Another strong year for the markets means another great year for Berkshire Hathaway.
As Chairman Warren Buffett described in his Feb. 25 letter to investors, Berkshire had a gain in net worth of $65.3 billion in 2017. That translated into a 23% increase in the per-share book value of its stock.
In the last 53 years, that figure has grown at a 19% yearly compound rate.
While $36 billion of that gain came from Berkshire’s operations, Buffett says, the rest — $29 billion — resulted from the recent tax-reform package.
How are Berkshire shares doing vs. the S&P 500? They rose 21.9% last year vs. 20.9% for the index, including dividends.
And, as Buffett points out, the firm’s figures are post-tax, while those of the index are pretax.
Read on to understand the wisdom behind those results and to prepare for Berkshire’s annual meeting, set for 8:45 a.m. on May 5 and available via livestream on the web:
1. Acquisitions That Count
When it comes to buying standalone businesses, Berkshire Hathaway seeks firms with the following: “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.”
This last requirement, Buffett says, proved difficult to meet in most cases in 2017 as prices for many businesses were at all-time highs.
The easy availability of cheap debt last year helped fuel this and busy M&A activity.
Berkshire, though, likes to look at acquisitions on an “all-equity basis.”
“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,” Buffett explained.
As for the rest of the corporate investing universe, the less prudent they are in their affairs, “the greater the prudence with which we must conduct our own.”
2. The Importance of Standout Purchases
Despite the cautious nature of its M&A operations, Berkshire bought a nearly 40% stake in Pilot Flying J (or PFJ) last year.
With about $20 billion in annual volume, Buffett says, “the company is far and away the nation’s leading travel-center operator,” run by “the remarkable Haslam family.”
Its operations include 750 sites in North America.
Berkshire stuck a deal in which it can boost its interest in PFJ to 80% in 2023.
The pit stops have food, gas and 5,200 showers.
3. Bolt-on Acquisitions
Clayton Homes bought two builders of conventional homes, which more than doubled Berkshire’s presence in this industry, which it entered three years ago. Along with Oakwood Homes in Colorado and Harris Doyle in Birmingham, Clayton’s site built volume should top $1 billion this year, the Oracle of Omaha says.
Plus, the builder also is focused on manufactured housing. Last year, it sold over 19,000 units via its own retail operations and another 26,700 through wholesale operations.
As a result, Clayton’s controls nearly 50% of the market for manufactured homes.
That’s “a far cry from the 13% Clayton achieved in 2003, the year it joined Berkshire,” Buffett says.
Both Clayton Homes and PFJ are based in Knoxville, Tennessee. Kevin Clayton told PFJ’s owners about the advantages of a Berkshire affiliation, which helped Buffett “cement the PFJ deal.”
Another Berkshire-owned firm, Shaw Industries, recently bought a rival that makes luxury vinyl tile, U.S. Floors.
“USF’s managers, Piet Dossche and Philippe Erramuzpe, came out of the gate fast, delivering a 40% increase in sales in 2017, during which their operation was integrated with Shaw’s,” Buffett boasted.
HomeServices, Berkshire’s real estate brokerage business, “exploded” by picking up the third-largest operator, Long and Foster; the 12th-largest, Houlihan Lawrence; and Gloria Nilson.
Then there’s Precision Castparts, which recently bought Wilhelm Schulz, a German maker of corrosion-resistant fittings, piping systems and parts.
“Mark Donegan, CEO of Precision, is an extraordinary manufacturing executive, and any business in his domain is slated to do well. Betting on people can sometimes be more certain than betting on physical assets,” the Oracle of Omaha explained.
4. The Right Insurance
Berkshire got into this business by buying National Indemnity and a sister company for less than $9 million in 1967.
It then used its nearly $7 million of tangible net worth to invest in marketable securities.
Plus, the insurance operation had about $19 million of “float,” or funds that belonged to others but were held by Berkshire’s two insurers.
“Ever since, float has been of great importance to Berkshire. When we invest these funds, all dividends, interest and gains from their deployment belong to Berkshire,” Buffett explained.
The insurance business it owns specializes in medical malpractice and product liability, which create far more float than, say, operations focused on car crashes and homeowner policies, which require nearly immediate payouts.
Property and casualty float can’t be withdrawn, so there’s no risk of big “runs” in times of financial stress, Buffet says.
“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,” he explained.
In the financial crisis a decade ago, Berkshire had “loads of Treasury bills that protected us from having to rely on funding sources such as bank lines or commercial paper,” Buffett said. “We have intentionally constructed Berkshire in a manner that will allow it to comfortably withstand economic discontinuities, including such extremes as extended market closures.”
As for other risks, Berkshire’s insurance managers are “conservative and careful underwriters,” he points out.
“That disciplined behavior has produced underwriting profits in most years, and in such instances, our cost of float was less than zero,” the investment guru said.
5. The Value of Human Capital
Still, Berkshire has lost $2 billion after taxes from the three hurricanes of 2017. That reduced Berkshire’s GAAP net worth by less than 1%.
“No company comes close to Berkshire in being financially prepared for a $400 billion mega-catastrophe,” Buffet says.
