Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) is set to report its results for 2018 this weekend, and investors should brace themselves for a bad outcome. In fact, it looks as if Berkshire is set to publish the worst loss in its history over the weekend.
Thanks for the introduction of new accounting regulations, which came into force just over a year ago, Berkshire Hathaway now has to reflect the movement of securities in its equity portfolio in its results. According to analysts at Morgan Stanley, this means that the conglomerate could report as much as $35 billion of mark-to-market losses in its $200 billion equity portfolio for the fourth quarter of 2018. The analysts estimate that the decline in the value of shares in consumer electronics giant Apple could be responsible for as much as $17 billion of this total.
These $35 billion of losses could be too large to be offset by the conglomerate's operating income. The investment bank is forecasting $5.5 billion of operating income for the fourth quarter of 2018 and $20 billion for the full year.
When Berkshire Hathaway reports earnings this weekend, the headline figure will look terrible, but it is important to remember that the losses on the investment side of the portfolio have not been crystallized. Indeed, the substantial recovery in the share prices of Berkshire's largest holdings since the beginning of the year has likely wiped out almost all of the decline.
Warren Buffett (Trades, Portfolio) himself has recommended investors look past the volatility and focus on Berkshire's underlying results. Here's the advice Buffett gave shareholders this time last year when commenting on the new accounting standard:
"The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line. Berkshire owns $170 billion of marketable stocks (not including our shares of Kraft Heinz), and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire’s “bottom-line” will be useless.
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With the new rule about unrealized gains exacerbating the distortion caused by the existing rules applying to realized gains, we will take pains every quarter to explain the adjustments you need in order to make sense of our numbers.
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At Berkshire what counts most are increases in our normalized per-share earning power. That metric is what Charlie Munger (Trades, Portfolio), my long-time partner, and I focus on – and we hope that you do, too."
It is essential to keep all of the above in mind when reading through Berkshire Hathaway's annual report when it is published. It is also critical not to get distracted by media reports, which will undoubtedly focus on the conglomerate's losses over anything else.
As Warren Buffett (Trades, Portfolio) put it in his 2017 letter to investors, "Televised commentary on earnings releases is often instantaneous with their receipt, and newspaper headlines almost always focus on the year-over-year change in GAAP net income." He went on to say, "Consequently, media reports sometimes highlight figures that unnecessarily frighten or encourage many readers or viewers."
Hopefully, many value investors and Berkshire Hathaway shareholders reading this will have bought the company not for short-term profit, but for its long-term potential, and will not let their investment decisions be influenced by media commentary.
Still, it is worth keeping the above in mind if the rest of the market decides the stock is too risky following the publication of its results over the weekend. If the market continues on its current trajectory, I expect a substantial recovery in the value of the group's portfolio in the first quarter of the year.
Disclosure: The author owns shares in Berkshire Hathaway.
