Silver as an investment

Berkshire Bags Record Gain Due To Tax Cuts, Hordes Cash “To Withstand Economic Discontinuities”

In its latest annual letter, released at 8am on Saturday, Warren Buffett’s Berkshire Hathaway said Q4 profit hit an all time high, rising more than five time, as net income soared to a record $32.44 billion, or $19.790 a share, from $6.29 billion, or $3.823 the prior year, while operating EPS fell 24% to $3,338, hurt by losses in the company’s insurance operations, however it was enough to beat the $2,617 consensus estimate.

For the full year, Berkshire earned $44.940 billion, up 87% last year’s $24.1 billion, despite “only” an 8% increase in total revenue to $242.1 billion. Where did the delta come from? Largely from Trump’s tax reform, which needless to say Berkshire was not a big fan of.

Discussing operting performance, Buffett says that “viewed as a group – and excluding investment income – our operations other than insurance delivered pretax income of $20 billion in 2017, an increase of $950 million over 2016. About 44% of the 2017 profit came from two subsidiaries. BNSF, our railroad, and Berkshire Hathaway Energy (of which we own 90.2%)

As Berkshire admits in its annual report, while the gain in net worth during 2017 was $65.3 billion – which increased the per-share book value of both our Class A and Class B stock by 23% –  $29.11 billion of its net income to the reduction of the U.S. corporate tax rate, to 21% from 35%.

As Buffett admits in starting the letter, “the format of that opening paragraph has been standard for 30 years. But 2017 was far from standard: A large portion of our gain did not come from anything we accomplished at Berkshire.”

The $65 billion gain is nonetheless real – rest assured of that. But only $36 billion came from Berkshire’s operations. The remaining $29 billion was delivered to us in December when Congress rewrote the U.S. Tax Code attributed roughly $29.11 billion of its net income to the reduction of the U.S. corporate tax rate, to 21 percent from 35 percent, that President Donald Trump signed into law in December.”

Next, on the increasingly sensitive topic of Berkshire’s mounting cash pile – which as discussed yesterday is invested mostly in Treasury bills – it grew to $116 billion at year-end, up from $109 billion in the third quarter.

Let’s also recall that Berkshire is one of America’s largest investors. Below is a list of the company’s 15 largest investments, which shows that as of December 31, 2017, Berkshire’s 5 top holdings were Wells Fargo, Apple, Bank of America, Coca Cola and American Express. Of note: Berkshire’s cost basis in AAPL is $20.961BN; the stake was worth $28.21BN as of Dec. 31, 2017.

Compare this to Berkshire’s top holdings as of Dec 31, 2016:

It is worth noting that the 17 page letter was notably shorter than in years past (last year it was 29 pages) and didn’t include commentary on some of the company’s largest stock holdings.

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First a few thoughts on what was not discussed in the letter: the most notable omission appears to be the lack of succession discussion, particularly notable given yesterday’s news that Buffett would retire from the board of Kraft Heinz.

Last month, Buffett elevated Ajit Jain and Greg Abel – the two most likely candidates to succeed Buffett and Charlie Munger atop the Berkshire Hathaway hierarchy – to vice chairmen, which the financial press widely interpreted as a signal that Buffett was toying with retirement. There was no further information in today’s letter on their fate.

Other things missing: any discussion on Wells Fargo, the recently announced Bezos-Buffett-Dimon employee health plan, Buffett’s traditional American bullishness… oh, and bitcoin.

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Before moving on to discuss his company’s performance in greater detail, Buffett advised readers about a change in GAAP that could lead to significant distortions in Berkshire’s numbers:

After stating those fiscal facts, I would prefer to turn immediately to discussing Berkshire’s operations. But, in still another interruption, I must first tell you about a new accounting rule – a generally accepted accounting principle (GAAP) – that in future quarterly and annual reports will severely distort Berkshire’s net income figures and very often mislead commentators and investors.

The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line. Berkshire owns $170 billion of marketable stocks (not including our shares of Kraft Heinz), and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period.

Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire’s “bottom-line” will be useless. The new rule compounds the communication problems we have long had in dealing with the realized gains (or losses) that accounting rules compel us to include in our net income. In past quarterly and annual press releases, we have regularly warned you not to pay attention to these realized gains, because they – just like our unrealized gains – fluctuate randomly.

That’s largely because we sell securities when that seems the intelligent thing to do, not because we are trying to influence earnings in any way. As a result, we sometimes have reported substantial realized gains for a period when our portfolio, overall, performed poorly (or the converse).

As Buffett points out, coverage of corporate earnings releases is often instantaneous, with media reports focusing on the year-over-year change in GAAP net income. Buffett said he would try to alleviate this problem by methodically explaining how the company’s per-share earning power – the key metric that he and Munger use to evaluate the company’s performance – changed during the quarter, and also by continuing their longtime practice of releasing earnings reports late Friday or early Saturday, when markets are closed – allowing investors more time to digest the material.

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Acquisitions:

Addressing a topic near and dear to the company’s shareholders, Buffett lamented the lack of well-priced acquisition opportunities and reiterated his advice that individuals should avoid debt and invest passively. He also said that Berkshire needs to make one or more huge acquisitions” to increase Berkshire Hathaway earnings, but admitted that finding a deal at “a sensible purchase price” has become a challenge.

“Prices for decent, but far from spectacular, businesses hit an all-time high” in 2017, preventing Berkshire from spending more cash on acquisitions, Buffett said, fondling his $116BN. “Our smiles will broaden when we have redeployed Berkshire’s excess funds into more productive assets.”

Buffett said that a debt-fueled “purchasing frenzy” binge by deal-hungry chief executives is making that task very difficult. “Price seemed almost irrelevant to an army of optimistic purchasers,” Buffett said. “The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity.”

In terms of M&A activity, Berkshire was notably inactive during 2017, largely thanks to one recurring factor: Buffett’s inability to find sensibly-valued companies. While the rest of the world embarked on an M&A frenzy fueled by cheap debt and the incessant cheerleading of investment bankers, Buffett says he and Munger sleep well at night because of their aversion to taking on debt.

As Buffett says, it’s foolish to risk what you have – and something you need – for something you don’t.

In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.

That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.

Why the purchasing frenzy? In part, it’s because the CEO job self-selects for “can-do” types. If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.

Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase. Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size. Investment bankers, smelling huge fees, will be applauding as well. (Don’t ask the barber whether you need a haircut.) If the historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint. The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity.

After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed. At Berkshire, in contrast, we evaluate acquisitions on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual business would generally be fallacious (leaving aside certain exceptions, such as debt dedicated to Clayton’s lending portfolio or to the fixed-asset commitments at our regulated utilities). We also never factor in, nor do we often find, synergies.

Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need. We held this view 50 years ago when we each ran an investment partnership, funded by a few friends and relatives who trusted us. We also hold it today after a million or so “partners” have joined us at Berkshire.

Berkshire’s one notable deal was the purchase of a 38.6% partnership interest in truck stop operator Pilot Flying J, which Buffett describes as “far and away the nation’s leading travel-center operator.” Berkshire, Buffett explains, is obligated to increase its partnership interest to 80% in 2023.

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On $116 billion in T-Bills and the kindness of strangers.

In discussing the results of Berkshire’s Insurance operations, a familiar topic and one which appears in every letter, Buffett had this potentially ominous explanation for the company’s giant cash hoard:

Charlie and I never will operate Berkshire in a manner that depends on the kindness of strangers – or even that of friends who may be facing liquidity problems of their own. During the 2008-2009 crisis, we liked having Treasury Bills – loads of Treasury Bills – that protected us from having to rely on funding sources such as bank lines or commercial paper. We have intentionally constructed Berkshire in a manner that will allow it to comfortably withstand economic discontinuities, including such extremes as extended market closures.

In other words, while many fret over the company’s record cash hoard and the inability to use it for accretive M&A, perhaps Buffett’s rationale is far simpler: a Plan B “to comfortably withstand economic discontinuities, including such extremes as extended market closures.”

