Industry Focus: Financials edition host Michael Douglass and Fool.com contributor Matt Frankel take a close look at Warren Buffett's latest letter to Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) shareholders. Despite no major surprises, the 16-page letter was nonetheless packed with information investors need to know.

A full transcript follows the video.

This video was recorded on Feb. 26, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, February 26th, and we're covering Buffett's annual shareholder letter. I'm your host, Michael Douglass, and I'm joined by Matt Frankel. Matt, good to have you!

Matt Frankel: Always good to be here!

Douglass: Fantastic! Folks, a little background before we get too far into the episode, Warren Buffett is the chairman and CEO of Berkshire Hathaway, which is, at its core, an insurance company. Insurance companies make their money in essentially two ways. The first is by making what's called an underwriting profit. This is, when you pay your premiums, the insurer ends out paying up some percentage, or perhaps all, and in some cases even more than all, of those premiums out in claims. Especially when a big natural disaster happens, that's the case. So, insurers make their money, hopefully, from their perspective, at least, by paying out less than they're taking in in premiums. That's what's called an underwriting profit. 

And the second way that they make money is by investing that float. That is the money that you've paid in in premiums that they haven't yet paid out. They're usually able to invest that in some way, shape or form, usually short-term bonds. That's another way they're able to leverage their money and make a few bucks here and there, which, particularly if they're not making an underwriting profit, can make the bridge to them surviving and hopefully prospering. Of course, Berkshire Hathaway is a wee bit more developed than most insurance companies.

Frankel: Yeah. Berkshire Hathaway actually started as a textile company that Buffett bought. I could do a whole 10 minutes spiel on how he came to acquire that. Anyway, he didn't have any interest in owning a failing textile business. He loved the insurance business for the reasons Michael just said, and instead of investing what's called the float in short-term bonds, Buffett's preference is to take it and invest in whole businesses, individual stocks nowadays. 

So, he started acquiring insurance companies, some of which have grown very, very big over the years. Geico is probably the biggest household name he owns, but it's actually a relatively small part of Berkshire's insurance operations. These generate cash from paid-in premiums that Buffett has been able to very successfully invest over time using none of his own money. It's someone else paying for your investments, which is why he loves the insurance business, particularly what's called reinsurance, which is insurance for insurance companies, because a more longtail payout occurs.

Douglass: Yeah. So, looking at Berkshire, what you really see is, they have the core insurance business, and then they have these stocks, which are also making Berkshire a lot of money. The third piece is, they have a number of wholly owned businesses, and Matt alluded to this. Berkshire owns the railroad, they own utilities companies, they own Fruit of the Loom, Brooks Running, and a number of other companies, some of what you know and some of which are really niche players. All of those, then, are able to provide more and more cash for Berkshire shareholders, so it creates this flywheel effect whereby each of the different very disparate parts of the business -- including, by the way, things like Dairy Queen -- can add and build to the whole. 

Now, we've glossed over a lot about insurance companies here in the interest of time so that we can really focus in on the letter, which is what we're here to talk about. I have two content links to send you if you email me at industryfocus@fool.com after today's episode. The first is a primer on insurance companies -- if you will, the insurance investor's Bible, which is written by one of our best writers on fool.com. It can really help you understand the insurance business, why Buffett loves it, why maybe you love it, or maybe you don't love it. The second, of course, is a link to Buffett's annual letter itself. We're going to be summarizing some of the main points, but it's a lot longer than we have time to fully cover today. If you want to hear pearls of investing wisdom from, in my opinion, the most brilliant investor alive today, it's kind of hard to beat the annual shareholder letter. So, again, the insurance Bible and Buffett's annual letter. Shoot us an email at industryfocus@fool.com.

With that, let's go ahead and turn to the letter itself. One of the first things, one of the big things that Buffett highlighted in his letter, is something that we've been hearing a lot about lately, which is tax reform.

Frankel: Yeah. Berkshire was a big beneficiary of tax reform, and not for the reasons that you've heard being talked about with other companies. Berkshire benefited because of its stock portfolio. Just to name one example, Buffett acquired their massive Coca-Cola investment for about $1.3 billion, and it's worth a little over $18 billion today. So, if Berkshire were to sell that, they would owe tax on it. Now the corporate tax rate has dropped from 35% to 21%, all of Berkshire's stock positions have less of what's called a deferred tax liability. And this is a big deal, because Berkshire's stocks are worth about $96 billion more than he paid for them. So, this is a big benefit. Overall, it was $29 billion in increased book value immediately following the passage of the tax bill. This is a big deal for Buffett and his shareholders.

