Why Warren Buffett Is Hiding $61 Billion in Plain Sight

The Oracle of Omaha explains why economic substance can sometimes be veiled by accounting conventions.

Jul 20, 2014 at 10:07AM


"Managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation."

- Warren Buffett (1982)

In most professional disciplines, going to the primary source is the best way to get an unblemished perspective on things. But thanks to a veritable tome of complicated accounting conventions that can obscure a company's substantive performance, the same can't be said of investing -- for the record, by "primary source" I mean a company's quarterly and annual financial statements filed with the Securities and Exchange Commission.

This is a point that Warren Buffett, the chairman and CEO of Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), made in his 1982 letter to shareholders. "Managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation," the 83-year-old billionaire wrote.

Accounting form vs. substance
While esoteric accounting rules are often used by executives to intentionally mask underperformance or to artificially inflate otherwise mediocre results, they can also convolute a company's success or failure even in the absence of wrongdoing. This was the position Berkshire found itself in at the beginning of the 1980s.

For much of the previous two decades, Berkshire had focused its (and its shareholders') attention on a very specific metric of success: operating earnings as a percent of beginning equity capital. "Management's objective is to achieve a return on capital over the long term which averages somewhat higher than that of the American industry generally," Buffett said in 1973.

While there's no doubt the Omaha-based conglomerate was successful at this, its large stakes in non-controlled companies like GEICO (at the time, Berkshire held only a minority stake in the insurance company) and The Washington Post, meant that its share of their earnings wouldn't be reflected in Berkshire's official results. And this wasn't just a nominal issue.

The magnitude of the distortion can be seen by looking at the performance of Berkshire's four largest holdings in 1982. That year, Berkshire reported operating earnings of $31.5 million, which amounted to 9.8% of its beginning equity capital. Meanwhile, its share of undistributed earnings from GEICO, General Foods, The Washington Post, and R.J. Reynolds Industries amounted to "well over $40 million."

As Buffett noted,

This number – not reflected at all in our earnings – is greater than our total reported earnings, which include only the $14 million in dividends received from these companies. And, of course, we have a number of smaller ownership interests that, in aggregate, had substantial additional undistributed earnings.

Fast forward three decades and Buffett's observation that accounting earnings can "seriously misrepresent economic reality" is abundantly clear. At the end of 2013, Berkshire's cost basis in its common stock portfolio was $56.6 billion. The market value, by contrast, was more than double that at $117.5 billion. That's a $61 billion gain not showing up in earnings. And, of course, this excludes the billions of dollars in dividends Berkshire has received from these companies throughout the years.

The Foolish takeaway
The point here is an important one. If you want to understand a business, it isn't enough to simply scan their regulatory filings on the SEC's website. One must also look beyond the veneer to the true sources of growth and profitability. Had you done this in 1982 with respect to Berkshire, perhaps you too would have enjoyed the subsequent 38,000% returns.

Cash in on the technology keeping Buffett awake at night
At the recent Berkshire Hathaway annual meeting, Warren Buffett admitted this emerging technology is threatening his biggest cash-cow. While Buffett shakes in his billionaire-boots, only a few investors are embracing this new market which experts say will be worth over $2 trillion. Find out how you can cash in on this technology before the crowd catches on, by jumping onto one company that could get you the biggest piece of the action. Click here to access a FREE investor alert on the company we're calling the "brains behind" the technology.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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