Buffett 2019 — "An element of compound interest operating in favour"

Published: February 22, 2020 — Warren Buffett, Berkshire Hathaway 2019 Annual Report

In 2019, Berkshire Hathaway's ten largest investees paid $3.8 billion in dividends that flowed directly into Berkshire's reported earnings. The same companies retained another $8.3 billion of profits that belonged, proportionately, to Berkshire — and went completely unrecorded in any income statement Berkshire filed. 1

Buffett devoted several pages of the 2019 letter to explaining why this gap matters — and why he considers it one of the most important and underappreciated facts about how equity investing actually builds wealth. The argument reaches back to a 1924 book that almost nobody reads today, an endorsement from John Maynard Keynes, and a principle Buffett calls one of the foundational insights of investing. The $8.3 billion is not an accounting technicality. It is the thing itself.

The 1924 book that changed how equities were understood

Edgar Lawrence Smith (an American financial analyst) published Common Stocks as Long Term Investments in 1924 with an intention that did not survive his own research. Smith had set out to argue that stocks outperform bonds during inflationary periods while bonds win during deflation. His data proved the first half correct and the second half wrong. Bonds did not, as he had expected, outperform stocks even in deflationary conditions. 1

Faced with findings that contradicted his thesis, Smith did something that remains genuinely unusual in financial literature: he published the failure. The book opens, as Buffett quotes in the letter, with a disarmingly direct confession:

"These studies are the record of a failure — the failure of facts to sustain a preconceived theory."

In working out why his original thesis was wrong, Smith identified something his predecessors had missed entirely. Before his book, the prevailing understanding of stocks was that they were vehicles for capital appreciation — or, in Buffett's phrase, "a short-term gamble on market movements," while "gentlemen preferred bonds." What Smith noticed was that well-managed companies routinely kept a portion of their earnings and reinvested them in the business, rather than distributing everything to shareholders. 1

That retention, compounded year after year, created a compounding mechanism inside the company that worked silently in favor of shareholders whether or not they were watching it happen.

Keynes reads Smith, and borrows from him

The book attracted a review from John Maynard Keynes (the British economist who transformed 20th-century macroeconomic thought), who called Smith's retained-earnings observation the most important — and most novel — point in the work. Buffett reproduces the full passage in the 2019 letter:

"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 operating in favour of a sound industrial investment." 1

Keynes italicized "compound interest" himself. The significance he was signaling is that the internal reinvestment of retained earnings generates returns that compound — not once but year after year, inside the business, before they ever appear in a shareholder's brokerage account or income statement. The shareholder doesn't see this accumulation directly; it accretes inside the companies they own, lifting intrinsic value in ways the reported dividend yield cannot measure.

Buffett's two-sentence verdict: "Smith's insight accounts for much of what has driven equity returns over the past century. Mr. Smith got it right." 1

The invisible $8.3 billion: what GAAP omits

The abstract principle becomes concrete in the 2019 letter through a table Buffett presents of Berkshire's ten largest equity holdings. The table shows, side by side, two numbers for each company: dividends that Berkshire actually received and recognized in earnings, and retained earnings attributable to Berkshire's ownership stake that went entirely unrecognized.

Berkshire's 10 largest investees: dividends received vs. retained earnings (2019)

GAAP records only the left column. The right column is the value accumulating inside the businesses. All figures are Berkshire's proportionate share. From the 2019 Annual Report.

Dividends received (GAAP-recognized)

$3.798B

Retained earnings (GAAP-invisible)

$8.332B

Apple alone — dividends vs. retained

$773M vs. $2.519B

Bank of America — dividends vs. retained

$682M vs. $2.167B

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The ten companies as of December 31, 2019 were Apple (5.7% owned, 250.9 million shares), Bank of America (10.7% owned, 947.8 million shares), American Express, Coca-Cola, Wells Fargo, J.P. Morgan Chase, Delta Air Lines, U.S. Bancorp, Bank of New York Mellon, and Moody's. 1

The retained earnings Berkshire's portfolio companies kept and reinvested — $8.3 billion in a single year — exceeded dividends received by more than two to one. None of it appeared anywhere in Berkshire's reported operating earnings. Buffett calls this "a standout omission of great magnitude." 1

He is not complaining about the accounting. GAAP rules reflect a legitimate concern: retained earnings might be squandered rather than invested productively. His response to that concern is characteristically direct: "Both logic and our past experience indicate that from the group we will realize capital gains at least equal to — and probably better than — the earnings of ours that they retained." The retained earnings are working, he argues; they will eventually surface in stock price appreciation when Berkshire sells — at which point the federal income tax bill (currently at 21%) will come due.

