Berkshire Hathaway Inc. (BRK.A) released its 2018 annual report on Feb. 23, 2019, and the letter to shareholders from Chairman Warren Buffett contains items of interest to Berkshire shareholders and the general investing public alike. Investopedia studied this letter, and found five observations by Buffett that should be of particular interest, as summarized below.
Buffett's Annual Letter: Five Key Takeaways
- On mark-to-market accounting: "Focus on operating earnings, paying little attention to gains and losses of any variety."
- "The annual change in Berkshire's book value...is a metric that has lost the relevance that it once had."
- "It is likely that--over time--Berkshire will be a significant repurchaser of its own shares."
- Buffett continues to "hope for an elephant-sized acquisition," but "prices are sky-high for businesses possessing decent long-term prospects."
- "Those who regularly preach doom because of government deficits" have been proven wrong by U.S. history.
Significance For Investors
Here we look at each of Buffett's observations in more detail.
Mark-to-market accounting. A new GAAP accounting rule compels Berkshire to value the securities in its investment portfolio based on current market prices. This has two impacts. First, Berkshire's balance sheet will reflect the market values of these securities. Second, any change in these market values from one reporting period to the next will flow into Berkshire's reported earnings. Declines in market value will produce mark-to-market losses that reduce earnings. Increases in market value will generate mark-to-market gains that are added to earnings.
With an equity investment portfolio worth about $173 billion at the end of 2018, Buffett notes that its valuation frequently fluctuates by $2 billion or more on any given day, rising to $4 billion or more when stock market volatility spiked in Dec. 2018. "As I emphasized in the 2017 annual report, neither Berkshire's Vice Chairman, Charlie Munger, nor I believe that rule to be sensible," Buffett writes. Quoting his 2017 letter, he says that the rule produces "wild and capricious swings in our bottom line."
Book value."Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses...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."
Share repurchases. While signaling that Berkshire plans to return significant amounts of capital to stockholders through this method, Buffett adds that this plan is another reason to abandon his former focus on book value. "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 insists that stock repurchases will be untaken only if they can "buy at a discount to Berkshire's intrinsic value," since this way "continuing shareholders reap an increase in per-share intrinsic value with every repurchase by the company." By contrast, "Blindly buying an overpriced stock is value-destructive, a fact lost on many promotional or over-optimistic CEOs."
New acquisitions and equity investments. "In the years ahead, we hope to move much of our excess liquidity into businesses that Berkshire will permanently own. The immediate prospects for that, however, are not good: Prices are sky-high for businesses possessing decent long-term prospects. That disappointing reality means that 2019 will likely see us again expanding our holdings of marketable equities. We continue, nevertheless, to hope for an elephant-sized acquisition."
However, Buffett has "pledged to always hold at least $20 billion in cash equivalents to guard against external calamities." Berkshire's cash "stash" was $112 billion at the end of 2018.
The federal deficit and the national debt. Since March 11, 1942, when Buffett made his first investment in stock, through Jan. 31, 2019, he notes that each dollar invested in the S&P 500 Index (SPX) would have grown to $5,288, with dividends reinvested and before taxes and transaction costs. Meanwhile, the national debt has increased roughly 400-fold, or by about 40,000%, during the same time period.
"Doomsayers" who worried about "runaway deficits and a worthless currency" and thus bought gold instead of stocks back then would have seen each dollar grow to only about $36, "less than 1% of what would have been realized from a simple unmanaged investment in American business," Buffett notes. "The magical metal was no match for American mettle," he adds.
Investment fees and portfolio performance. Buffett adds that, in the illustration above, the compound annual growth rate (CAGR) delivered by the S&P 500, with dividends reinvested, has been about 11.8% across nearly 77 years. Reduce that CAGR by just by 1 percentage point annually, to 10.8%, paying for "various 'helpers' such as investment managers and consultants," and he observes that each dollar invested in 1942 would have grown to only about $2,650 now, roughly half the result in the no-fee example.
Early in 2018, Buffett put Ajit Jain in charge of all insurance operations and Greg Abel at the head of all other operations. "These moves were overdue. Berkshire is now far better managed than when I alone was supervising operations. Ajit and Greg have rare talents, and Berkshire blood flows in their veins," Buffett writes. However, with Buffett and longtime right-hand-man Charlie Munger now aged 88 and 95, respectively, formally naming their successors in the two top spots is also long overdue.