Warren Buffett released his annual letter to Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) shareholders this morning, and as usual, it's filled with page after page of valuable information for investors to digest. Here are some of the highlights of Buffett's latest letter, and what they mean to investors.
Berkshire earned $4 billion in 2018, but there's more to the story
The first thing Buffett pointed out in the letter is Berkshire's $4 billion operating profit. However, this is under generally accepted accounting principles, or GAAP, and there's a recent change to this method that distorts Berkshire's true earnings.
Specifically, Berkshire is required to include the gains or losses from its stock portfolio in its profit calculations, even from stocks the company still owns, a method Buffett predicted would cause "wild and capricious swings in our bottom line." As most investors know, 2018 wasn't exactly a great year for stocks, and some major Berkshire holdings were particularly hard-hit.
Here's the point. That $4 billion figure includes $20.6 billion in unrealized losses from the company's stock portfolio. So, Berkshire's operating profit was actually about $25 billion for the year -- it just doesn't look that way.
It's "time to abandon" book value
There was one big change to the format of Buffett's letter this year. Typically, Buffett opens with a report of how Berkshire's per-share book value has changed.
"It's now time to abandon that practice," Buffett wrote. According to Buffett, book value simply isn't as relevant a metric as it once was. Specifically, the majority of Berkshire's value is in its many operating businesses, which are less accurately reflected in book value as time goes on, as accounting rules require them to be incorporated into book value at a lower value than they're actually worth.
In addition, Berkshire's recently revised buyback program will allow the company to buy back more stock. Since these buybacks will almost certainly happen for more than book value, this practice will further distort the company's book value metric as time goes on.
Berkshire bought back $417.5 million in stock during the fourth quarter
The fourth quarter wasn't a particularly active one for Berkshire Hathaway in terms of stock buybacks, with the company spending $417.5 million (about 0.1% of the company's outstanding stock). However, it's important to note that Berkshire did take advantage of the December plunge in the stock market. The majority of the buybacks took place between Dec. 13 and Dec. 24 at an average price of $295,954 per Class A share; those shares currently trade for $302,000.
Buying entire businesses wasn't the way to go
Berkshire's preference is to buy an entire business. After all, Berkshire has a market cap of nearly a half-trillion dollars, so it takes a pretty large investment to move the needle. Lately, however, valuations have been a big obstacle to making acquisitions, so Buffett and his team have utilized their favorite alternative -- buying stocks.
"Many stocks have offered far more for our money than we could obtain by purchasing businesses in their entirety," Buffett wrote. Berkshire was a net buyer of stocks in 2018, with $43 billion in purchases and $19 billion in stock sales. And, Buffett is confident that deploying this capital in the market was the best way to go. "Charlie (Munger) and I believe the companies in which we invested offered excellent value, far exceeding that available in takeover transactions."
Here's what investors can expect in 2019
At the end of 2018, Berkshire Hathaway had nearly $112 billion of cash and equivalents on its balance sheet, officially consisting of $30.4 billion in cash and $81.5 billion in short-term Treasuries.
Buffett prefers to hold at least $20 billion in cash and equivalents at all times, but this still leaves a massive $92 billion war chest to put to work. Finding ways to deploy Berkshire's cash has been a major problem for the company in recent years. As I mentioned, valuation has been a big obstacle to making a major acquisition, but that doesn't mean that Buffett and Munger are giving up. Buffett wrote:
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. (Just writing about the possibility of a huge purchase has caused my pulse rate to soar.)
Buffett, however, pointed out that Berkshire's most likely investments for 2019 will consist of further stock purchases. Buffett wants investors to understand that he's not saying stocks will be particularly attractive this year -- just that acquisitions continue to remain unattractive.
Berkshire works because it's so complex
Berkshire Hathaway consists of more than 60 subsidiary businesses, including massive insurance operations, partially owned businesses, and a diverse array of wholly owned companies. In addition, the company has a stock portfolio worth roughly $200 billion.
Buffett pointed out in his letter that Berkshire works so well as a business because its various parts complement each other so well. In fact, its structure "allows us to seamlessly and objectively allocate major amounts of capital, eliminate enterprise risk, avoid insularity, fund assets at exceptionally low cost, occasionally take advantage of tax efficiencies, and minimize overhead."
"At Berkshire, the whole is greater -- considerably greater -- than the sum of the parts," Buffett wrote.
The dangers of investment fees
As part of his letter, Buffett loves to include valuable investment lessons, and one recurring theme is how dangerous investment fees can be.
Buffett made his first investment in March 1942. In the time since, the S&P 500's value has increased 5,288 times over, including reinvested dividends. So, a $1 million investment would have grown to $5.3 billion.
However, if the exact same investment with the exact same returns was being managed by someone taking a 1% annual management fee, the gain would have been cut in half. In other words, paying a seemingly small 1% fee would have cost this investor a staggering $2.65 billion.
Now, investment fees aren't always excessive or unnecessary. But they should definitely be a major consideration.
Why gold isn't a great long-term investment
Buffett briefly discussed how many people point out that America's national debt has increased by 40,000% since 1942, and that our currency could end up collapsing due to runaway deficits. These types of people often advise buying gold.
Buffett wrote that if someone had put their money in gold back in 1942, their total return would have been less than 1% of what they would have achieved by simply investing in the S&P 500.
America's economy will do just fine, no matter who is in charge
As a final point, Buffett discussed how American business is still a powerful long-term growth engine. He pointed out that since he made his first investment, America has had seven Republicans and seven Democrats in the White House, and we've had several scary economic times in those years, including a rapid inflationary period, wars, a housing collapse, and more.
Buffett's point? We made it through each and every one.
Buffett believes America will be the biggest force working in investors' favor going forward: "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."
Check out Buffett's letter for yourself.