Berkshire loses $25bn for the qtr. Buffett soothes the pain with words of wisdom.

If you call a dog’s tail a leg, how many legs does it have? Four, because calling a tail a leg doesn’t make it one.

Abraham Lincoln, re-quoted by Warren Buffett

Omaha-based financial conglomerate Berkshire Hathaway (NYSE: BRK.B) reported a staggering loss of $25.1bn for the December 2018 quarter largely due to its 27% holdings in Kraft Heinz (NYSE: KHC), which itself reported a $12.6bn loss in the fourth quarter. Kraft Heinz also wrote down the value of its iconic brands by $15.4bn and disclosed an SEC investigation into its accounting policies, procedures and procurement related internal controls. This news spooked the stock markets which wiped out more than $12bn in the stock’s market cap last Thursday and left its shares trading at its lowest value in the past 4 years. All of this had a cascading effect on Berkshire which had to mark-to-market its losses in KHC as expenses as per new regulatory changes that are part of GAAP. Despite this huge loss for the quarter, Berkshire reported annual profits of $4bn for the entire calendar year of 2018. In his letter that accompanies the annual results, Warren Buffet - chairman of Berkshire - warned shareholders that they should get used to such huge swings in quarterly profits because they own a huge equity portfolio worth $173bn which can fluctuate by up to $2bn in a single day! For the benefit of investors, here are nuggets of wisdom that I could glean from his letter this year.

• Focus on operating earnings (EBITDA) rather than Net Profits. Berkshire goes one step further than EBITDA and includes manager compensation and restructuring expenses (if any) when calculating operating earnings. This conservative approach is in stark contrast to the frequent Wall Street practice of excluding a variety of real costs when computing operating earnings. For the record, Berkshire’s operating earnings soared 71 percent from a year ago.
• Book Value has lost its relevance it once had. Despite the volatility of stock markets, market price provides the best measure of business performance.
• Succession planning at Berkshire has been executed beautifully and is working like a charm.
• Berkshire’s business goal remains unchanged over the years i.e. to buy well-managed businesses that have durable economic attributes at reasonable prices.
• Buffet favors buyback decisions by investee companies. His reasoning is that when earnings of investee companies increase and their shares outstanding decrease (due to buybacks), then the investor’s pie increases without any additional cash outflow to the investor.
• Berkshire is a financial fortress and is sitting on more than $112bn in cash and cash-equivalents. At least $20bn of this cash is untouchable as a safeguard to protect the insurance business from losses resulting from external calamities. The remaining cash is not getting deployed because in the current market, prices are sky-high for businesses that have decent long term prospects. Berkshire has been holding more than $100bn in cash for six straight quarters now!
• Buffet does not focus on quarterly results and neither does the company give out any earnings estimate. His reasoning is that focusing on quarterly numbers encourages bad corporate behavior and induces managers to start ‘fudging’ earnings in order to meet their targets.
• The reduction in US corporate tax rate from 35% to 21% greatly boosted the earnings of Berkshire starting last year. Consequently it also boosted the intrinsic value of Berkshire stock.
• Berkshire’s insurance business is the engine that has been propelling its growth since 1967. It has operated at an underwriting profit for 15 of the last 16 years, except 2017.
• Berkshire uses debt sparingly for financing its operations, except for its asset heavy businesses like railroad and energy. Berkshire does not need to use debt because it has amassed a net worth of $349bn over the years and also leverages the float provided by the insurance business.
• Buffet attributes much of Berkshire’s success to the American tailwind – a reference to the steady growth in the American economy over the past decades. In the future he hopes to invest significant capital across American borders as well.

The subtext

Reading between the lines of Buffet’s letter, here are some points that I noted for myself.

