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Buffett's 2013 Shareholder Letter: Five Takeaways

The Science of Hitting

The Science of Hitting

245 followers

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:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.6/5 (35 votes)

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Comments

snowballbuilder
Snowballbuilder - 7 months ago

Hi science ! Great article as usual! I also ve spent my saturday reading the letter !

I think the result of brk are incredible and outstanding :

19 bln of earning (+30%)

115 bln of equity investment

its incredible to see what warren &charlie ve built in 50 years of hard word . Brk is one of the biggest and most profitable company in the world.

I also think the best part of brk now are the insurance and the operating not insurance (railroad and other) .while the stock investment result are , i think ,not so good as the were years ago. I think the size of brk and the amount of liquidity ve significantly reduce the quality of his stock investment.

The last two big stock investment (ibm and exxon) are not doing great and i think also 5 , 10 years from now will probably doing good but still not doing great ( nothing like amex, washington post or geico at their time).

I think the djco (munger) stock portfolio is significatly better that the one of brk (for quality and timing of the purchaising)

And , last but not least , i ve not apprecciate the change of benchmark from the 5 years period to the 6 years period. Its like draw the mark where the arrow is already gone.

vgm
Vgm - 7 months ago

Great stuff Science! You picked out the plums. Couldn't agree more.

It was also impressive to know that Weschler and Combs outperformed the S&P "handily" in "a year in which most equity managers found it impossible to outperform". It will be intriguing to hear Ted and Todd for the first time with Buffett on CNBC Monday.

The Science of Hitting
The Science of Hitting premium member - 7 months ago

Snowballbuilder,

Where have you heard about the switch from 5 to 6 years? I'm 99.9% sure that hasn't happened (but please let me know if I'm wrong). Thanks for the thoughtful comment and the kind words!

The Science of Hitting
The Science of Hitting premium member - 7 months ago

Vgm,

Thank you very much! And I'm very, very excited to hear from Todd and Ted on Monday as well; hopefully the folks at CNBC can put together a decent set of questions to ask them :)

okdokie
Okdokie - 7 months ago

Snowballbuilder is probably referring to this:

Over the stock market cycle between yearends 2007 and 2013, we overperformed the S&P. Through full cycles in future years, we expect to do that again. If we fail to do so, we will not have earned our pay. After all, you could always own an index fund and be assured of S&P results.

The Science of Hitting
The Science of Hitting premium member - 7 months ago

Okdokie & Snowballbuilder,

Found it. Didn't realize that he had referenced the market cycle - thought you were suggesting that he had switched out the five year comparison going back a few decades to six years (now that would've been odd). Your point still stands.

The outline for the five year test remains in the owner related business principles, but the historic comparison was removed after being added to the 2012 annual report (it has made appearences here and there over time - wasn't in 2009 or 2011, but was in 2010, etc); I certainly wish it would be a permanent addition to the 10-K.

Of course, anybody can calculate these figures on their own if they so desire: in the five years through 2013, Berkshire's book value increased ~91%; over that same period, the S&P with dividends increased by ~128%. My personal belief is that Warren should've addressed this shortfall with the logical explanation (to be expected in a rising market) and the usual warning for realistic expectations from investors looking forward; apparently he did not feel that was necessary.

Thanks for the comment!

sww
Sww - 7 months ago

All I heard about Bruce Greenwald is blah blah blah.

The Science of Hitting
The Science of Hitting premium member - 7 months ago

Sww - not a fan of Mr. Greenwald? :)

tgotech1
Tgotech1 - 7 months ago

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w1omega
W1omega - 7 months ago

lost all respect for Greenwald when he showed his face on TV and told the world that he thought Buffett lost his mind. You should be darn sure that you know what you are talking about before appearing on TV to say something like that about Buffett.

That leads me to believe that Greenwald is way, WAY overrated and should remain an academic who practices theory.

The Science of Hitting
The Science of Hitting premium member - 7 months ago

W1omega - there are many, many talking heads that could learn alot by reading your second sentence over and over again :) thanks for the comment!

AlbertaSunwapta
AlbertaSunwapta - 7 months ago

Yes Greenwald sure had a poor choice of words. Still, I sure wouldn't call Greewald a talking head or just an academic who practices theory. I'd say it was a case of hubris. I recall reading Greenwald's original position on the railroad with him saying something to the effect that they'd looked at it very carefully and saw no overriding value there. So he thought he was right and Buffett couldn't have seen anything more than his own people. That was probably so in terms of just looking at the financial statements. If you follow Greenwald you'll see that he is very much like the typical value investor none of whom you can say purely practice theory but they tend not to use skuttlebutt practices and only use historical data and an assumption of regression to the mean or and eventual correlation to the market. Just as Buffett has some failing investments in the past (Berkshire Hathaway, Dexter, etc.) due to not seeing the future path of the underlying business, I believe Greewald was just way too overconfident that "what's past is prologue." Buffett though is no longer just a "value" investor as the market defines them, but he is also a growth investor. (Remember Buffett's thinking that; growth and value are two sides of the same coin. In a sense, See's with its pricing power and Buffett and Munger's plans to increase prices seems to shift it into the growth camp.)