Douglass: Yeah. It's interesting that it was a different issue than we've seen elsewhere in financials when the banks benefited, most of which, in their case, was by short-term damage from tax reform, because they had to write down some liabilities, but, of course, long-term benefit to their tax rates. 

Another big point that Buffett noted was, Berkshire Hathaway now has $116 billion in cash. And that is, in any world, a lot of money, but for Berkshire, it's a really big amount of money. And what's interesting about this is, this massive cash pile has accrued despite the fact that Berkshire actually did not run an underwriting profit last year. Now, this is the first time in a long time they hadn't, but because of various natural disasters, which you've probably been hearing about in the news over the past year, Berkshire actually didn't achieve an underwriting profit for the first time in a long time.

Frankel: Yeah, Berkshire is one of the more profitable insurance operations, I would say. And this is what I was talking about with the reinsurance business, how it's more of a longtail payout. Most years you're going to do really well, but then, on occasion, you're going to have a lot of natural disasters that affect other insurance companies a whole lot, and then you're going to wind up having to pay out more money. 

But, on the topic of cash, Berkshire accumulated an additional $7 billion worth of cash in the fourth quarter alone. They simply cannot find any way to put it to work that Buffett would approve of. Buffett does not like paying dividends. Even though he mentioned it about a year ago, it turns out that might have just been out of frustration. He really has no interest in paying a dividend. Share buybacks are another possibility, but really, Berkshire wants to buy more companies, or invest in more common stocks, they just can't find attractive ways to put over $100 billion to work. Buffett likes to keep about $20 billion in reserves at all times, so realistically they would spend a little over $90 billion on a deal if they could find one, but he just can't find anything cheap enough.

Douglass: And what's really interesting about this to me is, last year it was the largest year for mergers and acquisitions. According to, I think it was McKinsey -- no, Thomson Reuters, about $3.5 trillion in deals last year, and yet Buffett couldn't find anything that he wanted, or anything really big that he wanted. There were some smaller bolt-on acquisitions. Again, that sort of stuff is in the letter. But, he really wasn't able to do the big deals he was looking for. 

And it's interesting to me because Buffett really dedicated about a page of his letter taking to task people for the way they've made mergers and acquisitions recently. One of them being, he said basically, "There's been a lot of cheap and easy debt, and that's one of the reasons there's been all this M&A activity. Me and Charlie Munger think it's really, really dumb to borrow what you don't have to buy something that you don't need." And I'm paraphrasing him very closely, that pretty close to a direct quote. He's basically like, "What are you doing? Why are you levering up your balance sheet for something that's only going to be accretive because you're levering so hard with debt?"

Frankel: Yeah, he brought up this concept of synergies, which are often used by companies to help justify M&A activity. And to be fair, in a lot of cases, it makes a lot of sense. If you're a retailer and you have one management team overseeing 100 stores, and another company has another management team overseeing 100 stores, and you combine that into one management company overseeing 200 stores, obviously there's some cost savings to be had there. 

But Buffett's point is, the concept of synergies is used to justify deals that otherwise don't make sense, which is what we're seeing a lot today. Buffett said they've evaluated a lot of deals over the past year, but none of them made good financial sense. And Michael just mentioned that M&A activity has been through the roof. A lot of the reason that companies are justifying this is, "The cost savings will get from this, we're going to work out the kinks with this," there's all these synergies that are expected. Buffett says, when they evaluate deals, first of all, they don't even consider synergies. Second of all, he said they don't wind up finding any, normally, after they do complete a deal. So, Buffett takes a different perspective on evaluating a deal than most companies do, which is why Berkshire has had such a tough time coming up with acquisitions they could justify.

Douglass: And it's interesting, because when I look at Buffett's commentary, my immediate thought was, what does the data say? And I found a McKinsey report that showed that about 40% of mergers and acquisitions realized less than 90% of the synergies that they had claimed beforehand. And that tells me that there's probably a lot that he's talking about here, particularly because when I look at mergers and acquisitions activity, a lot of the small ones will either work out or fail cheaply. If you're a $20 billion company and you bought another company for $1 billion and it doesn't work out, it's not necessarily the end of the world. But if you do a merger of equals between two $80 billion companies and that does not generate the expected synergies, and you end up cannibalizing each other, or creating dis-synergies, even, then that can be a lot more dangerous. 

I have to say, the more I look at the idea of synergies, the more skeptical I become of it. Just covering major deals in the last three or four years, I've seen a lot of claims for synergies, and it's usually been to help cement a deal that I wasn't really that thrilled about in the first place. So, for me at least, Buffett's commentary rang very true. And it's definitely a bigger concern for me on my radar now than it was in the past.

Frankel: Definitely. It's especially true if the acquiring business takes on a lot of debt, as you mentioned, in order to fund the acquisition. Then these synergies, or lack thereof, can be very dangerous, especially if that was used to justify the deal in the first place.

