Warren Buffett on Turnarounds

CEO Charlie Scharf opened the Q4 2023 review against the backdrop of a multi-year transformation that had produced the third consecutive year of operating expense reduction in absolute dollar terms and had moved the Common Equity Tier 1 ratio above eleven percent on a standardized basis. Management told the call that the Company had repurchased approximately $17 billion of common stock during 2023, had increased the common dividend by approximately sixteen percent and that the Federal Reserve had not objected to the 2023 capital plan authorising an incremental buyback program. CFO Mike Santomassimo walked analysts through the net interest income trajectory, indicating that the rate-driven tailwind was moderating as the asset sensitivity normalised and that the outlook for 2024 saw modest sequential declines in net interest income, partially offset by the operating leverage from the expense reduction and by the contribution from the credit card and the investment banking franchises. He flagged that the asset quality metrics remained within the historical range and that the credit loss provisions taken during the year were consistent with the long-run normalisation trajectory rather than with a cycle deterioration. On the Q&A, analysts pressed on whether the asset cap would be lifted in 2024. Scharf responded that the regulatory work was ongoing, that the Company had made material progress on the consent order remediation and that the asset cap was ultimately at the discretion of the Federal Reserve. He also pushed back on the suggestion that the franchise's growth potential was structurally limited by the asset cap, arguing that the operating leverage achieved under the constraint had actually positioned the Company for faster growth once the cap was lifted and that the credit card, investment banking and wealth management franchises had been the principal beneficiaries of the repositioning. The call closed with management reiterating the long-term framework of positive operating leverage, mid-teens return on tangible common equity and a return of essentially all of the operating earnings power to shareholders, and committing to continue the share repurchase pace through the cycle as the regulatory environment normalised.

CEO Tim Sloan opened the Q4 2018 review against the backdrop of the February 2018 Federal Reserve enforcement action that had capped the Company's total assets at approximately $1.95 trillion until governance and risk management controls were certified as effective. Management told the call that the operating earnings power of the franchise had continued to grow despite the asset cap, that the Federal Reserve had conditionally approved the 2018 capital plan and that the Company had repurchased approximately $4.1 billion of common stock during the fourth quarter under the 2018 CCAR cycle. CFO John Shrewsberry walked analysts through the operating leverage achieved under the asset cap, indicating that net interest income had grown despite the constraint by repositioning the asset side of the balance sheet toward higher-yielding loans and away from lower-yielding securities. He flagged that the expense trajectory had been elevated by the regulatory remediation costs but that the underlying operating expense run-rate would compress once the remediation programs wound down. On the Q&A, analysts pressed on whether the Federal Reserve asset cap would be lifted in 2019. Sloan responded that the Company was executing against the consent order requirements, that an independent third-party review was under way and that the timeline for lifting the cap was ultimately at the discretion of the Federal Reserve. He also defended the operating framework, arguing that the asset cap had actually driven better capital allocation discipline by forcing the Company to grow only the highest-returning asset categories and to contract the lower-returning ones. The call closed with management framing 2019 as a transition year of expense discipline, regulatory remediation and selective asset growth, and reiterating the long-term objective of mid-teens return on tangible common equity and a return of essentially all of the operating earnings power to shareholders through the cycle.

Chenault opened the Q4 2015 review by reporting full-year revenues net of interest expense of $32.7 billion and earnings per share of $5.64, both up on a constant-currency basis. Management told the call that the proprietary consumer and small-business network had grown both billings and Card Member loans in the mid-teens year over year, and that the renewal of the Costco co-brand portfolio to Citigroup and Visa had been the most consequential strategic decision of the year, framed as a willingness to walk away from a portfolio whose unit economics did not clear the Company's return-on-equity hurdles. CFO Jeff Campbell walked analysts through the $400 million pre-tax restructuring charge taken in the quarter, which had accelerated the Company's transition to digital-first service and marketing. He flagged that more than seventy percent of new accounts were being acquired through digital channels, that mobile was now the largest customer-service channel and that the underlying technology cost-to-serve would compress materially over the following two years. On the Q&A, analysts pressed on whether the Costco decision would produce a multi-year overhang on revenue growth. Chenault defended the decision, arguing that the renewal terms being offered by Costco would have destroyed the marginal economics of the portfolio and that the underlying premium proprietary franchise was growing fast enough to absorb the volume loss. He also signalled that the loss of the JetBlue co-brand to Barclays reflected similar discipline around the minimum acceptable return on the deployed capital in co-brand. The call closed with management reaffirming the long-term algorithm of mid-teens earnings growth, anchored on the durability of the premium proprietary spend franchise, and signalling that 2016 would be a transition year affected by the Costco exit before the proprietary growth re-accelerated in 2017.

