RAKESH SHARMA
Moneycontrol Contributor
"An elephant-sized acquisition" is still something that Warren Buffett is eyeing even as his company Berkshire Hathaway registered its worst annual performance in nearly two decades. In what has become a globally anticipated bulletin, Buffett discusses the Berkshire Hathaway business and also delivers what he believes to be his guiding principles to investing. Naturally, millions around the world wait eagerly for the words of the investment maven. The Oracle of Omaha delivering his gospel is an event all worshippers of capitalism listen to with a religious fervour. And he did not disappoint this year either. A few key takeaways from his newsletter are what we bring to you on our Pick of the Day. My name is Rakesh Sharma, and you are listening to Moneycontrol.
Buffett, in his folksy no-nonsense style, had something for everyone in this year's newsletter. "Even at our ages of 88 and 95 – I’m the young one – that prospect [of an elephant-sized acquisition] is what causes my heart and Charlie’s to beat faster,” Buffett said, referring to Charlie Munger, the vice-chairman of Berkshire Hathaway. Acquisitions based on solid fundamentals is the name of the game in Buffett's books, and always has been. Not one to predict stock patterns, Buffett said, "My expectation of more stock purchases is not a market call. Charlie [Munger] and I have no idea as to how stocks will behave next week or next year. Predictions of that sort have never been a part of our activities. Our thinking, rather, is focused on calculating whether a portion of an attractive business is worth more than its market price." This tactic that Buffett is known for, is called Value Investing. Value investors seek out stock that they believe to be undervalued in the market.
Aside from reiterating the importance of value investing, Buffett also appeared to be taking a swipe at President Donald Trump whose penchant to claim all the credit for the nation's economic growth is only too well known. “It is beyond arrogance for American businesses or individuals to boast that they have ‘done it alone’,” Buffett wrote. He also took a veiled shot at the America First principle of Donald Trump, suggesting that isolationism was not conducive to American growth. “There are also many other countries around the world that have bright futures. About that, we should rejoice: will be both more prosperous and safer if all nations thrive,” he wrote. “At Berkshire, we hope to invest significant sums across borders.”
Berkshire ended 2018 with $172.8bn of equities, but many of these suffered double-digit price declines in the quarter, including a 30% slide in its largest holding, iPhone maker Apple. Reuters reported that those declines were a major factor in Berkshire’s huge quarterly loss, and its 91% drop in full-year net income to $4.02bn from $44.94bn the prior year, when it benefited from a lower corporate tax rate. Accounting rules require Berkshire to report unrealised stock gains and losses with net income, causing huge quarterly swings that Buffett says are usually meaningless.
Operating profit in the quarter totalled $5.72bn topping analyst forecasts, and for the year rose 71% to $24.78bn. Results also were hurt by a $3.02bn writedown for intangible assets that Buffett said was “almost entirely” attributable to Kraft Heinz, in which Berkshire owns a 26.7% stake. The packaged food company on Thursday shocked investors when it reported a $15.4bn writedown for Kraft, Oscar Mayer and other assets, slashed its dividend, and said the US Securities and Exchange Commission was examining its accounting practices.
Buffett's letter was finalised a while ago, and could not have predicted the worse trouble brewing in Kraft Heinz but he did perhaps allude to it when he wrote, "A few of our trees are diseased and unlikely to be around a decade from now." He did however comfort his shareholders, saying, "Fortunately, it's not necessary to evaluate each tree individually to make a rough estimate of Berkshire's intrinsic business value. That's because our forest contains five "groves" of major importance, each of which can be appraised, with reasonable accuracy, in its entirety."
Key takeaways from the letter
(by Kshitij Anand)
- Diversification of business:
This is one age-old principle which is relevant for all businesses that are looking for growth. Investors who evaluate Berkshire sometimes obsess on the details of many diverse businesses, also known as economic “trees”, as quoted in the newsletter.
Analysis of that type can be mind-numbing, given that Berkshire owns a vast array of specimens, ranging from twigs to redwoods. Buffett in the newsletter said that a few of our trees (referring to diversity in business) are diseased and unlikely to be around a decade from now, but many others, though are destined to grow in size and beauty.
