WWII 114: Warren Buffett's 2017 Berkshire Hathaway Letter Highlights
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Main Topic: Warren Buffett's 2017 Berkshire Hathaway Letter Highlights - Part 1
Warren Buffett released his annual Berkshire Hathaway shareholder letter this weekend, a much anticipated annual event. On this episode, I give you my thoughts about the contents thereof and read some excerpts that I believe are interesting and timely.
The King of Compounding
Buffett's letters always begin with the performance of Berkshire Hathaway on an annual basis since 1965, the first year he began reporting the statistics. The headline is that since 1965, Buffett and his investing partner and vice chairman of Berkshire Hathaway, Charlie Munger have compounded the book value of Berkshire by 19.1%, compounded annually.
Thanks for the Tax Benefit, The Donald
2017 was an excellent year for Berkshire, as book value rose by 23%, although a little less than half of that rise was due to the change in tax law, not operating income.
The headline number here is $29 billion. That's the amount that Berkshire will benefit from due to the Donald Trump tax cuts. Berkshire had an enormous deferred tax liability. The change in the tax laws means that Berkshire's future taxes will be lower, and therefore the tax liability will be reduced. This reduction of future tax liabilities led to a one-time gain by decreasing the liability, resulting in an additional $26 billion in G.A.A.P. earnings. Buffett, another billionaire, thanks you, the Donald.
Another Dumb Accounting Rule
The tax benefit is not the only change going forward for Berkshire. Buffett points out another accounting rule that will impact Berkshires numbers going forward.
In discussing the fact that a new accounting rule will require Berkshire to report any changes in the unrealized value of its investment portfolio as part of earnings, a rule that makes absolutely no sense, Buffett had this to say:
" At Berkshire what counts most are increases in our normalized per-share earning power. That metric is what Charlie Munger, my long-time partner, and I focus on – and we hope that you do, too."
When you have to value businesses to make good investing decisions, you need to understand accounting, and changes to accounting rules which will impact the earnings of a company you are evaluating.
A few episodes ago, I mentioned the valuation allowance one-time impact on earnings for companies with large deferred tax assets. That allowance will reduce earnings, sometimes dramatically for a quarter or two. That was the opposite of the Berkshire Hathaway situation because Berkshire has been profitable for decades.
So work on understanding these accounting changes and how they will impact companies in your portfolio.
Getting back to the Buffett quote, he mentions "normalized per-share earning power" and that is a phrase worth taking a moment to discuss.
Normalized Earnings Power
The phrase "normalized per-share earning power" is an incredibly important one for any investor to understand. The way to value a business is to figure out what the normalized per-share earnings power company has and apply a reasonable multiple to it. This valuation method has resulted in the biggest, and continuing gains in net worth for me personally.
Companies get in trouble from time to time and their prices will fall. If you can determine that their franchise is intact, that their earnings power will return eventually, you may have found a gem. This happens often in every industry.
2017 Was A The Year of the Tuck-In
Buffett didn't make a major acquisition in 2017 and lamented that fact. Prices were relatively high, competition was fierce and willing to pay any price, and leverage was cheap and easy to get. These make it difficult for the acquisitive.
However, even though Buffett didn't slay any "elephants," in 2017 he did manage to buy in to Pilot Flying J, a travel center company, and absorb a bunch of companies as "tuck-in" acquisitions. These are typically initiated by the managers of the Berkshire companies and paid for by Buffett from headquarters (or with cash held at the portfolio company).
In discussing these type of acquisitions, Buffett laid out the four ways Berkshire can build value:
(1) sizable stand-alone acquisitions;
(2) bolt-on acquisitions that fit with businesses we already own;
(3) internal sales growth and margin improvement at our many and varied businesses; and;
(4) investment earnings from our huge portfolio of stocks and bonds.
This, in a nutshell, are the ways ANY company can add value to itself, and is something that you should consider in looking at potential investments.
Berkshire's Share of Hurricane Losses Estimated at $3 Billion
If you are just getting started analyzing insurance businesses, there is no better place to start than to read Buffett's comments about Berkshire's insurance operations. Buffett goes into some history and you can read a ton about Berkshire's insurance operations by reading the 10K as well.
2017 was a tough year for insurers because of the hurricanes that hit Florida, Texas, and Puerto Rico. Buffett goes in to detail about his estimate for Berkshire's insured losses from the hurricanes and points out that the $3 billion estimate is less than 1% of Berkshires net worth.
Buffett Continues to Buy American
"Berkshire is always looking for ways to expand its businesses and regularly incurs capital expenditures that far exceed its depreciation charge. Almost 90% of our investments are made in the United States. America’s economic soil remains fertile."
Buffett's Elephant Gun is Loaded
"Berkshire’s goal is to substantially increase the earnings of its non-insurance group. For that to happen, we will need to make one or more huge acquisitions. We certainly have the resources to do so. At yearend Berkshire held $116.0 billion in cash and U.S. Treasury Bills (whose average maturity was 88 days), up from $86.4 billion at year-end 2016. This extraordinary liquidity earns only a pittance and is far beyond the level Charlie and I wish Berkshire to have. Our smiles will broaden when we have redeployed Berkshire’s excess funds into more productive assets."
Buffett Loves Delicious Apple
The largest individual stock position Berkshire holds is currently Apple, a position worth more than $28 billion. This purchase was kind of a head scratcher for many Buffett followers as many of us felt that Apple was a technology company and Buffett had spent decades specifically saying that he avoided technology companys because he could not predict who would "win."
Now, after a faulty move into IBM, a position that has since been liquidated completely, Apple is the most prominent buy for Buffett.
Leverage is Bad
Buffett goes out of his way to show what can happen to Berkshire stock, or any stock during periods of market crashes in this amazing call-out:
"Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long-term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips.
Here are the gory details:
March 1973-January 1975
This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions."
That's it for Part 1 of this 2 part podcast series. More on this letter next week.
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