Moynihan opened the Q4 2014 review by reporting full-year net income of $4.8 billion, with operating earnings per share of $0.75 for the quarter, and a return on tangible common equity of approximately twelve percent for the year. Management told the call that the legacy mortgage-related charges had finally rolled off and that the Company's operating leverage during the quarter had been the best of the post-crisis era, with operating expense down year over year on the back of Project New BAC's full run-rate savings. CFO Bruce Thompson walked analysts through the Common Equity Tier 1 ratio of approximately ten percent, the supplementary leverage ratio build and the share repurchase activity during the year. He flagged that the Federal Reserve had conditionally approved the 2014 capital plan and that the Company had repurchased roughly $1.5 billion of common stock during the quarter, with the intent to step up the pace as the operating earnings power normalised. On the Q&A, analysts pressed on whether the Bank could finally return to a steady-state capital return trajectory given the litigation and regulatory overhang of the prior five years. Moynihan argued that the litigation pipeline had been substantially resolved, that the Company had moved into the upper quartile of CCAR stress-test outcomes and that the intent was to step up the common dividend at a measured pace and to drive the buyback pace off the operating earnings power rather than off the excess capital build alone. The call closed with management framing the next phase as the operational transformation of the consumer banking and the wealth management franchises - investing in mobile banking, financial adviser headcount and digital mortgage - rather than as the capital-restructuring phase that had dominated the prior five years.

BERKSHIRE HATHAWAY INC. ACQUISITION CRITERIA We are eager to hear from principals or their representatives about businesses that meet all of the following criteria: (1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units), (2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations), (3) Businesses earning good returns on equity while employing little or no debt, (4) Management in place (we can’t supply it), (5) Simple businesses (if there’s lots of technology, we won’t understand it), (6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown). The larger the company, the greater will be our interest: We would like to make an acquisition in the $5-20 billion range. We are not interested, however, in receiving suggestions about purchases we might make in the general stock market. We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer – customarily within five minutes – as to whether we’re interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don’t participate in auctions.

The sell-off alternative, on the other hand, lets each shareholder make his own choice between cash receipts and capital build-up. One shareholder can elect to cash out, say, 60% of annual earnings while other shareholders elect 20% or nothing at all. Of course, a shareholder in our dividend-paying scenario could turn around and use his dividends to purchase more shares. But he would take a beating in doing so: He would both incur taxes and also pay a 25% premium to get his dividend reinvested. (Keep remembering, open-market purchases of the stock take place at 125% of book value.) The second disadvantage of the dividend approach is of equal importance: The tax consequences for all taxpaying shareholders are inferior – usually far inferior – to those under the sell-off program. Under the dividend program, all of the cash received by shareholders each year is taxed whereas the sell-off program results in tax on only the gain portion of the cash receipts. Let me end this math exercise – and I can hear you cheering as I put away the dentist drill – by using my own case to illustrate how a shareholder’s regular disposals of shares can be accompanied by an increased investment in his or her business. For the last seven years, I have annually given away about 4 1⁄4% of my Berkshire shares. Through this process, my original position of 712,497,000 B-equivalent shares (split-adjusted) has decreased to 528,525,623 shares.