“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,” he explained. “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.”
Before last year, Berkshire had 14 consecutive years of underwriting profits, totaling $28.3 billion pretax. But last year, the firm lost $3.2 billion pretax from underwriting.
Buffet pulls no punches regarding this development.
“The only point I will add here is that you have some extraordinary managers working for you,” he wrote. “This is a business in which there are no trade secrets, patents or locational advantages. What counts are brains and capital.”
6. Long-Term Investments
In his letter, Buffett highlights 15 common stock investments owned by Berkshire, excluding Kraft Heinz.
“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,” he explained.
Berkshire’s stock portfolio produced $3.7 billion of dividends in 2017.
“That dividend figure, however, far understates the “true” earnings emanating from our stock holdings,” Buffett added.
The firm expects undistributed earnings to produce equivalent or better earnings via capital gains.
“Stocks surge and swoon, seemingly untethered to any year-to-year buildup in their underlying value,” he said. “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.’”
7. Warning Against Leverage
“Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long-term growth in value,” the Oracle of Omaha wrote.
While the firm has built value through the reinvestment of its earnings and “letting compound interest work its magic” over the past 53 years, its shares have experienced “truly major dips,” he says.
For instance, they fell by 37% during the markets’ worst months of 1987, 49% in the rough period of ’98-’00, 51% in the financial crisis of ’08-’09, and 59% in the troubled times of ’73-’75.
“This … 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,” Buffett explained.
“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,” he added.
While no one can predict when such declines will happen, they offer “extraordinary opportunities to those who are not handicapped by debt,” the Berkshire chairman says.
8. Passive vs. Active
Berkshire made a 10-year bet to prove its conviction that “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.”
Protégé Partners, the counterparty to the bet, picked five funds of funds that it thought would outperform the S&P 500. The funds of funds owned interests in more than 200 hedge funds.
“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 10 years, investing with new ‘stars’ while exiting their positions in hedge funds whose managers had lost their touch.”
The fixed fees averaged about 2.5% of assets.
How did the funds do? The range of total 10-year gains was 3% to 88% vs. a 126% jump in the S&P 500.
The average annual gain for the funds was between 0.3% and 6.5%. Meanwhile, the index had an average yearly improvement of 8.5%.
“Let me emphasize that there was nothing aberrational about stock-market behavior over the 10-year stretch,” said Buffett.
“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,” he added.
While making money over the past 10 years should have “been easy,” many of the funds’ investors “experienced a lost decade,” Buffett explained. “Performance comes, performance goes. Fees never falter.”
9. What Else to Think?
“Though markets are generally rational, they occasionally do crazy things …. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals,” Buffett said.
Sometimes, this boils down to looking foolish, he argues.
“Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date,” he wrote.
And risk is the chance that this goal won’t be achieved.
While stocks are riskier than bonds in the short term, “a diversified portfolio of U.S. equities becomes progressively less risky than bonds” over the long run.
To Buffett, it’s “a terrible mistake … to measure …investment ‘risk’ by [a] portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk,” he explained.
10. About That Bet …
“Stick with big, ‘easy’ decisions and eschew activity,” the Sage of Omaha said.
While hedge-fund managers tend to prefer lots of buy and sell moves and think long and hard about them, “Protégé and I, meanwhile, leaning neither on research, insights nor brilliance, made only one investment decision during the 10 years [of our bet].”
They sold a bond investment at a price of more than 100 times earnings and moved their money into Berkshire.
“Fueled by retained earnings, Berkshire’s growth in value was unlikely to be less than 8% annually, even if we were to experience a so-so economy,” Buffet said.
“After that kindergarten-like analysis, Protégé and I made the switch and relaxed, confident that, over time, 8% was certain to beat 0.88%,” he added. “By a lot.”
P.S.: Mind the GAAP
The Oracle of Omaha wants investors to know about a new rule under the generally accepted accounting principles (GAAP) that will “severely distort Berkshire’s net income figures” and could mislead observers.
“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,” he explained. “That requirement will produce some truly wild and capricious swings in our GAAP bottom line.”
How big might these swings be? The value of Berkshire’s $170 billion of marketable stocks (excluding shares of Kraft Heinz) “can easily swing by $10 billion or more within a quarterly reporting period,” he said.
This means, Buffett argues, Berkshire’s “bottom line” will be useless.
Plus, the new rule makes communication issues tied to realized gains (or losses) more complicated.
In the past, “we have regularly warned you not to pay attention to these realized gains, because they — just like our unrealized gains — fluctuate randomly.”
Berkshire sells securities when it seems like the smart thing to do, not to influence earnings.
“As a result, we sometimes have reported substantial realized gains for a period when our portfolio, overall, performed poorly (or the converse),” Buffett explained.
With the new rule, he says, the firm will do all it can “to explain the adjustments you need in order to make sense of our numbers.” It also plans to release its financial reports late on Friday.
“At Berkshire what counts most are increases in our normalized per-share earning power,” he wrote. “That metric is what Charlie Munger, my longtime partner, and I focus on — and we hope that you do, too.”