*Update: I fixed the link to the podcast.
I reviewed the Berkshire Hathaway (BRK)’s 2018 letter and listened to CNBC interview that followed. I also share my comments on The Intelligent Investing Podcast with Eric Schleien from Granite State Capital Management.
During Warren Buffett’s career of over sixty plus years, whatever needed to be said about investing has been said. You are not going to get a shocking change of opinion from an 87 year old man. The latest letter doesn’t contain any surprises and he was notoriously sphinxlike during the three interview on CNBC. Buffett can talk for hours but rarely said anything that you could use.
There are things that never change. The letter contains what you would expect, including the classic hits; “I’m younger than Charlie”, “stocks are better than gold”, and “invest in an index fund” among others.
Warren used his shareholder letter to talk to his shareholders and to educate them. Now he probably feels like he’s writing the letter for everybody to read. It gets picked up in the media and is quoted everywhere. If you are an investor looking for more technical content, the Warren Buffet Partnership letters are great.
Warren Buffett is a household name. When you think of the greatest golfer of all time, Tiger Woods comes to mind. When you think of the greatest investor of all time, you think Warren Buffett. When you achieve this level of fame you have an outsize audience. The new investors, students, people with savings, professional, and non-investors are turning to you for advice. Warren realizes that he has to be careful with what his words.
However I will mostly remember this letter for what’s wasn’t being said.
- In the letter Buffett talked about “diseased trees”, companies that will not be around in 10 years. No details on that out of respect for the workers there. But I think as a shareholder I would like a little bit more clarity.
- I wish there was a deeper look at industrial businesses.
- No comments on Apple, which is now the 2nd biggest position on his equity portfolio.
- It would be fun to hear from the investment managers Ted Weschler and Tom Combs, and from Greg Abel and Ajit Jain. Maybe they can write a letter too?
- No details on his Fintech investments, Paytm and StoneCo.
- No details on his healthcare venture with JPMorgan and Jeff Bezos.
In the letter Buffett talks about focusing on the forest and not the trees (the companies), and he divides his trees into five groves to simplify things. I appreciate anything that simplify life. But as an investor in the company, I should know more about BRK’s investments. I like to learn about bushiness. I would like to learn more about the companies inside BRK, not just the 4-5 big ones. I don’t need a full 10k of details. For example: It would be fun to learn about what is Brooks working on? What’s their vision of the shoe of the future? Where do they see the company in five or ten years? How’s Dairy Queen doing? It could be a paragraph or two. I understand there are like two hundred companies. Since BRK decentralized everything, the manager of these companies can write a separate report. Brookfield Asset Management, another company with many moving parts, does a good job talking about their various investments without getting immersed or entangled in details or complexities.
For Berkshire Hathaway, I see three possible paths forward.
- Return cash. Accept that BRK must be less ambitious but will likely not go down that path.
- More takeover but expensive. That’s Buffett preferred route.
- Wait for a crash and load up on stocks.
Here are some notes:
BRK outperformed the S&P 500 for the third year in a row, 4 out of the last 5 years, and 7 out of the last 10 years (2009-2018). The shares increased at a 17.3% (11.5%) CAGR during 2013-17 (2014-18), compared with a 15.8% (8.5%) average annual return for the S&P 500.
It’s worth noting that BRK’s returns are after-tax and the S&P are pre-tax with dividends included.
- Per-share change: 2.8%
- Book value per share: 0.4%
- S&P: -4.4%
Compounded Annual Gain per share from 1965-2018: 20.5% vs 9.7% for the S&P 500 (dividends included). Over the past 54 years, book value has increased from $19 to $348,703.
It’s amazing that BRK can still outperform at its current size ($500b market cap). For the longest time, Buffett and Munger remind us year after year that they do not expect to outperform the S&P but they still do. BRK is the 7th largest most-valuable publicly traded company. The other 6 are tech companies. I do not expect Berkshire to be able to consistently increase its book value per share at a double-digit rate going forward–a feat the firm achieved six times during 2009-18.