In other words, preparing for a crash.

Seen in this light, Berkshire’s record $116BN in cash and T-Bills makes much more sense.

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On the 2017 trifecta of Hurricanes and its impact on the insurance business

And speaking of catastrophic losses, here is Buffett’s discussion of last year’s unprecedented trifecta of hurricanes.

Berkshire’s insurance managers are conservative and careful underwriters, who operate in a culture that has long prioritized those qualities. That disciplined behavior has produced underwriting profits in most years, and in such instances, our cost of float was less than zero. In effect, we got paid then for holding the huge sums tallied in the earlier table. I have warned you, however, that we have been fortunate in recent years and that the catastrophe-light period the industry was experiencing was not a new norm. Last September drove home that point, as three significant hurricanes hit Texas, Florida and Puerto Rico.

My guess at this time is that the insured losses arising from the hurricanes are $100 billion or so. That figure, however, could be far off the mark. The pattern with most mega-catastrophes has been that initial loss estimates ran low. As well-known analyst V.J. Dowling has pointed out, the loss reserves of an insurer are similar to a self-graded exam. Ignorance, wishful thinking or, occasionally, downright fraud can deliver inaccurate figures about an insurer’s financial condition for a very long time.

We currently estimate Berkshire’s losses from the three hurricanes to be $3 billion (or about $2 billion after tax). If both that estimate and my industry estimate of $100 billion are close to accurate, our share of the industry loss was about 3%. I believe that percentage is also what we may reasonably expect to be our share of losses in future American mega-cats.

Is more pain coming? Perhaps, but as Buffett said, “no company comes close” to his conglomerate in its ability to financially withstand even a mega-catastrophe that causes $400 billion of insurance losses. Buffett said the odds of such a catastrophe in any year is just 2 percent, but that Berkshire would lose only about $12 billion, a sum more than offset by annual profits from its non-insurance businesses. “Concurrently, much – indeed, perhaps most – of the p/c world would be out of business,” he wrote, referring to property and casualty insurers.

We believe that the annual probability of a U.S. mega-catastrophe causing $400 billion or more of insured losses is about 2%. No one, of course, knows the correct probability. We do know, however, that the risk increases over time because of growth in both the number and value of structures located in catastrophe-vulnerable areas.

No company comes close to Berkshire in being financially prepared for a $400 billion mega-cat. Our share of such a loss might be $12 billion or so, an amount far below the annual earnings we expect from our non-insurance activities. Concurrently, much – indeed, perhaps most – of the p/c world would be out of business. Our unparalleled financial strength explains why other p/c insurers come to Berkshire – and only Berkshire – when they, themselves, need to purchase huge reinsurance coverages for large payments they may have to make in the far future.

Bottom line: last year’s natural disasters cost Berkshire a $3.2 billion pre-tax loss from underwriting.

Prior to 2017, Berkshire had recorded 14 consecutive years of underwriting profits, which totaled $28.3 billion pre-tax. I have regularly told you that I expect Berkshire to attain an underwriting profit in a majority of years, but also to experience losses from time to time. My warning became fact in 2017, as we lost $3.2 billion pre-tax from underwriting.

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On investments.

Earlier, we showed Berkshire’s 15 top investments…

… and this is what Buffett had to say about them:

Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our  investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results. In America, equity investors have the wind at their back.

From our stock portfolio – call our holdings “minority interests” in a diversified group of publicly-owned businesses – Berkshire received $3.7 billion of dividends in 2017. That’s the number included in our GAAP figures, as well as in the “operating earnings” we reference in our quarterly and annual reports.

That dividend figure, however, far understates the “true” earnings emanating from our stock holdings. For decades, we have stated in Principle 6 of our “Owner-Related Business Principles” (page 19) that we expect undistributed earnings of our investees to deliver us at least equivalent earnings by way of subsequent capital gains.

The connection of value-building to retained earnings that I’ve just described will be impossible to detect in the short term. Stocks surge and swoon, seemingly untethered to any year-to-year buildup in their underlying value. Over time, however, Ben Graham’s oft-quoted maxim proves true: “In the short run, the market is a voting machine; in the long run, however, it becomes a weighing machine.”

