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.
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!