In comparison to Greenwald, I believe Buffett saw the potential in shipping crude by rail to boost rails' near term returns (remember, Buffett visited Alberta around that time to 'better understand the economics of oil'). Moreover, look at where Buffett lives. He had to have had insight into what was happening with shale oil and gas just through newspaper reports. (Remember, Buffett reads something like six newspapers a day.)

At the time, probably erroneously, I even speculated that maybe Buffett even saw future synergies with his existing businesses and a west coast earthquake hedge. At some point too, I think Buffett started to realize the cost advantage of shipping goods by rail. Oil prices rising to $140/bbl oil might help. (He may also have noted the operational success CNR had in reshaping rail, and had looked into the dramatic gains both Y and Gates had seen from their CNR positions over the years. They sure deserve more press for their CNR investments!)

LwC
LwC - 7 months ago

"That leads me to believe that Greenwald is way, WAY overrated and should remain an academic who practices theory."

Greenwald was personally selected by Robert Heilbrunn and his family, and Graham associate Professor Roger Murray to recreate the value investing program at Columbia, and by all accounts it is a big success. Many of the value investors who are worshipped in this forum support the program out of friendship and respect for Greenwald.

Also, Greenwald is Director of Research at First Eagle Investment Management. What's your professional experience?

The Science of Hitting
The Science of Hitting premium member - 7 months ago
Alberta: I should've been a bit clearer in my comments - I do not consider Mr. Greenwald a "talking head" like the gentleman from CNBC who was rambling about Buffett's buyback preferences / history without ever researching what he had said over the years (not surprisingly, Buffett had been 100% consistent over a few decades - it was the CNBC commentator who was dead wrong). I think he is very smart and worth listening to; in this instance, I think he stepped a bit too far.



LwC: I'll add my personal thoughts - I am not in agreement with the statement you quoted. However, I also think that it is a bad idea to come out and say Warren Buffett (Trades, Portfolio) "lost his mind" - as has happened in similar situations in the past, there's a good chance you'll be the one proven wrong (as has happened this time). I don't think anybody would have cared if Mr. Greenwald said "we don't see what Buffett sees here, and think he will be proven wrong on this one" - or at least I wouldn't have; instead, he chose to be a bit looser with his words. Thanks for the comments!

w1omega
W1omega - 7 months ago

LwC,

I guess you value titles and resume above all else. Does that mean Greenspan knew more than Michael Burry in 2006 since Greenspan had a more impressive title? Yes, Greenwald has an impressive title and resume, but he still made a terrible call that time and he has no real world investment record either.

In theory there is no difference between theory and practice. In practice there is.

Yogi Berra

robfetters
Robfetters - 7 months ago

Thanks for the excellent synopsis. Indeed, for diehard fans reading the annual letter is a holiday of sorts. Just check your grammar: "I've wrote...." Otherwise, perfect!

LwC
LwC - 7 months ago

W1omega, At least I know who Greenwald is and what his professional experience is. He has earned his "titles and resume" because he has worked hard for decades and has been recognized for his efforts. On the other hand I have no idea who "W1omega" is, and I see you've declined to provide information about your professional experience. Greeenwald enjoys the respect of many successful value investors who actually know him and work with him while "W1omega" appears to spend its time making inane comments in internet forums.

As for your comment that he made a terrible call on BNSF, well I've also made mistakes at times, and I'm certain that you have too.

So "W1omega", what's your professional experience?

batbeer2
Batbeer2 premium member - 7 months ago

Hi LwC, W1omega,

Please stop.

TannorP
TannorP premium member - 7 months ago

Thanks Science for summarizing the crucial points of the Annual letter, simplicity at its finest.

In regards to Greenwald, he should be respected and disagreements are what makes a market, if everyone drew the same conclusions we would have 0 liquidity and a completely efficient market.

Cheers,

w1omega
W1omega - 7 months ago

Science, sorry that the conversation turned. Didn't mean to steal your thunder. You wrote a great article and I enjoyed reading it.

In the original comment, I shouldn't have used such a strong language to put someone down, especially since I'm anonymous.

The Science of Hitting
The Science of Hitting premium member - 7 months ago

Thanks for the kind comments all, and glad you enjoyed the article!

W1 - no worries!

vgm
Vgm - 7 months ago

To his credit, W1omega made one very relevant point which Science highlighted: It's only common sense when the greatest investor of all time is making a colossal bet that we should try mightily to understand why, especially if we don't at first glance. It's entirely likely that he's correct and that we can learn something. But as Munger would remind us, common sense is not all that common.

What someone called "professional experience" (a term so vague as to be dangerous) can get in the way on such ocassions and our egos can blind us to the obvious.

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