Warren Buffett (Trades, Portfolio)’s latest shareholder letter landed Saturday, but investors will be pondering the contents for weeks and months to come.
As with most years, the annual missive raised hot topics and dropped inside information on the Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) empire. While much stayed the same at the company, including Buffett’s reliance on the constant “American Tailwind” Buffett credits for much his gains over his 77 years of investing, this year’s letter included several historic highlights and changes.
All’s well on operating earnings front
2018 marked the advent of Berkshire incorporating unrealized investing gains and losses into its bottom-line earnings results. Both Buffett and his business partner, Charlie Munger (Trades, Portfolio), opposed the rules, which have already driven massive swings in the quarterly figure, as they predicted.
Since the rules took effect, Berkshire has reported two quarters of net losses. Before 2018, it last reported a net loss during the financial crisis nearly a decade ago, in 2009. That followed a loss in 2001 due to a $2.2 billion pre-tax insurance loss from the terrorist attacks of Sept. 11.
But Buffett has long preferred a different metric for measuring the strength of the businesses that compose Berkshire Hathaway: operating income. Berkshire defines operating earnings as “net earnings exclusive of investment and derivative gains/losses.” The metric shows revenue after subtracting the expenses of business, such as cost of goods sold, depreciation, and selling and marketing, without considering non-business expenses such as interest and taxes.
While net earnings careened, coming in positive for the year at $4 billion after $20.6 billion in losses from investments, Berkshire’s operating income steadily advanced. Berkshire recorded operating earnings of $5.72 billion for the fourth quarter, an increase from $3.34 billion in the fourth quarter of 2017. For the full year 2018, the businesses’ operating earnings reached $24.78 billion on improved performance, rising from $14.46 billion for 2017.
Unlike more sensitive net earnings, operating earnings at Berkshire have been positive and growing without fail for the past decade.
Investment returns
Buffett has insisted investors ignore net earnings because their inclusion of unrealized investment returns gives a less accurate portrait of Berkshire’s profitability, but this year they highlight that volatility in investment returns has increased. Prior to 2018, Buffett did report changes to his equity portfolio’s value but relegated it to a section called “other comprehensive income.”
Recent data shows that these unrealized gains and losses have fluctuated along with the market, but including them may not often affect Berkshire’s bottom line in the future as dramatically as it did in 2018. The fourth quarter, which was Berkshire’s fourth time to include unrealized gains in net earnings, saw the S&P 500 drop 13.97%, its worst performance since the third quarter of 2011, when it declined 14.33%. Unrealized gains in Berkshire’s fourth-quarter portfolio amounted to $20.6 billion, with swings as large as $4 billion in either direction occurring in single days, Buffett wrote.
Book value
Buffett took the truly monumental step of retiring his report of a fundamental measure of Berkshire’s value he has used for thirty years: book value. Berkshire’s book value is defined as total stockholders’ equity (total assets less total liabilities), less preferred stock, divided by shares outstanding. It tells the investor a rough estimate of what they would receive if the company liquidated.
As Berkshire further expands ownership of businesses and focuses less on marketable stocks, accounting requirements that force it to undervalue its companies mean book value becomes increasingly distorted, Buffett said. Berkshire’s wholly owned subsidiaries rose to 66 generating $225.38 billion in revenue in 2018 from 50 reporting $112.49 billion in revenue in 2009. Meanwhile, Buffett’s portfolio value has expanded from $57.93 billion in the fourth quarter of 2009 to $183.07 billion in the fourth quarter of 2018.
In addition, Berkshire’s commitment to share repurchases going forward will affect the reliability of book value.
“Third, it is likely that – over time – Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value,” Buffett wrote. “The math of such purchases is simple: 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.”
Share repurchases
Last summer, Berkshire made its first major stock buyback since 2011, buying $928 million of its shares. Buffett made the move after finally repealing his prior requirement that the price dip below a 20% premium to book value. Instead, he said he would purchase shares whenever they fell below his estimate of intrinsic value.
Berkshire paid an average of $207.09 for each of its B-shares, higher than the stock’s price before it released the figure, which sent share prices up. In his fourth-quarter letter, Buffett assured investors that the pattern would continue.
“For continuing shareholders, the advantage is obvious: If the market prices a departing partner’s interest at, say, 90¢ on the dollar, continuing shareholders reap an increase in per-share intrinsic value with every repurchase by the company,” Buffett wrote.
Though Buffett acknowledged in his letter that investors may opt for faster-growing stocks, the market took Berkshire's changes in stride. The company's B-shares closed at $201.39 Thursday, about flat from their price since the release of Buffett’s letter.