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On trading and forecasting the market

Buffett has long been an opponent of retail investors using leverage to buy shares – or frankly any share purchases – instead he has been a big fan of passive, index acquisitions. He repeats that same theme today:

This table offers the strongest argument I can muster against ever using borrowed money to own stocks.

There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.

In the next 53 years our shares (and others) will experience declines resembling those in the table. No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow.

When major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt. That’s the time to heed these lines from Kipling’s If:

“If you can keep your head when all about you are losing theirs . . .
If you can wait and not be tired by waiting . . .
If you can think – and not make thoughts your aim . . .
If you can trust yourself when all men doubt you . . .
Yours is the Earth and everything that’s in it.”

So about that $116BN in cash and T-bills again…

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Market vs Active Management

For the second year in a row, Buffett returns to the bet he made with Protege Partners that over 10 years, the market – in the form of an unmanaged S&P index fund – would outperform actively managed funds. As he explains, he won the bet:

Last year, at the 90% mark, I gave you a detailed report on a ten-year bet I had made on December 19, 2007.(The full discussion from last year’s annual report is reprinted on pages 24 – 26.) Now I have the final tally – and, in several respects, it’s an eye-opener.

I made the bet for two reasons: (1) to leverage my outlay of $318,250 into a disproportionately larger sum that – if things turned out as I expected – would be distributed in early 2018 to Girls Inc. of Omaha; and (2) to publicize my conviction that my pick – a virtually cost-free investment in an unmanaged S&P 500 index fund – would, over time, deliver better results than those achieved by most investment professionals, however well-regarded and incentivized those “helpers” may be.

Addressing this question is of enormous importance. American investors pay staggering sums annually to advisors, often incurring several layers of consequential costs. In the aggregate, do these investors get their money’s worth? Indeed, again in the aggregate, do investors get anything for their outlays?

Protégé Partners, my counterparty to the bet, picked five “funds-of-funds” that it expected to overperform the S&P 500. That was not a small sample. Those five funds-of-funds in turn owned interests in more than 200 hedge funds.

Essentially, Protégé, an advisory firm that knew its way around Wall Street, selected five investment experts who, in turn, employed several hundred other investment experts, each managing his or her own hedge fund. This assemblage was an elite crew, loaded with brains, adrenaline and confidence. The managers of the five funds-of-funds possessed a further advantage: They could – and did – rearrange their portfolios of hedge funds during the ten years, investing with new “stars” while exiting their positions in hedge funds whose managers had lost their touch.

Every actor on Protégé’s side was highly incentivized: Both the fund-of-funds managers and the hedge-fund managers they selected significantly shared in gains, even those achieved simply because the market generally moves upwards. (In 100% of the 43 ten-year periods since we took control of Berkshire, years with gains by the S&P 500 exceeded loss years.)

Those performance incentives, it should be emphasized, were frosting on a huge and tasty cake: Even if the funds lost money for their investors during the decade, their managers could grow very rich. That would occur because fixed fees averaging a staggering 2.5% of assets or so were paid every year by the fund-of-funds’ investors, with part of these fees going to the managers at the five funds-of-funds and the balance going to the 200-plus managers of the
underlying hedge funds.

The five funds-of-funds got off to a fast start, each beating the index fund in 2008. Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund.

Let me emphasize that there was nothing aberrational about stock-market behavior over the ten-year stretch. If a poll of investment “experts” had been asked late in 2007 for a forecast of long-term common-stock returns, their guesses would have likely averaged close to the 8.5% actually delivered by the S&P 500. Making money in that environment should have been easy. Indeed, Wall Street “helpers” earned staggering sums. While this group prospered, however, many of their investors experienced a lost decade.

Performance comes, performance goes. Fees never falter.