• A much improved situation is emerging at NetJets, which sells and manages fractionally-owned aircraft. This company has never had a problem growing: Revenues from flight operations have increased 596% since our purchase in 1998. But profits had been erratic. Our move to Europe, which began in 1996, was particularly expensive. After five years of operation there, we had acquired only 80 customers. And by mid-year 2006 our cumulative pre- tax loss had risen to $212 million. But European demand has now exploded, with a net of 589 customers having been added in 2005-2006. Under Mark Booth’s brilliant leadership, NetJets is now operating profitably in Europe, and we expect the positive trend to continue. Our U.S. operation also had a good year in 2006, which led to worldwide pre-tax earnings of $143 million at NetJets last year. We made this profit even though we suffered a loss of $19 million in the first quarter. Credit Rich Santulli, along with Mark, for this turnaround. Rich, like many of our managers, has no financial need to work. But you’d never know it. He’s absolutely tireless – monitoring operations, making sales, and traveling the globe to constantly widen the already-enormous lead that NetJets enjoys over its competitors. Today, the value of the fleet we manage is far greater than that managed by our three largest competitors combined. There’s a reason NetJets is the runaway leader: It offers the ultimate in safety and service.

(1) Large purchases (at least $10 million of after-tax earnings), (2) Demonstrated consistent earning power (future projections are of little interest to us, nor are "turnaround" situations), (3) Businesses earning good returns on equity while employing little or no debt, (4) Management in place (we can't supply it), (5) Simple businesses (if there's lots of technology, we won't understand it), (6) An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

Help! Help! Regular readers know that I shamelessly utilize the annual letter in an attempt to acquire businesses for Berkshire. And, as we constantly preach at the Buffalo News, advertising does work: Several businesses have knocked on our door because someone has read in these pages of our interest in making acquisitions. (Any good ad salesman will tell you that trying to sell something without advertising is like winking at a girl in the dark.) In Appendix B (on pages 26-27) I've reproduced the essence of a letter I wrote a few years back to the owner/manager of a desirable business. If you have no personal connection with a business that might be of interest to us but have a friend who does, perhaps you can pass this report along to him. Here's the sort of business we are looking for: (1) Large purchases (at least $10 million of after-tax earnings), (2) Demonstrated consistent earning power (future projections are of little interest to us, nor are "turnaround" situations), (3) Businesses earning good returns on equity while employing little or no debt, (4) Management in place (we can't supply it), (5) Simple businesses (if there's lots of technology, we won't understand it), (6) An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown). We will not engage in unfriendly takeovers.

Mistakes of the First Twenty-five Years (A Condensed Version) To quote Robert Benchley, "Having a dog teaches a boy fidelity, perseverance, and to turn around three times before lying down." Such are the shortcomings of experience. Nevertheless, it's a good idea to review past mistakes before committing new ones. So let's take a quick look at the last 25 years.

(1) Large purchases (at least $10 million of after-tax earnings), (2) demonstrated consistent earning power (future projections are of little interest to us, nor are "turnaround" situations), (3) businesses earning good returns on equity while employing little or no debt, (4) management in place (we can't supply it), (5) simple businesses (if there's lots of technology, we won't understand it),

(2) demonstrated consistent earning power (future projections are of little interest to us, nor are 'turnaround' situations), (3) businesses earning good returns on equity while employing little or no debt, (4) management in place (we can't supply it), (5) simple businesses (if there's lots of technology, we won't understand it), (6) an offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

We hope to buy more businesses that are similar to the ones we have, and we can use some help. If you have a business that fits the following criteria, call me or, preferably, write. (1) large purchases (at least $10 million of after-tax earnings), (2) demonstrated consistent earning power (future projections are of little interest to us, nor are "turnaround" situations),

We have written in past reports about the disappointments that usually result from purchase and operation of 'turnaround' businesses. Literally hundreds of turnaround possibilities in dozens of industries have been described to us over the years and, either as participants or as observers, we have tracked performance against expectations. Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.

GEICO's problems at that time put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true 'turnaround' situation in which the managers expect - and need - to pull off a corporate Pygmalion.

Our forecast is for an average combined ratio for the industry in the 105 area over the next five years. While we have a high degree of confidence that certain of our operations will do considerably better than average, it will be a challenge to us to operate below the industry figure. You can get a lot of surprises in insurance. Nevertheless, we believe that insurance can be a very good business. It tends to magnify, to an unusual degree, human managerial talent - or the lack of it. We have a number of managers whose talent is both proven and growing. (And, in addition, we have a very large indirect interest in two truly outstanding management groups through our investments in SAFECO and GEICO.) Thus we expect to do well in insurance over a period of years. However, the business has the potential for really terrible results in a single specific year. If accident frequency should turn around quickly in the auto field, we, along with others, are likely to experience such a year.