Regular readers of the annual letter probably noticed that Buffett diminished the annual change in BRK’s book value because over time that number has become out of touch with BRK’s economic reality. What really counts of course is per-share intrinsic value. But that’s a subjective figure and book value was a useful tracking indicator when book value and intrinsic value were much closer. For the large majority of its existence BRK’s assets were then largely securities whose assets were continuously restated to reflect their current market price.
Today BRK has shifted in a major way to owning and operating large businesses and many are worth far more than their cost-based carrying value. That number is never revalued upward. Consequently the gap between BRK’s book value and intrinsic value has material increased. That’s why BRK has introduced the historical record of BRK’s stock price to the performance table.
In the letter Buffett cited three main reasons for that:
- BRK’s value is now mostly derived for the operating businesses that it owns. It used to be derived from its massive stock portfolio
- Accounting rules dictates that equity holdings are marked-to-market (market prices) and operating companies at their cost-based carrying value, which is below their current value and not reflected in the financial statements.
- BRK will likely buy more if its shares over time above book value but below intrinsic value. If you do it right, each transaction will make per-share intrinsic value go up, while per-share book value will go down.
BRK’s intrinsic value far exceeds book value, that’s why it made sense to repurchase shares at 120% book value made sense. Now that policy has been dropped and BRK now repurchase shares when it feels it below intrinsic value.
BRK earned $4 billion in 2018 and how we arrived at that number is broken down below.
Because of the new mark-to-market rule, the last item brings wild swings to the bottom line. BRK has an equity portfolio of $173 billion. So a 1% change is either a 1.7% accounting gain or loss. The $20.6b loss was no actually triggered. It’s a change in value. It’s an accounting number that distort the true economic value of the company. That’s why it’s important to focus on the operating earnings. Operating earnings is a better performance metric than net income, since the latter is subject to numerous accounting rule.
Management – Succession
No update here except that Ajit Jain and Greg Abel are doing well. Ajit runs all insurance activities and Greg is in charge of all other operations. Todd and Ted are expected to run investments but I’m not sure if this is set in stone.
Focus on the Forest – Forget the Trees
- Compares BRK to this massive forest with many different trees. Some trees are sick and will die. Others will grow in size.
- He said you don’t need to evaluate each tree (business) individually to make a rough estimate of BRK’s intrinsic value.
- The forest contains five “groves” of major importance. Each grove can be appraised with reasonable accuracy.
- Operating businesses: $16.4b in earnings.
- Equity portfolio of $173b. $3.8b in dividends received.
- Shared control. Kraft Heinz, Berkadia, etc…$1.3b in earnings.
- Cash & Treasury bills: $132b in cash/fixed income instrument.
- Insurance operations: $2b underwriting gain, $5.5b in investment income.
- BRK’s main goal is to buy whole or part businesses that possess favorable and durable economic characteristics at a good price.
- If he can’t find what he wants, will look at publicly trade stocks. Bough $43b and sold $19b last year.
- Buffett rant on “adjusted EBITDA”, a measure that excludes a bunch of real cost like stock-based compensation.
- BRK spends more than $8.4b depreciation charge to remain competitive. Spent $14.5B in capex.
- The $173b stock portfolio paid dividends of $3.8b.
- BRK gets about$745 million in dividends from Apple. Wells-Fargo pays $809m. I expect Apple to over-take Wells-Fargo if BRK doesn’t reduce their stake too much.
- Berkshire’s portion of the $6.9 billion earned by American Express was $1.2 billion, about 96% of the $1.3 billion we paid for our stake in the company.
Here’s a table of BRK’s five largest holdings:
Buffett promised that he will always to keep a $20b rainy day fund. They are having a hard time to find to invest their excess liquidity because of sky-high prices for businesses possessing decent long-term prospects. As of consequence, Buffett expects to buy more public equities in the short-term.
This is how Buffett calculates BRK’s intrinsic value. Add the 4 segments together (or groves) and subtract taxes payable on marketable securities. Intrinsic value is basically all the future cash flow that can be taken out of a business during its remaining life discounted to the present.
