Warren Buffett published his annual Letter to Shareholders on February 25. As in the last two years, this blog post summarizes a few observations and takeaways, though I encourage you to read the letter itself – it rarely disappoints!
My observations this year are focused on three subjects in the report:
- How to measure Berkshire’s results
- Float and the insurance business
- Other observations about accounting and investing
One of the perennial questions about Berkshire Hathaway is “How much money do they make?” There is, of course, an accounting and SEC answer to that question, but as Buffett himself is the first to point out, those rules do not get to the economic answer. His answer is that change in intrinsic value per share is the way to answer this question.
The problem is, while conceptually pure, it is a very wishy-washy measure, and no two people will probably ever agree on it because it requires projecting future cash flows, and the future is always hard to predict. Buffett explained decades ago in his booklet “An Owners Manual” that he preferred to use change in book value per share as a proxy for change in intrinsic value. Even though, in absolute terms, it will always be significantly lower, he views the year-on-year change in book value per share as “likely reasonably close to that year’s change in intrinsic value”.
Last year he added change in market value per share to his performance table and comparison with the S&P 500 (page 2). This time he seems to be endorsing market value per share as the best proxy for intrinsic value per share for Berkshire. “Over time, stock prices gravitate toward intrinsic value. That’s what has happened at Berkshire, … ” He goes on to explain that the investment strategy has changed at Berkshire, to one of buying entire businesses rather than making investments in marketable securities, and that is why book value per share has become less and less valuable as a measure of intrinsic value. So Buffett’s answer to “how much money do they make” seems now to be to look at change in market value per share, because that is the best proxy for change in intrinsic value per share.
The subject of “float” is one that is close to Buffett’s heart and is a cornerstone of Berkshire’s strategy: “our most important sector, insurance … has been the engine that has propelled our growth since 1967”. Float is generated by Berkshire’s insurance operations as the timing difference between when premiums are received and claims are paid. Buffett discusses at length the unique characteristics of Berkshire’s float, the fact it is a source of free capital and that most of their float will be “both costless and long-enduring”. At the end of 2016, float reached an all-time high of $91,577 billion, recently topping over $100 billion following the latest AIG retroactive reinsurance deal (“a huge policy”). He goes on to discuss the accounting for float, which requires it to be deduced as a liability in calculating book value, but in reality, it should be viewed as a “revolving fund” with a true liability that is “dramatically” less than the accounting liability.
Buffett contrasts Berkshire’s portfolio of insurance businesses (and they are in a number of completely separate insurance businesses) with the rest of the industry:
- Intense competition causes the property & casualty industry as a whole to regularly operate at a significant underwriting loss, but Berkshire’s insurers have an excellent underwriting record — operating with an underwriting profit for 14 consecutive years. The underwriting discipline at Berkshire “is a religion, Old Testament style”.
- The investment portfolios of almost all P&C insurers are heavily concentrated in bonds. As a result, their earnings from float will steadily decrease as maturing bonds are replaced by those yielding a “pittance”. It is a good bet, according to Buffett, that the industry will do way worse over the next 10 years than it did in the last. Berkshire, by contrast, due to its “unrivaled financial strength”, is not constrained by needing to invest in bonds and has far more flexibility than the rest of the industry.
- The combination of massive float, investment flexibility and profitable underwriting makes Berkshire quite untypical of the rest of the industry.
Berkshire Hathaway Specialty Insurance is also called out, and Buffett prophesies that it is “destined to become one of the world’s leading P&C insurers”. BHSI is less than three years old, but under the leadership of Peter Eastwood (poached from AIG), it has been profitable from the start and expanding rapidly. In addition to BHSI, Berkshire owns several other smaller commercial insurers and collectively is now a strong presence in the commercial insurance marketplace.
Buffett treats us to an interesting rant about restructuring charges and stock-based compensation … and not for the first time. He feels both devices are used to manipulate earnings to make corporate managers look good. Even though Berkshire is continuously restructuring, they never hide such expenses in restructuring charges. Buffett cringes when Wall Street praises a management who always “make the numbers” when in reality, life is much less predictable. As for stock-based compensation, his argument goes: If stock-based compensation is not employee compensation, then what is? If employee compensation is not an expense, then what is? And if expenses should not be deducted in determining earnings, then what should be? He views the current accounting for stock-based compensation, which does not take it into account in determining earnings, as “make-believe” accounting. I, for one, agree with him.
The subject of corporate inversions and the taxation of the overseas cash holdings of U.S. corporations is quite topical and political. Many companies choose, to the extent possible, to keep retained earnings overseas rather than pay a significant tax penalty on bringing those earnings stateside. Buffett simply points out that its $86 billion of cash and equivalents is held stateside, and not subject to double taxation. Berkshire’s cash, therefore, is worth more than an equivalent amount of cash held overseas.
Finally, Buffett treats us to another interesting rant on the subject of actively managed funds. I will only very briefly summarize here because I think the subject is worthy of a lengthy treatment, and he writes about it engagingly. Again, I wholeheartedly agree with him. His standard investment advice to those of modest means, as well as the mega-rich, is to invest in an S&P 500 low-cost index fund. The mega-rich individuals, institutions and pension funds never take his advice. Buffett reports on the outcome of a bet that he made in the 2005 Annual Report. He offered a wager of $500,000 that no investment professional could select a set of at least five hedge funds that could, over a 10-year period, match the performance of an unmanaged S&P 500 index fund. Nine years in, Buffett reports on progress, but it seems that he is going to be keeping his money. His bottom line: “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
I suppose the exception to this advice is if you happen to be an investor in Berkshire Hathaway’s stock, which is also actively managed but outperforms the S&P 500!