Berkshire Hathaway : Lollapalooza Earnings & The Bet

Numbers are staggering. Berkshire Hathaway, the holding chaired by Warren Buffett and Charlie Munger, earned $44.94 billion last year vs $24.07 billion in 2016, in large part thanks to tax cuts decided by the Trump administration. Operating earnings actually declined to $14.46 billion from 17.58 billion a year ago, mainly because the insurance business lost money. Tax cut contributed $29.11 billion to results, which « derives from a reduction of net deferred income tax liabilities that arose as a result of the reduction in the U.S. corporate income tax rate from 35% to 21%. »

A more meaningful number for understanding the valuation of BRK is the evolution of the net asset per share or book value per share. Last year, the number grew 23% to $211,750, outperforming S&P 500 by 1.2%. CAGR return for book value per share over 1965-2017 is 19.1% vs 9.9% for S&P 500. Patience, discipline, opportunistic approach, great deal of focus on price and knowing his circle of competence explain such an amazing performance.

The most important part of BRK release of its annual report is Buffett’s letter to shareholder. This year, Buffett covers the following topics :

  • Tax impact on book value ;
  • Volatility to expect from new GAAP rule (net change in unrealized gains and losses in stocks held must be included in future net income published on both a quarterly and annual basis) ;
  • M&A: key point here, Buffett says that all businesses reviewed for potential acquisition couldn’t go through because of high prices.

« Prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemd almost irrelevant to an army of optimistic purchasers. » This goes with the unusual kind of remark but straight to the point comment Buffett is famed for : « If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life. »

Valuable lesson here is that when people get over excited and don’t pay attention to the price they pay, Buffett and Munger consider it’s time for caution.

Next to the buyout of PFJ (travel-center operator), BRK’s business mainly focused on bolt-on acquisitions. No big deal.

  • Insurance and « mega-cats ». The 2017 hurricanes (Texas, Florida, Puerto Rico) reached the $100 billion mark, but losses for BRK were only $3 billion (insurance underwriting business sufferred a loss in 2017).

Buffett underlines that things could have been worse and mentions a U.S. mega-catastrophe causing $400 billion or more of insured losses that has a c2% probability. « No company comes close to BRK in being financially prepared for a $400 billion mega-cat. Our share of such a loss might be $12 billion or so, an amount far below the annual earnings we expect from our non-insurance activities. »

  • Not participating in M&A doesn’t prevent the company from investing in the US economy – BRK spent $11.5 billion in capex while depreciation reached $7.6 billion. « America’s economic soil remains fertile », says Buffett.
  • The most followed part of the letter concerns investments. At end of 2017, the largest investments (Amex, Apple, Bank of America, Coca-Cola, Wells Fargo, U.S. Bancorp and many others) had a market value of $170.54 billion (note that Sanofi, which was listed among the largest investments is no longer on the list – latest 13-F filings before this publication showed a reduction in the number of shares held in the French company).
  • Investing… Buffett talks about the risk of leverage in a declining market (he refers to 1973-75, 1987, 98-2000 and 08-09 boom/bust or crashes experienced by investors), and his basic principle : « when major declines occur, they offer extraordinary opportunities to those who are not handicapped by debt. »
  • Buffett also refers to a bet he made 10 years ago that his investment in an index fund replicating the S&P 500 would do better than 5 fund of hedge funds managed by Protégé Partners. Those funds returned between 2.8% for the worst (actually it was liquidated in 2016) and 87.8% for the best while the S&P 500 returned 125.8%.

This example helps Buffett make 2 points, one about which I think investors need to be careful. First is that fees matter. As Buffett puts it : « Performance comes, performance goes. Fees never falter. »

The other point one could derive from this demonstration is that for the investor, it’s probably best to invest passive rather than trying to pick stocks to beat the market.

Well this is where people should be careful. Buffett is a stock picker, eager to spot market inefficiencies. He has a bigger advantage than any active fund manager : he doesn’t report to anyone because he manages his « own » money in a certain way and he has been very disciplined, taking advantage of the market when things go awry (that’s exactly what he did in 2008). He also has always been cautious about overexcitment on Wall Street (for instance when he called derivatives weapons of mass destruction some years before the subprime crisis…).

If everyone tried to play the same game the way Buffett does, market inefficiencies would probably be more difficult to unearth. Massive amounts of information and technology helps investor find opportunities much faster than 10-20-50 years ago.

You can’t expect Buffett to start saying to everyone they should read Graham and focus on quality/growth stocks when markets go crazy (usually that’s when those quality stocks tend to be cheap enough to buy).

Pointing to passive investing is a way to help some investors taking advantage of stock market (provided they pay attention to the price they pay). But it’s also a way to protect his own turf.

He is not trying to fool anyone yet. Just giving an honest opinion and leverage from his deep and long experience of investment and the human mind.

That’s actually what follows when he warns about the risk of investing in equities.

  • A lesson for the long run : « in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates. »
  • Final lesson : « stick with big, ‘easy’ decisions and eschew activity. »

 

The investing philosophy:

« Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results. In America, equity investors have the wind at their back. »

Link to Buffett’s Annual Letter to Shareholders

Link to the 2017 Annual Report

Link to 4Q earnings release

 

DISCLAIMER

I own shares of Berkshire Hathaway (B class) and I was lucky to attend BRK meeting in Omaha twice (2014, 2015), which is the most amazing experience you can get as a shareholder in a public company. No public company is a match in terms of friendliness and positive atmosphere when it comes to gathering around 45k people from all over the world in a single place. And Omaha people are amazing and super nice btw 🙂