Investors expecting big changes in tone, or radical shifts in strategy from Warren Buffett and Charlie Munger in Berkshire Hathaway’s 2018 shareholder letter were once again disappointed. Berkshire didn’t unveil a dividend, both believe the whole of the conglomerate is worth more than the sum of its component parts, and they didn’t brag that hunting for acquisitions in today’s market was easy.
But there were a few important developments of note. For years, investors have studied succession plans at Berkshire for Buffett, 88, and Munger, 95, and this year’s letter gave further evidence of what they will be. In 2018, Berkshire named Ajit Jain head of its sprawling insurance activities, led by GEICO, National Indemnity and its reinsurance operations, and Greg Abel as head of of its non-insurance operations. Those businesses span utilities, railroads, energy, chemicals, aviation, paints and housing and athletic wear, among others.
A year in, Buffett and Munger seem pleased with the performance of both, who are also now vice chairmen. “Berkshire is now far better managed than when I alone was supervising operations. Ajit and Greg have rare talents, and Berkshire blood flows through their veins,” the letter said. “These moves were overdue.”
In 2018, Berkshire’s insurance businesses returned to profitability and ended the year with a record $122 billion in float. Its railroad, utilities and energy business saw operating profits rise 30% to $7.8 billion and the bevy of other businesses that Abel was tasked with overseeing generated a further $9.3 billion in operating earnings, up 29%.
“Buffett threw a bone to those wanting more on succession by formalizing and endorsing the Ajit Jain and Greg Abel organization structure,” said Drew Wilson, a portfolio manager at Fenimore Asset Management, which has owned Berkshire shares with little turnover since around the time of the 1987 market rout. However, this year Buffett and Munger didn’t mention their investing lieutenants Ted Weschler and Todd Combs by name in the shareholder letter. “I’m guessing we’ll get a lot of questions wanting more detail at the annual meeting,” added Wilson, who co-manages the $1.1 billion in assets FAM Value Fund.
Another wrinkle was Buffett’s decision to downplay Berkshire’s book value, an accounting metric that has headlined the company’s annual results for decades. “Long-time readers of our annual reports will have spotted the different way in which I opened this letter. For nearly three decades, the initial paragraph featured the percentage change in Berkshire’s per-share book value. It’s now time to abandon that practice,” said Buffett.
According to him, book value has lost relevance because Berkshire’s gargantuan $173 billion investment portfolio is a fraction of the firm’s overall assets, which are now weighted to operating businesses, led by insurance. New accounting rules, he argued, undervalue these operating businesses. Most important, Berkshire expects to repurchase a ton of stock, likely at prices well above book value. “The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality,” Buffett said.
An unsurprising point, Buffett reiterated his belief that the easy buys of the post-recession market are gone. Thus Berkshire didn’t make major acquisitions in 2018, but bought $43 billion in public securities, primarily Apple. There were three finer points of Berkshires earnings and shareholder letter worth dwelling on.
Seeing The Forest From The Trees
No one wants to lose $25 billion in the span of 90-days, especially Buffett. But that’s exactly what Berkshire reported as it marked its books for a quarter in which U.S. stock markets slumped in October, and then plunged through December. Berkshire’s investment portfolio was marked down by $27 billion and it recorded a $3 billion impairment related to its share of Kraft Heinz’s recent $15.4 billion write down, where it’s a large holder. That mark-to-market loss more than wiped out $5 billion plus in operating profits, driving a $25 billion quarterly loss. For 2018, Berkshire lost $17 billion on marks to its investment portfolio, though virtually all of those were on paper, thus overall net income was just $4 billion for the year, a 90% drop.
