Warren Buffett (Trades, Portfolio)’s annual letter to shareholders of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) was released last weekend, and as usual, Wall Street has spent the last few days dissecting the letter for any guidance and tips from the Oracle of Omaha on investing and strategy.
Buffett’s letter to investors has become somewhat of a yearly investment bible for value investors, and it always contains some interesting nuggets of information – not necessarily about investing.
In this year’s letter, Buffett struck a relatively upbeat tone, noting that he believes the outlook for stocks is positive despite having Donald Trump in the White House, political risk growing around the world and rising valuations.
Aside from Buffett’s commentary on the markets, there are two paragraphs in this year’s annual letter that stand out to me for reasons that will become apparent. These paragraphs do not concern the general process of investing, market values or potential investments. Indeed, they are related to Berkshire’s method of accounting.
Buffett writes in his annual letter:
“As is the case in marriage, business acquisitions often deliver surprises after the 'I dos.' I've made some dumb purchases, paying far too much for the economic goodwill of companies we acquired. That later led to goodwill write-offs and to consequent reductions in Berkshire's book value. We've also had some winners among the businesses we've purchased, 'a few of the winners very big' but have not written those up by a penny."
"We have no quarrel with the asymmetrical accounting that applies here. But over time it necessarily widens the gap between Berkshire's intrinsic value and its book value. Today, the large 'and growing' unrecorded gains at our winners produce an intrinsic value for Berkshire's shares that far exceeds their book value. The overage is truly huge in our property/casualty insurance business and significant also in many other operations.”
These paragraphs highlight something that has been known for a long time but is rarely factored into investors’ calculation of Berkshire stock. Many of the conglomerate’s businesses are undervalued on the balance sheet. Many of the underlying business are impossible to value because they're private; General Re, for example, may be worth tens of billions more in the public markets than as a private entity.
Two undervalued holdings
The two significant cases where this is the case concern Berkshire’s Kraft Heinz (KHC, Financial) holding and the Bank of America (BAC, Financial) warrants. The stake in Bank of America is not listed on quarterly filings as it is derived from Berkshire’s ownership of 700 million warrants exercisable to common shares in 2021. While the warrants will not be exercised until that time, Berkshire’s economic stake in Bank of America is very real and very material. At the time of writing these warrants are worth over $17 billion (purchase cost of would be $5 billion).
The Kraft holding produces another valuation gap.
Valuation gap
In 2015, Buffett was forced to "write up" the Kraft holding:
“Though we sold no Kraft Heinz shares, 'GAAP' (Generally Accepted Accounting Principles) required us to record a $6.8 billion write-up of our investment upon completion of the merger. That leaves us with our Kraft Heinz holding carried on our balance sheet at a value many billions above our cost and many billions below its market value, an outcome only an accountant could love.” – Buffett 2015 annual letter to investors
Because Berkshire is part of Kraft’s control group, the conglomerate can account for each share in the business via the "equity" method, which does not require frequent revaluations. Therefore, the holding is worth significantly more than Berkshire’s balance sheet dictates.
“The 325,442,152 shares Berkshire owns of Kraft Heinz are carried on our balance sheet at a GAAP figure of $15.3 billion and had a yearend market value of $28.4 billion.” – Buffett 2016 annual letter to investors
Overall, these two holdings are hiding nearly $30 billion of investment gains at Berkshire. If you are looking to invest in the business, it is worth considering this hidden value.
Disclosure: The author owns no stock mentioned.
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