The mechanism Keynes identified in 1924 as an "element of compound interest operating in favour" of industrial investments is, in Buffett's telling, exactly what is being measured (and missed) in this table.

What this means for how investors read reported earnings

The retained earnings argument carries a specific implication for how investors should evaluate companies they own.

Dividend yield understates return potential. A company that pays out only 30% of its earnings and retains 70% is building book value, reducing share count through repurchases, or funding future growth through its retained capital. The yield visible in the dividend screen tells you only what the company chose to distribute; it says nothing about what the retained portion is doing. Over long holding periods, the retained portion — if deployed well — tends to drive the bulk of total return. 1

Operating companies held at cost are systematically undervalued on balance sheets. Berkshire's own internal reinvestment illustrates this: over the decade ending in 2019, depreciation charges totaled $65 billion while investments in property, plant, and equipment totaled $121 billion — meaning Berkshire reinvested nearly twice the depreciation charge back into its operating infrastructure. None of that incremental investment capacity is reflected in a GAAP retained-earnings line that simply adds up accounting income. 1

The investor's task is to find companies that earn well on retained capital. This is the filtering question Smith's observation implies. The insight is not simply that all retained earnings compound — it is that retained earnings compound if the company can deploy them at attractive returns. Berkshire's equity holdings, Buffett notes, were earning on a weighted basis "more than 20% on the net tangible equity capital required to run their businesses" while carrying little excessive debt. 1 At that return on equity, retained capital compounds fast enough to be worth far more than its face value, even after the tax drag on eventual realization.

The 2019 performance numbers in context

The 2019 letter also recorded a year in which Berkshire's per-share market value rose 11.0%, compared with the S&P 500's 31.5% return (including dividends) — a 20.5-percentage-point lag, and Berkshire's worst relative year since 2009. Buffett reported the table without defense. 1

The five-decade context, as of year-end 2019:

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Berkshire vs. S&P 500 compounded annual gain, 1965–2019. 1

The overall gain since 1964: 2,744,062% for Berkshire versus 19,784% for the S&P 500. The single-year gap does not rewrite a five-decade record; Buffett has never argued otherwise. What the 2019 letter adds to this history is a more fundamental account of where that record came from — not from market timing or clever trading, but from the retained earnings of well-managed businesses compounding for decades without being noticed on any income statement.

What to carry forward from this letter

The Edgar Lawrence Smith section is easy to skip. It reads like a historical footnote, and the author it describes has been almost entirely forgotten. But Buffett chooses to give it prominent space in the letter because it names something that most investors, including professionals, have been trained by accounting conventions to overlook.

When you review a stock portfolio today and look at the dividend line, you are seeing only the fraction of each company's earnings that its management decided to distribute. The larger fraction — in many high-quality businesses, the dominant fraction — stays inside the company, compounds at the prevailing return on equity, and accretes to intrinsic value without generating a single entry in your brokerage income section.

For investors holding positions in companies that earn well on retained capital and that management is reinvesting in businesses rather than squandering on ill-conceived acquisitions, this is good news: the income statement dramatically underreports what is happening in the investment. The relevant question is not "how much is this company paying me?" but "at what rate is this company compounding the capital it keeps?"

That is the question Edgar Lawrence Smith identified in 1924. Keynes endorsed it as the most novel point in the book. And in 2019, Buffett used a single table — $3.8 billion visible, $8.3 billion invisible — to show that it remains the central fact about how long-term equity investing builds wealth.

berkshirehathaway.comhttps://www.berkshirehathaway.com/letters/2019ltr.pdf外部リンク

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The 2019 letter was published on February 22, 2020. It is the year GAAP earnings swung from $4 billion to $81.4 billion on the strength of a new mark-to-market accounting rule — a "crazy 1,900% increase," in Buffett's own phrase — while operating earnings were "little changed." 1 The insurance float reached a record $129.4 billion. Apple's position had grown to $73.7 billion, nearly doubling from the $40.3 billion position at year-end 2018. And in a year when the headline accounting figure was noise, Buffett used the letter to return to first principles — to a book published when he was not yet born, and a mechanism Keynes called "compound interest," in italics, for emphasis.

Cover image: AI-generated illustration

参考ソース

1Berkshire Hathaway 2019 Annual Shareholder Letter