On Saturday, Warren Buffett released his Golden Anniversary shareholder letter, followed by yesterday's release of Berkshire Hathaway's (NYSE:BRK-B) 2014 annual report. (2015 marks a half-century since Buffett took control of a struggling New England textile business by the name of Berkshire Hathaway.) Mr. Buffett's message is one of optimism, tempered by a dispassionate assessment of the facts: In terms of financial strength, earnings power, and permanence, Berkshire Hathaway appears better positioned than ever -- even as the end of Mr. Buffett's tenure draws ever nearer.
Buffett breaks down the "sprawling conglomerate, trying to sprawl further," into four major segments:
- Regulated, capital-intensive businesses
- Manufacturing, service, and retailing
- Finance and financial products
A separate section is devoted to Berkshire's common stock investments.
Over the course of his presentation, Buffett presents a primer on the insurance industry (his discussion of "float" is essential reading). Insurance is, in Buffett's own words, "Berkshire's core operation. That industry has been the engine that has propelled our expansion since 1967." The numbers speak for themselves:
Berkshire's huge and growing insurance operation again operated at an underwriting profit in 2014 -- that makes 12 years in a row -- and increased its float. During that 12-year stretch, our float -- money that doesn't belong to us but that we can invest for Berkshire's benefit -- has grown from $41 billion to $84 billion. Meanwhile, our underwriting profit totaled $24 billion during the 12-year period, including $2.7 billion earned in 2014. And all of this began with our 1967 purchase of National Indemnity for $8.6 million.
Berkshire's great managers, premier financial strength and a variety of business models protected by wide moats amount to something unique in the insurance world. This assemblage of strengths is a huge asset for Berkshire shareholders that will only get more valuable with time.
Regulated, capital-intensive businesses: energy and rail
Earnings attributable to Berkshire Hathaway from Berkshire Hathaway Energy, which covers utilities and pipeline assets and is 89.9% owned by Berkshire, rose 28% to $1.8 billion. The unit also received top marks from Buffett ("as we have in every year of our ownership") in terms of satisfying regulators and customers. That is critical in order to ensure the former constituency will continue to allow utilities to earn reasonable returns. If that is case -- and Buffett expects it will be -- "we relish making [multi-billion dollar capital] commitments."
On the other hand, BNSF, "by far, Berkshire's most important non-insurance subsidiary," did not turn in a satisfactory performance on this front. Although profitability at the railroad was stable (net earnings were $3.9 billion, up 2% from 2013), BNSF disappointed in terms of customer service and, as result, lost market share to its nearest rival, Union Pacific.
BNSF is expected to spend $6 billion improving its operations in 2015 -- an astonishing 26% of estimated annual revenues. The tide may already have turned: "During the last three months, BNSF's performance metrics have materially improved from last year's figures."
Manufacturing, service, and retailing
This segment covers a veritable hodgepodge of activities ("from lollipops to jet airplanes"). In summary:
Viewed as a single entity, the companies in this group are an excellent business. They employed an average of $24 billion of net tangible assets during 2014 and, despite their holding large quantities of excess cash and using little leverage, earned 18.7% after-tax on that capital.
Nevertheless, it's worth keeping in mind that "the difference between intrinsic value and carrying value in both the insurance and regulated-industry segments is far greater. It is there that the truly big winners reside."
Finance and financial products
For the first time, Buffett is including in this segment Marmon's leasing operations, which covers railcars, containers, and cranes. This activity contributed more than a third of the segment's $1.8 billion in earnings in 2015, which rose 18% year over year on a like-for-like basis (i.e., including Marmon's leasing business).
Clayton Homes delivered another standout performance, selling "30,871 homes, about 45% of the manufactured homes bought by Americans. When we purchased Clayton in 2003 for $1.7 billion, its share was 14%."
In 2014, the value of Berkshire's investments advanced 8.4% to $140,123 per share (against 11.4% for the S&P 500). Among its "Big Four" investments (American Express, Coca-Cola, IBM, and Wells Fargo), Buffett only added to Berkshire's position in IBM, raising the ownership interest to 7.8% at year end from 6.3% a year earlier.
Buffett did recognize a major blunder, however, in exiting his losing position in U.K. supermarket chain Tesco at an after-tax cost to shareholders of $444 million -- "about 1/5 of 1% of Berkshire's net worth." Buffett's post-mortem:
In 2013, I soured somewhat on the company's then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior "thumb-sucking." (Considering what my delay cost us, he is being kind.)
During 2014, Tesco's problems worsened by the month. The company's market share fell, its margins contracted, and accounting problems surfaced. In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen, and as the days go by, you meet its relatives.
Investing isn't a game of certainties; even the greatest investors aren't immune to losses.
The next 50 years
At the time of Berkshire's 2009 acquisition of BNSF -- the largest in the company's history -- Buffett called the transaction an "all-in wager on the economic future of the United States." The same could largely be said of Berkshire Hathaway itself (even as Buffett increasingly looks overseas for acquisitions):
Despite our conservatism, I think we will be able every year to build the underlying per-share earning power of Berkshire. ... The U.S. economy will ebb and flow -- though mostly flow -- and, when it weakens, so will our current earnings. But we will continue to achieve organic gains, make bolt-on acquisitions and enter new fields. I believe, therefore, that Berkshire will annually add to its underlying earning power.
Although the upside for Berkshire Hathaway's shareholders is capped by virtue of Berkshire's size -- it won't come close to the performance of the last 50 years -- their downside is also limited (as much as that of any equity investment can be):
I believe that the chance of permanent capital loss for patient Berkshire shareholders is as low as can be found among single-company investments. That's because our per-share intrinsic business value is almost certain to advance over time.