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Hoang Quoc Anh
Hoang Quoc Anh
Articles (281)  | Author's Website |

Warren Buffett's 2018 Letter: 3 Key Lessons for Every Investor

A review of main takeaways from the annual shareholder letter

March 27, 2019 | About:

In February, Warren Buffett (Trades, Portfolio) released his 2018 letter to Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholders.

Many investors look forward to reading the letter since it is considered to be a great source of investment and business wisdom. Here are some important lessons from the letter:

Lesson 1: Ignore short-term, mark-to-market accounting's effect on the bottom line

Our advice? Focus on operating earnings, paying little attention to gains or losses of any variety. My saying that in no way diminishes the importance of our investments to Berkshire.”

To evaluate any company, including Berkshire Hathaway, investors should focus on operating earnings and ignore the short-term changes in unrealized capital gains or losses. A new generally accepted accounting principles rule requires companies to adjust the value of their marketable securities to the current market value. Any unrealized capital gains or losses from quarter to quarter are flowing straight to the bottom line even though those securities are not sold. Both Buffett and Charlie Munger (Trades, Portfolio) believe the new standard is not “sensible” and does not reflect the true picture of a company’s operations.

Because of this GAAP rule, Berkshire Hathaway’s bottom line has experienced wild swings within its $173 billion investment portfolio. The company reported GAAP losses of $1.1 billion and $25.4 billion in the first and fourth quarters and profits of $12 billion and $18.5 billion in the second and third quarters. Therefore, investors should pay little attention to short-term, bottom-line fluctuations caused by mark-to-market accounting principles.

Lesson 2: What is “real earnings?"

“When we say 'earned,' moreover, we are describing what remains after all income taxes, interest payments, managerial compensation (whether cash or stock-based), restructuring expenses, depreciation, amortization and home-office overhead.”

In order to properly assess the valuation of any business, investors should understand what those companies really earn. According to Buffett, “adjusted EBITDA,” or earnings before interest, taxes, depreciation and amortization, is not a true earnings number as it excludes many real costs.

While depreciation is really an economic cost, acquisition-related amortization expenses are not. Buffett often adds amortization costs back to GAAP earnings. In 2018, Berkshire Hathaway’s intangible asset amortization expense came in at nearly $1.4 billion, including trademarks and trade names, patents and technology and customer relationships.

The GAAP earnings number does not include the retained earnings of investees, but those retained earnings are important and should be included in the company’s valuation. In order to properly value the retained earnings, investors should look at the look-through earnings, a concept that was introduced by Buffett. He explained it in his 1990 letter to shareholders:

"Look-through earnings = share of yearly retained earnings of investees – incremental taxes paid if those share of retained earnings are paid in dividends."

Indeed, the retained earnings of Berkshire Hathaway’s investees are quite significant.

Source: Berkshire Hathaway 2018 letter to shareholders.

Lesson 3: Berkshire Hathaway’s four sources of funding

Normally, every company has two sources of funding: debt and equity. Berkshire Hathaway has two additional streams, which have been extremely important to the company’s growth over the past five decades.

The first of these is insurance float. Buffett has relied on insurance float for the past half a century to grow Berkshire Hathaway from a small company to a global powerhouse. The business model of  property and casualty insurance companies, collect now, pay later, allow them to receive the premium upfront and pay claims later. This money is referred to as “float.” Insurance companies can use the float to invest for their own benefit. The longer they can hold and invest the float, the better.

Because of the disciplined underwriting policy, Berkshire Hathaway’s insurance business has performed very well over the past two decades. Buffett mentioned the business had underwriting profit for 15 of the past 16 years. Profitable underwriting results mean the company even got paid to hold the growing float.

The second funding source is deferred income taxes, which are considered liabilities that Berkshire Hathaway will have to pay later. Until then, it can be considered an interest-free loan from the government. Munger also added the present value of this interest-free loan to calculate Wesco Financial's intrinsic value. In 2018, Berkshire Hathaway had $50.5 billion in deferred taxes, including $14.7 billion in unrealized gains in its equity holdings and $28.3 billion in the acceleration of asset depreciation.

Indeed, anything from Buffett and Munger is an invaluable source of investment and business wisdom. Investors should learn from what they have taught and look through the noise to avoid costly investment mistakes.

About the author:

Hoang Quoc Anh
Chief investment strategist for the Global Hidden Gems Portfolio (https://ghginvest.com). Searching around the world for stocks that trade below net cash but are still profitable.

Visit Hoang Quoc Anh's Website

Rating: 4.7/5 (3 votes)



Valuator - 1 year ago    Report SPAM

Asawhneyy - 1 year ago    Report SPAM

Good article.


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