Douglass: And it's one of those things where you have to ask yourself the question -- when the market's tacking left and Buffett's tacking right, who are you going to believe? And in general, Buffett has a real history of beating the market. He has a real history of running a business much better than almost anybody else. So, when he says, "That seems kind of not prudent," I'm inclined to give him the benefit of the doubt.

Frankel: Yeah. He's not only beat the market, but he's done so in a way that most people consider boring and safe. So, it's kind of the best of both worlds. He's not taken out a whole lot of risk, but he's managed to beat all the people who have taken on all the risk.

Douglass: Right. Actually, with that, let's hop into our next commentary here. Even though he has run a conservative business, frankly, Berkshire has swung pretty widely a few times. It's had four major crashes across its history. And one of his comments there is, hey, this is a sign. Even with Berkshire, even with as big and blue-chippy and as safe a stock as Berkshire Hathaway stock has historically been, it still had some major price swings. You probably shouldn't be borrowing money to invest, because if you do, this is when really bad things can start happening.

Frankel: He also said, "This will happen again." Not "this might." "This will happen again. Do not borrow money to buy stocks." The problem with borrowing money to buy stocks, generally, with margin, you can buy twice the value of stocks as you have cash in your account. So, when a stock drops by more than 50%, you could actually wind up owing money if you're leveraged to the max to buy this stock in the first place. It could literally wipe out your portfolio, whereas if you just bought what you could afford, over time, that's always come back and then some. The big problem with margin is also that you can't take advantage of opportunities as they come up. Buffett, points out, we already talked about his cash, that they like to keep at least $20 billion on hand at all times. Which to them is like you or me keeping $1,000 in the bank.

Douglass: [laughs] Right.

Frankel: [laughs] But, the reason they do that is so that when the market crashes like that, or even Berkshire stock crashes like that, they can take advantage, buying the companies they've been following at a discount, buying whole companies that, when M&A activity dries up, they're flush with money so then they get the best deals, buying their own stock back at a discount after it falls by 60% during the financial crisis. So, it's not only avoiding debt to avoid financial ruin. It's avoiding debt so you have financial flexibility when things do go bad.

Douglass: Yeah. I would double underline that. I personally have about 30%, maybe 25%, of my portfolio in cash, so far basically at all times, because I've been an investor only during this massive bull market. And at some point, things get ugly. And when that happens, those who have cash on hand can disproportionately benefit. Now, will I also probably start eating ramen during that time so I can put even more money into the market? Probably. [laughs] But, at least this guarantees at least some money that I can start with then.

Frankel: I was a little bit older than Michael -- well, I am a little bit older than Michael.

Douglass: [laughs] Still are, yeah.

Frankel: Still am. I think I started investing in '02 or '03, so I was investing well before the financial crisis, through the bubble, beforehand. So, I saw firsthand. And I can tell you firsthand, I wish, wish I'd had more money to put in the market in late 2008, early 2009. I would be in a much different financial category today if I had really known what I know today and, like Michael said, would have eaten ramen and put all my money into the market during those periods where everyone was panicking and staying on the sidelines or, even worse, selling. Thankfully, I didn't do any selling, but I was one of the unfortunate few who stayed on the sidelines. But I didn't have a ton of debt, I hadn't bought on margin so I didn't have to sell my stocks at a fire sale, which is kind of what Buffett wants people to avoid.

Douglass: And to be clear, we're not endorsing any ramen [laughs] all the time.

Frankel: No, it's not very healthy.

Douglass: But every now and then. Particularly, when I can get a dinner for $0.25, sometimes it's hard to argue with that. And by the way, this is one of the things that's really great about Buffett's letter. It's a letter to Berkshire shareholders, but it's also a letter to all investors basically ever. He certainly talked about Berkshire, and you've heard us talking about Berkshire and weaving in Berkshire to this conversation, but he's also talking about broader stuff. Should we invest in companies that are levering up hard to buy other companies? Maybe, but it depends on whether they have a really good thesis behind that purchase. Should you be borrowing money to buy stocks? No. And that's the sort of thing that goes beyond his role as chairman at Berkshire, but expands into his role as the so-called Oracle of Omaha, the voice of investing.

With that, to take the conversation back to Berkshire a little bit, one of the other big things that we noticed in this letter was, he didn't really address some of the big things that we've been hoping to learn more about, I'd say particular the succession plan. Two of his lieutenants have now been appointed to vice-chairmanships. Ted Weschler and Todd Combs are now managing more money while Buffett and Munger focus on finding investments. But it's still not really clear who's going to take over when our fairly old chairman and vice-chairman decide to retire.