• The world’s greatest investor is not infallible and his investment in Kraft Heinz is proof that even he can make mistakes – big mistakes!
• Buy and Hold as an investment strategy does not work, again as proved by the huge loss reported by Kraft Heinz. It is therefore prudent to always watch for warning signs of trouble and exit a troubled holding before disaster strikes. Could Buffet have seen this one coming? Sure he could, you could too. Take a look at the page for Kraft Heinz from our icTracker database. You will observe that Economic Value Added (EVA) for this stock was continuously negative until March 18 when it went slightly positive for the first time. Thereafter it turned negative once again in June 18 and September 18. That was two quarters of warning and enough time for Buffet to exit his holding in Kraft Heinz during that period.
• Does Buy and Hold strategy encourage emotional bias towards a stock? It possibly does, again as shown by the Kraft Heinz episode. If as an investor you ignore the warning signs of trouble despite obvious indications then you are definitely afflicted by emotional affection towards the stock, which is never a good thing for any long term investor.
• Do tailwinds exist in economies other than the American economy? Sure they do. Buffet himself admits so and is in fact preparing for investing significantly in other emerging economies (such as India IMHO). Berkshire’s recent investment of $300mn in Paytm is proof and is just the beginning. Therefore we can expect more action from him in the future in the sub-continent.
• Despite the extra-ordinarily big loss for the quarter, Berkshire stock price has compounded at an annual rate of 20.5% from 1965 until 2018, in contrast to the S&P500 which has compounded at only 9.7% during the same period. In other words, a dollar invested in the S&P500 in 1965 would have appreciated to $150.19 by the end of 2018. The same dollar invested in Berkshire however, would have appreciated to a whopping $24,726.27 in the same period! In the process, it would have outperformed the S&P500 by a multiple of 164! The question naturally arises - should you invest in Berkshire at this time? Let me put it this way – the $25bn loss is too big even for Berkshire to digest quickly. If you are already invested in Berkshire, then you can ride out the storm along with Buffet. If on the other hand you are planning to make a fresh investment today in the stock markets today, there are many more attractive options available at this time.

Happy Investing!

How to find businesses with wide moats

I was a chartist. I loved all that stuff. I had charts coming out my ears. Then, all of a sudden a fellow explains to me that you don't need all that, just buy something for less than it's worth.

Warren Buffet

In the investing world, “moat” is a term that has been popularized by the legendary investor Warren Buffet to mean the amount of competitive advantage that a business enjoys in the marketplace over the competition. Moats create entry barriers for the competition and enable the business to harvest uninterrupted profit from its products and services. Therefore moats are a very desirable attribute for investors, when screening for investment opportunities. If they exist at all, moats can be either wide moats or narrow moats. Obviously wide moats are preferred over narrow moats, not only because of the extent of competitive advantage that they provide to the business but also because such an advantage may even be sustainable in the long run. Businesses with wide moats are therefore the ones that long term investors want to ‘Buy and forget’. In the Indian context, such investments fall in the category known as ‘Buy right, sit tight”.

Wide moats in a business may exist for a number of reasons. Some of these include strong brand, widespread distribution network, loyal customer base, low cost of operations, etc. Whatever be the reason for the wide moat, the search for the source for it always ends in an intangible asset – i.e. an asset that is not present or reported on the balance sheet of the business. Isn’t this strange – the one asset that gives the business a wide moat and hence a lasting competitive advantage does not even make it to the company balance sheet and hence never ever reported to investors. This is the single biggest reason why screening for businesses with wide moats is a task fraught with danger, because the person doing the screening may have to rely on hearsay and assumptions rather than hard facts. Unless of course there was a way to measure the intangible assets of the business and value it in monetary terms, in the first place!

This is where the icTracker comes in. We developed this software explicitly to address this very problem i.e. to measure the intangible assets of the business from the company’s reported financials and value it in monetary terms. Next we developed a ratio called the Knowledge Basis – which is just the ratio of the Intangible Assets over the Total assets of the business. Note that Total assets equal the Intangible Assets as calculated plus the physical and financial assets which are reported on the Balance sheet of the Business. The Knowledge Basis then becomes a simple measure for checking if the business has a wide moat. As a thumb rule we consider that a Knowledge Basis greater than 50% means that the business has a wide moat, else it has a narrow moat. The icTracker software has therefore quantified the calculation of wide moat and made it objective, thus making screening of stocks easier and more importantly, reliable. Our icAdvisor service in fact uses the icTracker database when designing and rebalancing client portfolios.

What to Do

When making investment decisions for your stock portfolio, always ensure that the underlying business has a wide moat. But that is the easy part – the difficult part is staying on top. Moats can disappear very quickly if a new competitor takes over the market for instance using a superior moat. Hence it is very important to check the moat of the business every quarter to ensure that the competitive advantage it enjoyed earlier is still in place. It is well and good if you have the time and passion for doing this yourself. If not, you should approach a SEBI Registered Investment Adviser to help you with this process.