Apart from equity portfolio, Berkshire held $112 billion at year end in US Treasury bills and other cash equivalents, and another $20 billion in miscellaneous fixed-income instruments.
Berkshire considers a portion of that stash to be untouchable, having pledged to always hold at least $20 billion in cash equivalents to guard against external calamities.
- Buy 'ably-managed' businesses:
Even for Indian markets, most analysts focus on the management pedigree which is the most important ingredient of any company which could give consistent returns or creates value over a period of time. Consistency is the key to wealth creation.
Buffett also highlighted that Berkshire looks to buy ably-managed businesses, in whole or part, that possess favorable and durable economic characteristics. “We also need to make these purchases at sensible prices. Sometimes we can buy control of companies that meet our tests,” quoted the letter.
Charlie and Buffett believe that companies in which they have invested offer excellent value, far exceeding that available in takeover transactions.
- Investment horizon:
If you are looking to create wealth then patience as well as stock selection is the key. Berkshire’s equity investments were worth nearly $173 billion at year-end, an amount far above their cost.
If the portfolio had been sold at its year-end valuation, federal income tax of about $14.7 billion would have been payable on the gain. In all likelihood, we will hold most of these stocks for a long time, the note to shareholders quoted.
Our investees paid us dividends of $3.8 billion last year, a sum that will increase in 2019. Far more important than the dividends, though, are the huge earnings that are annually retained by these companies.
- Blindly buying an overpriced stock is value destructive:
Warren Buffett was one of the key individuals who promoted the concept of value investing. In his letter, he said blindly buying an overpriced stock is value destructive, a fact lost on many promotional or ever-optimistic CEOs.
When a company says that it contemplates repurchases, it’s vital that all shareholder-partners be given the information they need to make an intelligent estimate of value.
“We do not want a partner to sell shares back to the company because he or she has been misled or inadequately informed,” he said.
If it’s okay for the boss to cheat a little, it’s easy for subordinates to rationalize similar behavior:
Warren Buffett always emphasized in value both in terms of quantitatively as well as qualitatively. Berkshire does not give estimates or give heat to what Street is expecting because this is one step which could result in unethical behavior.
Over the years, Charlie and I have seen all sorts of bad corporate behavior, both accounting and operational, induced by the desire of management to meet Wall Street expectations, as was highlighted in the letter to shareholders.
What starts as an “innocent” fudge in order to not disappoint “the Street” – say, trade-loading at quarter-end, turning a blind eye to rising insurance losses, or drawing down a “cookie-jar” reserve – can become the first step toward full-fledged fraud.
“Playing with the numbers “just this once” may well be the CEO’s intent; it’s seldom the end result. And if it’s okay for the boss to cheat a little, it’s easy for subordinates to rationalize similar behavior,” added the letter.
- Looking for elephant size acquisition, but no target:
That disappointing reality is that 2019 will likely see Berkshire again expanding their holdings of marketable equities. “We continue, nevertheless, to hope for an elephant-sized acquisition. Even at our ages of 88 and 95 – I’m the young one – that prospect is what causes my heart and Charlie’s to beat faster,” the note added.
- Magical metal was no match for the American mettle:
Those who believe in theories and gloom and doom would have bought gold but that might not have resulted in value creation. Hence, investors should look for stocks instead of gold.
“Those who regularly preach doom because of government budget deficits might note that our country’s national debt has increased roughly 400-fold during the last of my 77-year periods. That’s 40,000%!,” Warren Buffett said in the letter.
“Suppose you had foreseen this increase and panicked at the prospect of runaway deficits and a worthless currency. To “protect” yourself, you might have eschewed stocks and opted instead to buy 31⁄4 ounces of gold with your $114.75,” he explains.
- And what would that supposed protection have delivered?
“You would now have an asset worth about $4,200, less than 1% of what would have been realized from a simple unmanaged investment in American business. The magical metal was no match for the American mettle,” he concludes.
“Over the next 77 years, however, the major source of our gains will almost certainly be provided by The American Tailwind. We are lucky – gloriously lucky – to have that force at our back,” Warren Buffett said.
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