Frankel: I mean, don't get me wrong, I hope Buffett is in charge of Berkshire until he's well into his hundreds. But --

Douglass: But, that's not that far away anymore. 

Frankel: It's not that far away. And not only that, he's kind of given indication that he might not want to work until he's that old. He just retired from the Kraft Heinz board, that was a big item in the news this past week. So, he's slowly stepping his role back, including serving on boards like that, managing Berkshire's investments, he's giving more and more leeway to Ted and Todd over the years. There were rumors circulating before the letter came out that there was going to be a big reveal with his succession plan, whether he was retiring, or he would name an actual successor or whatever. But that didn't really happen. There was nothing really new in terms of the succession plan.

Douglass: Yeah. This is one of those things that we're never really going to know, because no one can really know the mind of Buffett. But, Greg Abel is now the vice chairman for Non-Insurance Operations -- Dairy Queen, Brooks, all those other wholly owned businesses for Berkshire. Ajit Jain is now the vice chairman for Insurance Operations. Again, you have Todd and Ted both managing larger portfolios, and then Buffett and Munger focusing on M&A. 

The thing is, Insurance, Non-Insurance, Stocks, those are the three key pillars of Berkshire's operating business. It's not really clear whether any one of them will be foremost long-term. It's not clear that Ajit has the inside track because Buffett loves insurance, or that Ted or Todd has it, or Greg Abel, either. It's very unclear what this is going to mean for succession.

Frankel: Yeah. Another thing that I would have liked to hear more color with is this new healthcare initiative that they've been talking about in the news so much, Berkshire's collaboration with Amazon and JPMorgan. I was hoping to hear a little bit more of what their plans are. Why the addition of Teva Pharmaceuticals to his portfolio, did that have anything to do with it? Something like that, and he didn't mention too much about that, or any of his stocks at all, for that matter. 

This was actually a pretty short letter for Buffett. It's long in terms of thinking of writing a letter. But, it's 16 pages. I think last years was 27 or 28. They're generally in the 30-page range, and this one was only 16 pages long. But, the healthcare collaboration I would have liked to hear a little bit more info about. He did mention in an interview today that they're actively searching for a CEO for that venture. But, in terms of the how, is what I was hoping to hear.

Douglass: Yeah. It's interesting, because they've been very, very sketchy on details. There have been essentially no details about this venture except that the plan is to bend the cost curve on insurance.

Frankel: Right. How?

Douglass: Yeah, right. You kind of want to know what that means. That said, Buffett has strongly implied a few times at past Berkshire meetings, "If there's a guy I'm not going to bet again, it's Jeff Bezos." And I, Michael, would personally add to that, I generally don't believe in betting against Warren Buffett or Jamie Dimon where possible. So, when all three of them get together, that, I think, says a lot about the potential. Certainly, my perception of Warren Buffett is, he's not really a headline chaser, he's not the kind of person who has to be like, "Yeah, we're going to try to fix this thing and get a bunch of big PR out of something that's not actually going to make a difference." What's that's going to mean long-term, of course, who knows. But I think we will definitely see questions about that at the shareholder meeting this year, which is beginning in May, and I think we will also be expecting to see more in the coming years as well on that.

Frankel: It's worth mentioning, generally, if there is a Buffett surprise that happens at the shareholder meeting rather than in the letter, that's been the case over the last couple of years, that's when he mentioned the dividend for the first time last year, for example. That's something to keep an eye out for as we head toward, I think it's in May this year, it's at the beginning or end of the month, not sure exactly which month it falls into this year, but I think it's May. But, definitely keep an eye out for surprises there. You generally don't see too many surprises in the letter, although there have been a few.

Douglass: Yeah. Saturday, May 5th is the meeting.

Frankel: Thank you. Yeah, sometimes it's the end of April.

Douglass: Yeah, I remembered that it was the beginning of May, but I had to look up the date myself. So, a lot of good stuff there. I've been to the last two annual meetings and I thought it was fantastic, I had a really good time both times. There's nothing like listening to Buffett and Munger answer questions for, I don't know, six hours, something like that, each time, to really give you a lot of respect for their staying power and also cleverness under pressure.

Buffett is a story that we will be covering extensively, particularly as we get closer to the Berkshire shareholder meeting. Matt, as always, thanks for coming on the show. Folks, that's it for this week's Financials show. Questions, comments, or do you want those pieces of content I shared? You can always reach us at industryfocus@fool.com. As always, people on the program may have interests in the stocks they talk about. I'm a Berkshire shareholder, personally. And, The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Matthew Frankel owns shares of Berkshire Hathaway (B shares). Michael Douglass owns shares of Amazon and Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Amazon and Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.