeply. How should stock be evaluated.

Regarding Smith's insights, I would like to quote an early commentator, who is John Maynard Keynes, "I keep Mr. Smith's most important, and of course, his most novel ideas to the end. Generally, management is good Industry company will not distribute all of its profits to shareholders. In a good year, even if not all the years, they will retain a portion of the profit and reinvest in the business. Therefore, there is a favorable compounding factor for good investment "After many years, in addition to the dividends Pay has paid to shareholders, the real value of the assets of a solid industry company will continue to grow in the form of compound interest."

Under the splash of holy water, Smith's insights became easy to understand.

It's hard to understand why Retained earnings were not valued by investors before Smith's book publishing. After all, earlier like Carnegie, Rockefeller, and  Ford It's no secret that such Giants have accumulated incredible wealth. They all retain a lot of business profits to support growth and create greater profits. Similarly, throughout the United States, some small capitalists have long followed the same approach to becoming rich.

However, when corporate ownership is split into very small pieces-"stocks"-former Smithera buyers often consider their stocks to be short-term gambling on market fluctuations. Even with the good news, stock is considered speculative. And gentlemen prefer Bond.

Although investors have come to understand this very late, the mathematical principles of retained profits and reinvestment are now clear. Today, children in school can understand what Keynes calls "novel speech": the combination of Saving and compound interest creates a miracle.

At Berkshire, Munger and I have long focused on using Retained earnings effectively. Sometimes this work is easy, sometimes it is difficult, especially when we start dealing with huge and growing funds.

When allocating our retained funds, we first sought to invest in a number of different businesses that we already have. Over the past 10 years, Berkshire's Depreciation expenses have totaled 65 billion dollars, while the company's internal investments in Real Estate, Factory, and device have totaled 121 billion dollars. The reinvestment of produce assets will always be our priority.

In addition, we are constantly seeking to acquire new businesses that meet three criteria. First, their net tangible capital must yield good returns. Second, they must be managed by competent and honest managers. Finally, they must be bought at a reasonable price.

When we find a company that meets the criteria, our first choice is to buy a 100% stake. However, large acquisition opportunities that meet our criteria are scarce. More often than not, the volatile stock market offers us the opportunity to buy a large but non-holding share of a public company that meets our criteria.

Regardless of the approach we take, the Holding Company still holds a large number of shares through the stock market alone, and Berkshire's Finance performance will largely depend on the future earnings of the companies we acquire. Nevertheless, there is a very important accounting difference between these two investment methods, which you must understand.

In our Holding Company (defined as a company with more than 50% of Berkshire's shares), the revenue from each business flows directly into the Operation profit we report to you. What you see is what you get.

Of the non-holding companies where we own valuable stock, only Berkshire's dividends are recorded in our reported operations. Retained earnings? They are working to create more added value, but we don't count it directly into Berkshire's reported earnings.

In almost all major companies except Berkshire, investors will not find the importance of what we call “unrecognizable earnings”. However, for us, this is a prominent omission, and we introduce its size below for you.

Here, we list the 10 companies with the largest shareholdings in the stock market. According to the US General Purpose Accounting Guidelines (GAAP), this form reports to you separately the earnings-these are the dividends Berkshire received from these 10 investment objects and our share of the profits retained by investment objects and invested in Operation Share. Typically, these companies use Retained earnings to expand their business and increase efficiency. Sometimes they use a large portion of these Fund repurchase's own stocks, a move that expands Berkshire's share of its future earnings.

Berkshire shares (in millions)

Company's shareholding ratio at the end of the year Dividend (1) Retained earnings (2)

American Express 18.7% $261 $998

APPLE 5.7% 773 2519

BANK OF AMERICA 10.7% 682 2167

BANK OF NEW YORK MELLON 9.0% 101 288

Coca Cola 9.3% 640 194

Delta Airlines 11.0% 114 416

JPMORGAN CHASE 1.9% 216 476

Moody 13.1% 55 137

US BANCORP 9.7% 251 407

WELLS FARGO 8.4% 705 730

Total $ 3798 $ 8332

(1) Based on current annual rate.

(2) Based on 2019 profit minus paid Ordinary Shares and Preferred stock dividends.

Obviously, the realized revenue we ultimately record from each of these partially-owned companies does not exactly correspond to our share of its retained earnings. Sometimes Retained earnings have no effect. But logic and our past experience have shown that from its entirety, the Capital Gain we get can be at least equal to and may exceed our share in its retained earnings. (When we sell stock and realize a profit, we will pay the Income tax (benefit) expense at the prevailing tax rate. At present, the federal tax rate is 21%.)

To be sure, Berkshire's returns from these 10 companies and many of our other holding companies will be displayed in a very irregular manner. There are periodic losses, sometimes losses for specific companies, and sometimes losses related to the downturn in the stock market. At other times (last year was one of them), our earnings will increase significantly. Overall, the retained earnings of our investment objects will definitely play a significant role in Berkshire's value growth.

Mr Smith is right.