Every year, I eagerly wait for Warren Buffett to release his annual letter to Berkshire Hathaway shareholders. In his past letters, they have contained nuggets of wisdom that give you insights on how Warren Buffett built his Berkshire Hathaway empire from scratch from a failing textile maker in 1965 to a Fortune 500 company today. He also shares the mistakes he made along the way like acquiring Dexter Shoes Co. for US$433 million in Berkshire Class A shares in 1993 which folded just eight years later.
Buffett candidly lays out all these stories in his letters and explains them in a way that even an eight-year-old (albeit one who’s interested in investments) can understand. That’s why I highly recommend you read his letters too!
With that, here are seven things I learned from Warren Buffett’s 2018 letter to Berkshire shareholders:
1. Buffett changed the way he opened his letter this year and has moved away from using per-share book value as a yardstick to measure performance. The new GAAP rule of recognising unrealized fair value gains and losses greatly distorts the company’s bottom line and book value. Through the course of the year, Berkshire’s equity portfolio experienced wild swings, from a profit as high as US$18.5 billion down to a loss as low as US$20.6 billion. Fluctuations in the stock market are merely a reflection of sentiment. Its impact is immaterial in the short run with regards to the performance of the company. What’s more important is that Berkshire’s portfolio continues to compound at a satisfactory rate in the next five to ten years.
‘My expectation of more stock purchases is not a market call. Charlie and I have no idea as to how stocks will behave next week or next year. Predictions of that sort have never been a part of our activities.’
2. Aside from the change in accounting rules, Buffet also mentioned that book value is a poor metric to use in estimating Berkshire’s intrinsic value. The gap between the two has widened and will continue to do so in the future. Berkshire has transitioned from a company that’s largely composed of marketable securities — which are valued at market on the books — to owning a conglomerate of operating businesses. Generally, bad acquisitions are written off the books. However, businesses such as GEICO that grew sales by 1,200% since 1994 are still recorded on the balance sheet at less than US$2.3 billion — the price at which Berkshire paid to acquire the remaining 50% stake in the auto insurer. When, in fact, the company should be worth many more times today than it was 25 years ago.
‘First, Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses. Charlie and I expect that reshaping to continue in an irregular manner. Second, while our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years… That combination causes the book-value scorecard to become increasingly out of touch with economic reality.’
3. The best way, according to Buffett, is to use the sum-of-the-parts valuation method. One can approximate the intrinsic value of each of Berkshire’s five segments based on their earnings and market value. In summary:
- Non-insurance businesses – earnings of US$16.8 billion
- Jointly-controlled entities – earnings of US$1.3 billion
- Investment portfolio – market value of US$173 billion
- U.S. Treasury bills and cash equivalents – US$132 billion (US$112 billion in U.S. Treasury bills and US$20 billion in miscellaneous fixed-income instruments)
- Property/casualty insurance business – underwriting profit of US$2.0 billion
‘I believe Berkshire’s intrinsic value can be approximated by summing the values of our four asset-laden groves and then subtracting an appropriate amount for taxes eventually payable on the sale of marketable securities… Beyond that, much of our ownership of the first four groves is financed by funds generated from Berkshire’s fifth grove – a collection of exceptional insurance companies… Berkshire’s value is maximized by our having assembled the five groves into a single entity. This arrangement allows us to seamlessly and objectively allocate major amounts of capital, eliminate enterprise risk, avoid insularity, fund assets at exceptionally low cost, occasionally take advantage of tax efficiencies, and minimize overhead.’
4. As Berkshire’s opportunity to allocate large amount of capital diminishes, Buffett will slowly turn to repurchasing more of the company’s shares in the future. He started last August by repurchasing US$1 billion worth of shares. Adjusted for unrealized gains and losses, expect this value to be north of 1.2x book value, a buyback policy that Buffett abolished last year.
‘When a company says that it contemplates repurchases, it’s vital that all shareholder-partners be given the information they need to make an intelligent estimate of value. Providing that information is what Charlie and I try to do in this report. We do not want a partner to sell shares back to the company because he or she has been misled or inadequately informed.’
5. Overall, Berkshire is built like a financial fortress, taking on debt sparingly. Most of which are found in their asset-heavy subsidiaries such as railroad and energy. These are highly resilient businesses whose cash flow should not be affected in an economic downturn.
‘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 CEOs will be right most of the time. At rare and unpredictable intervals, however, credit vanishes and debt becomes 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. But that strategy would be madness for Berkshire. Rational people don’t risk what they have and need for what they don’t have and don’t need.’
6. Furthermore, Berkshire will continue to remain disciplined in underwriting insurance policies, pricing them appropriately to the level of risk. This will lead to more years of underwriting profit and a larger float to invest. On top of that, Berkshire has US$132 billion in cash equivalents, Treasury bills and fixed-income securities, to guard against any catastrophic claims.
‘Berkshire has now operated at an underwriting profit for 15 of the past 16 years, the exception being 2017, when our pre-tax loss was $3.2 billion. For the entire 16-year span, our pre-tax gain totaled $27 billion, of which $2 billion was recorded in 2018. That record is no accident: Disciplined risk evaluation is the daily focus of our insurance managers, who know that the benefits of float can be drowned by poor underwriting results. All insurers give that message lip service. At Berkshire it is a religion, Old Testament style.’
7. Lastly, Buffett shared a story on how any investor can do well by investing in an index fund. If you had invested US$1 million in a no-fee S&P 500 index fund in 1942 – the year that Buffett bought his first stock at the age eleven – and held it till 31 January 2019, you would have grown that amount to US$5.3 billion. That’s despite the country having gone through a World War and the Great Recession. However, if you invested in a hedge fund with similar returns, the fees alone would reduce your return by half to US$2.65 billion. That’s a 1% decrease in annual rate of returns over 77 years, from 11.8% to 10.8%. (I guess not many of us would expect how much of a difference a single percent can make in the long run!)
One more bonus point: Berkshire’s annual meeting will once again be available via live webcast on Yahoo. To view the event, go to https://finance.yahoo.com/brklivestream at 8:45 a.m. Central Daylight Time (GMT-6) on Saturday, 4 May 2019. If you’d like to read Buffett’s full 2018 annual letter to Berkshire Hathaway shareholders (which I recommend you do), you can click here. Enjoy the read!