This is the most valuable segment. BNSF and Berkshire Hathaway Energy are the two biggest holding. They earned $9.3b pre-tax combined, up 6% from 2017. Other holdings are Clayton Homes, International Metalworking, Lubrizol, Marmon, Precision Castparts, Forest Rivers, John Mansville, MiTek, Shaw, TTI and much more.
- Earned $20.8b pre-tax. 24% more than in 2017. $9.3b, almost after, is two companies, BNSF and BHE.
Insurance Operations and the Float
BRK’s ownership in the first four segments (groves) is financed by funds generated from the insurance companies called the “float”. Property/Casualty insurers (P/C) receive premiums upfront and pay claims later. This collect-now, pay-later model leaves P/C companies holding large sums called “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit.
Float has grown over the years:
If premiums exceed the total of our expenses and eventual losses, insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, BRK enjoy the use of free money – and, better yet, get paid for holding it.
Achieving an underwriting profit is hard because of intense competition. A lot of P/C insurers operates at an underwriting loss but hopes to make money with the investment segment. Buffett expects subnormal returns in the future.
The insurance operations earned $2b in 2018. Berkshire has now operated at an underwriting profit for 15 of the past 16 years.
In most cases, the funding of a business comes from two sources – debt and equity. In addition Berkshire has access to float and deferred taxes.
- Debt: BRK is very conservative using debt. Most of the debt are linked to capital intensive companies like BHE and BNSF, where cash generation is plentiful
- Equity: $349 billion in equity capital. The amount is huge because BRK kept earnings and the magic of compounding
- Float: As describe in the paragraph above, BRK has been paid in most years for holding and using other people’s money.
- Deferred Taxes: Part of deferred taxes is unrealized capital gain in the equity portfolio. Liabilities that we will eventually pay but that are meanwhile interest-free. Taxes will be paid from the investment are sold. Basically it’s an interest-free “loan” that allows BRK to have more money working for them in equities until they sell. Deferred tax also results from our being able to accelerate the depreciation of assets such as P&E.
- “Usually win, occasionally die” is a great summary of leverage.
- CEO Tony Nicely, who has been GEICO since he was 18, retired. Bill Roberts is the new CEO, Tony’s long time partner.
- GEICO is America #2 auto insurer.
- $22b float.
- Premiums are up to $34.1b
- Rates are increasing on policies
Kraft Heinz (KHC)
- Owns 325,442,152 shares or 26.7%
- Berkshire valued its Kraft Heinz stake at $13.8 billion in 2018, down from $17.6 billion the prior year. Berkshire’s cost basis for the investment was $9.8 billion.
- The $4 billion loss is 1% of book value, 0.8% of market cap, or 0.5% of assets.
- Buffett mentioned on CNBC that he overpaid for Kraft, but not Heinz.
- Buffett admits he made some mistakes on the purchase. Private brands are getting stronger.
- Buffett “We may have made a mistake in terms of trying to push hard against certain…retailers and finding out that we weren’t as strong as we thought,” “You’ve got the weaker bargaining hand than you had ten years ago,”
- “House brands, private label, is getting stronger,” said Mr. Buffett in the television interview. “And it’s gonna keep getting bigger.”
- “It’s very hard to offer a significant premium for a packaged-goods company and have it make financial sense,” “Branded packaged goods are a very, very, very good business in terms of return on tangible assets. But they’re not a sensational business in terms of where you could be five or 10 years from now.”
- Buffett learned about the SEC investigation 10 days before the public.
Ted and Todd
- Have been with BRK for 8 years
- Slightly underperforming the index
- Warren said that they have performed better than him.
- The road ahead was never smooth. Civil war, Great Depression, two World Wars.
- America faced many difficult problems in the past and has overcome them.
- Since Buffett’s first stock purchase in 1942, the S&P is up 5,288x. A $1 million investment by a tax-free institution of that time would have grown to about $5.3 billion.
- Bet on America.