The loss, however, may go a long way in proving an important point in the shareholder letter. Buffett insisted investors look at the totality of Berkshire’s assets and the advantaged way in the way they’re housed. Said Buffett: “Investors who evaluate Berkshire sometimes obsess on the details of our many and diverse businesses – our economic “trees,” so to speak. Analysis of that type can be mind-numbing, given that we own a vast array of specimens, ranging from twigs to redwoods. A few of our trees are diseased and unlikely to be around a decade from now. Many others, though, are destined to grow in size and beauty… Fortunately, it’s not necessary to evaluate each tree individually to make a rough estimate of Berkshire’s intrinsic business value. That’s because our forest contains five “groves” of major importance, each of which can be appraised, with reasonable accuracy, in its entirety.”
The mark-to-market loss may prove the point. There are few, if any, entities on the planet that could bear such marks. In fact, Berkshire still saw its overall cash and book value grow for the year. Those stuck looking at trees might obsess over the daily or quarterly marks of Berkshire’s growing investment portfolio, or have doubts when specific stocks like Apple falter, but the bigger picture is that its portfolio is housed in a structure that can bear the market’s inherent volatility. It is one of the biggest advantages Buffett’s enjoyed in beating the market over many decades.
Stock Buybacks And Retained Earnings
There are many examples of companies who should be criticized for buying back their stock at overvalued prices thus wasting money, or simply spending cash they don’t have. The tens of billions of dollars that banks like Lehman, Bear , Goldman, Merrill, Morgan, Citigroup and BofA spent collectively to buy back their shares in 2007 and 2008 as the housing market began cratering is one of the unforgivable sins of the crisis. They didn’t have the money for buybacks, but used them to delay a reckoning. When each imploded, or had to dilute their stock in government rescues, the folly of Wall Street’s biggest financiers was astounding.
For companies that do have the money, however, buybacks can still be effective.
Buffett did a good job showing this, using Berkshire’s holdings in American Express. Berkshire hasn’t traded Amex in the past eight years, because the company bought tens of billions in stock Berkshire’s holding has gone from 12.6% of Amex’s shares outstanding to 17.9%. As a result, Berkshire’s portion of the $6.9 billion Amex earned was about $1.2 billion, in theory. “When earnings increase and shares outstanding decrease, owners – over time – usually do well,” said Buffett.
What was unique in this explanation is Buffett didn’t dwell on stock prices. Berkshire’s $1.2 billion theoretical claim on Amex’s 2018 profits is about equal to the $1.3 billion cost it paid for its shares. The price at which buybacks occur does matter, but the most important element in this explanation is whether investors’ holdings are increasing in a sustainably profitable business. In the case of Amex, it is the company’s fundamentals over time that have likely proven more important to Berkshire’s gains than the exact price of buybacks. Failed buybacks come at bad prices, but mostly because the business is bad.
When Berkshire Invests It Isn’t Just Stocks And Elephant-Sized Deals
A theme that deserves more study at Berkshire is how it invests cash into its operating businesses. These divisions are becoming more sizable, so it should be no surprise the size of investments are growing. Last year, Berkshire recorded nearly $10 billion in depreciation and amortization on the assets of its operating businesses and invested a record $14.5 billion in plant, equipment and other fixed assets.
As Buffett notes, “Berkshire’s $8.4 billion depreciation charge understates our true economic cost. In fact, we need to spend more than this sum annually to simply remain competitive in our many operations. Beyond those “maintenance” capital expenditures, we spend large sums in pursuit of growth. Overall, Berkshire invested a record $14.5 billion last year in plant, equipment and other fixed assets, with 89% of that spent in America.”
This spending may well be among the conglomerate’s most important and highest return in coming years. As profitable as Berkshire’s operating businesses were last year, Buffett, Munger, Jain and Abel decided in favor of growth investment, over billions in added profits they could have recorded to impress shareholders. What will be the outcome of growth capex at BNSF versus spending cuts by many of its rail peers, or at Berkshire Hathaway Energy for that matter? Don’t sleep on Jain and Abel as investors, Berkshire’s owned businesses generated $37.4 billion in operating cash flow last year.
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