Of course, we are confident that Buffett’s discussion how central banks effectively took over capital markets and there  is no longer such a thing as a “market”, was merely delayed to next year…

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If hedge fund managers didn’t hate Buffett before, they do now:

A final lesson from our bet: Stick with big, “easy” decisions and eschew activity. During the ten-year bet, the 200-plus hedge-fund managers that were involved almost certainly made tens of thousands of buy and sell decisions. Most of those managers undoubtedly thought hard about their decisions, each of which they believed would prove advantageous. In the process of investing, they studied 10-Ks, interviewed managements, read trade journals and conferred with Wall Street analysts.

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On sizing of investments, and bashing of TSYs

An interesting tangent to the Protege Partners bet above:

The bet illuminated another important investment lesson: Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.

Originally, Protégé and I each funded our portion of the ultimate $1 million prize by purchasing $500,000 face amount of zero-coupon U.S. Treasury bonds (sometimes called “strips”). These bonds cost each of us $318,250 – a bit less than 64¢ on the dollar – with the $500,000 payable in ten years. As the name implies, the bonds we acquired paid no interest, but (because of the discount at which they were purchased) delivered a 4.56% annual return if held to maturity. Protégé and I originally intended to do no more than tally the annual returns and distribute $1 million to the winning charity when the bonds matured late in 2017.

After our purchase, however, some very strange things took place in the bond market. By November 2012, our bonds – now with about five years to go before they matured – were selling for 95.7% of their face value. At that price, their annual yield to maturity was less than 1%. Or, to be precise, .88%.

Given that pathetic return, our bonds had become a dumb – a really dumb – investment compared to American equities. Over time, the S&P 500 – which mirrors a huge cross-section of American business, appropriately weighted by market value – has earned far more than 10% annually on shareholders’ equity (net worth).

In November 2012, as we were considering all this, the cash return from dividends on the S&P 500 was 2.52% annually, about triple the yield on our U.S. Treasury bond. These dividend payments were almost certain to grow. Beyond that, huge sums were being retained by the companies comprising the 500. These businesses would use their retained earnings to expand their operations and, frequently, to repurchase their shares as well. Either course would, over time, substantially increase earnings-per-share. And – as has been the case since 1776 – whatever its problems of the minute, the American economy was going to move forward.

Presented late in 2012 with the extraordinary valuation mismatch between bonds and equities, Protégé and I agreed to sell the bonds we had bought five years earlier and use the proceeds to buy 11,200 Berkshire “B” shares. The result: Girls Inc. of Omaha found itself receiving $2,222,279 last month rather than the $1 million it had originally hoped for.

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So stay away from Treasurys?

One day after the Fed warned that stock valuations are high, Buffett underscores the point (in bold):

Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that this objective won’t be attained. By that standard, purportedly “risk-free” long-term bonds in 2012 were a far riskier investment than a long-term investment in common stocks. At that time, even a 1% annual rate of inflation between 2012 and 2017 would have decreased the purchasing-power of the government bond that Protégé and I sold.

I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.

With the bolded section in mind, this is what the Fed warned just yesterday:

In general, valuations are higher than would be expected based solely on the current level of longer-term Treasury yields. In part reflecting growing anticipation of the boost to future (after-tax) earnings from a corporate tax rate cut, price-to-earnings ratios for U.S. stocks rose through January and were close to their highest levels outside of the late 1990s; ratios dropped back somewhat in early February.

Don’t expect Buffett to urge you to sell though, especially not Berkshire stock…

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Why does Buffett always release the letter on Saturday morning?

In case you were wondering…

While I’m on the subject of our owners’ gaining knowledge, let me remind you that Charlie and I believe all shareholders should simultaneously have access to new information that Berkshire releases and, if possible, should also have adequate time to digest and analyze that information before any trading takes place. That’s why we try to issue financial data late on Fridays or early on Saturdays and why our annual meeting is always held on a Saturday (a day that also eases traffic and parking problems). We do not follow the common practice of talking one-on-one with large institutional investors or analysts, treating them instead as we do all other shareholders. There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his or her savings. As I run the company day-to-day – and as I write this letter – that is the shareholder whose image is in my mind.

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Read the report in its entirety below (pdf link):