This Saturday was a holiday of sorts for value investors: the release of Warren Buffett (Trades, Portfolio)’s (BRK.A, BRK.B) annual letter to shareholders. You’ve likely read the letter on your own by this point, and probably have seen a few articles discussing the results as well; as such, I’ll keep my rambling short. I’m going to cover a few bullet points that jumped out to me as I read the letter; hopefully a few of these items will offer a different perspective than what you’ve read other places. With that, let’s begin:
Share Repurchases - This is the first thing that really jumped off the page (the third page, to be exact) as I read the letter. A quick history lesson is in order: in September 2011, Berkshire’s board announced an authorization to repurchase A & B shares at no more than a 10% premium to book; the market quickly recognized that this was too good to be true, and pushed the shares above 110% of book before too long (Berkshire only managed to scoop up $67 million of stock before it moved above that cap). In December 2012, Berkshire issued a press release saying that $1.2 billion worth of shares had been repurchased at an updated cap – 120% of book. Comments made after that date (namely at the shareholder meeting in May 2013) suggested that Warren and Charlie were quite comfortable with repurchasing shares in a big way under 120% of book.
That brings us to the 2013 letter; while Warren hasn’t been shy about suggesting that Berkshire would be a buyer under 120% of book, many have wondered how meaningful this activity would be if given the opportunity. On Saturday, I think we got an answer (bold added for emphasis):
As I’ve long told you, Berkshire’s intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That’s why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount. We did not purchase shares during 2013, however, because the stock price did not descend to the 120% level. If it does, we will be aggressive.
It sounds to me like Berkshire would step to the plate in a big way if given the opportunity; with the A shares trading at roughly $173,000 on Friday’s close – a 28% premium to year end book value of $135,000 per share ($115 and $90 per B share, respectively) – we’re not too far away…
Berkshire’s Underwriting Results – It’s easy to categorize these results in a word: fantastic. Berkshire’s insurance operations have now reported eleven consecutive years of underwriting profitability, with the total exceeding $3 billion in 2013; over that period, the aggregate pre-tax underwriting profit was $22 billion ($2 billion per year, a figure that goes uncounted in the per-share investments / non-insurance pre-tax earnings figures that Warren provides to estimate intrinsic value). Float expanded from $41 billion to $77 billion over that period. Consider those results in comparison to the country’s largest insurer – over that same period, State Farm reported an underwriting loss (on average) in three out of every four years. GEICO has now passed Allstate (ALL) as the second largest auto insurer (behind the aforementioned State Farm), and should continue adding policies in force in the years to come (with Warren saying in the letter that he thinks GEICO’s economic goodwill is “approaching $20 billion”). Finally, give Ajit Jain much praise – Berkshire Hathaway Reinsurance Group (BHRG) accounted for nearly 50% of Berkshire’s float at year end ($37 billion), from zero in 1985 (and ~$14 billion ten years ago).
Burlington Northern – BNSF reported $22 billion in revenues for 2013, an increase of 6% from 2012; earnings before interest and taxes increased ~11%, to $6.6 billion (roughly $5.9 billion pre-tax, with cumulative pre-tax earnings from the past three years exceeding $16 billion).
Compare this to the price tag that Berkshire paid when the deal was announcement just over four years ago: $26.3 billion. If you want to see what the market thinks, go look at a five year chart for Union Pacific (UNP), which is similar in size to BNSF. With trailing 2013 financials that are quite comparable to Burlington, the market cap for UNP is now more than three times higher – at $82 billion – than Berkshire’s purchase price (to put it another way, that’s equal to a four year compounded annual growth rate well above 30%). For a deal that was widely criticized at the time (Bruce Greenwald said he thought Warren had “lost his mind”), 2013 provides even more evidence that Berkshire Hathaway shareholders are lucky to be the owners of BNSF.
Bank of America – I’ve wrote about this a couple times, and you would think my amazement in this investment would’ve started to wane by now; in reality, it only continues to strengthen.
Again, a quick history lesson is in order: back in August 2011, Berkshire purchased $5 billion of preferred stock from Bank of America (BAC), with a 6% yield; as part of the deal, BAC can repurchase the preferred at any time at a redemption premium of 5% (they haven’t yet).
While that portion alone is valuable, the real beauty comes from the 700 million warrants that Berkshire received as part of the deal; those warrants have a strike price of $7.14 per share, and do not mature until September 2021. As noted in Warren’s letter, these warrants, if exercised at year end 2013, would’ve been worth $10.9 billion. Here’s some quick math: if we assume BAC stock goes up by just 5% a year between yearend 2013 and 2021, the ten year compounded annual return from the warrants alone would be ~12.4% per annum. After considering the $300 million annual dividend currently being paid on the preferred, the $5.25 billion Berkshire will receive on redemption, and the possibility that Bank of America common could advance by more than 5% per annum (still trades at a sizable discount to book), it’s clear that this is a grand slam.
Investment Advice –The story about Warren’s purchase of Nebraska farm land and New York real estate real is revealing in its simplicity, consistency, and – ultimately – success. It brings home a message that investors on this blog are familiar with: the combination of conservative assumptions based on years (or decades) of financial data, along with the patience to only act when prices imply an attractive forward rate of return based on those conservatively calculated assumptions, is a formula for solid results over time. It’s a formula that Warren and Charlie have followed for many years (their patience in the Coca-Cola (KO) investment and Burlington Northern purchase, to name two examples, are worth studying). It’s a formula more people should replicate.
I promised I would keep this short – I’m sure you’ve got more Berkshire articles to read. I hope this one provided a slightly different (and meaningful) perspective than others.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.