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  • KPB & Co Research

Over the years, Warren Buffet's shareholder letters have provided insights into the mind of the owner/operator of one of the most profitable investment partnerships of our time. Every year we examine the content of the letter to tease out the key elements that have driven his remarkable performance. This year, his letter contains a few insights that have been mentioned before, but is worth emphasizing given their importance. These insights are: the importance of intrinsic value in determining when to buy, and the importance of identifying the true operating earnings business before you buy. There are also areas where his actions has seemingly deviated the fundamental principles that have governed his investment process, and so we also look to ascertain the reason for this.

HoldING a fully diversified portfolio of businessES is Wrong

In years gone by, Warren Buffet along with many value investors promote the idea that it is virtually impossible to find more than 20 high quality business at any point in time. As such, investing in a fully diversified portfolio of businesses is likely to lead to sub-optimal portfolio returns, as the investor is likely take ownership in pieces of businesses that are fundamentally weak as the number of names in his/her the portfolio increases. Today, Berkshire Hathaway's portfolio contains hundreds of privately held business that are invariably hard to track. By Buffet's own admission, some of these businesses have deteriorating economic fundamentals.

Investors who evaluate Berkshire sometimes obsess on the details of our many and diverse businesses - our economic "trees," so to speak. Analysis of that type can be mind-numbing, given that we own a vast array of specimens, ranging from twigs to redwoods. A few of our trees are diseased and unlikely to be around a decade from now. Many others, though, are destined to grow in size and beauty.

With the increase in the number of names in his portfolio, the average annual rate of returns have decreased over the last 10 years, relative to historical norms. The amount of sub-par businesses in his portfolio is causing a reversion to mean. Nevertheless, this apparent conflict is not as straight forward as one would think at first glance. Berkshire's portfolio of businesses is extraordinarily large, which makes it very challenging for even the greatest investor to allocate efficiently. Often the company finds itself with the "high class problem" of having too much cash on hand. In the fiscal year ending in 2008, the company had an equity investment portfolio of approximately US$173Bn. In spite of deploying a net US$24Bn in cash in 2018, the company still had net US$132Bn in liquid securities (US$112 US treasury + US$20 in fixed income). Looking at these number it becomes abundantly clear that when you have excess liquidity it is better to own a few low return businesses as opposed to cash.

Intrinsic value is Everything

This concept have been repeated at nauseam, but yet many investors fail to appreciate its importance. If you don't know the value of a business why are you buying? You wouldn't buy a car that is worth a thousand, for 50 thousand wouldn't you ? Warren Buffet is not even buying his own company's stock at prices above its intrinsic value, let alone a company where he has limited information on. Investors should never buy a stock above its intrinsic value, and should even be more cautious when they are outsiders of the company. According to Warren Buffet:

Earlier I mentioned that Berkshire will from time to time be repurchasing its own stock. Assuming that we buy at a discount to Berkshire's intrinsic value - which certainly will be our intention - repurchases will benefit both those shareholders leaving the company and those who stay.
For continuing shareholders, the advantage is obvious: If the market prices a departing partner's interest at, say, 90? on the dollar, continuing shareholders reap an increase in per-share intrinsic value with every repurchase by the company. Obviously, repurchases should be price-sensitive: Blindly buying an overpriced stock is value- destructive, a fact lost on many promotional or ever-optimistic CEOs.

Berkshire and Mr. Buffet went to great lengths to provide a clear picture of the operating earnings of Berkshire so that investors can ascertain for themselves the intrinsic value of Berkshire. This not only underscores the importance to him in forming his own opinion of potential investments, but also the importance of carrying out his fiduciary responsibilities as stewards of investor capital. Mr Buffet went on to state:

When a company says that it contemplates repurchases, it's vital that all shareholder-partners be given the information they need to make an intelligent estimate of value. Providing that information is what Charlie and I try to do in this report. We do not want a partner to sell shares back to the company because he or she has been misled or inadequately informed.

Understanding True Earnings

As outlined before, Warren Buffet went to great lengths to explain the primary drivers of the intrinsic value of Berkshire. In doing so, he described the metric he uses, and how it differs from those used by Wallstreet. Undoubtedly many individual Investors are enamoured by the sound of Wallstreet and Baystreet talk, and continues to get duped into following the trend of focusing on Earnings before interest, taxes, depreciation, and amortization (EBITDA) as a means to determine the true earnings of a company. In our view, there are times when EBITDA adequately portrays the real earnings of the company and there are times when it doesn't. Of course whenever a company appends the adjective "Adjusted" to it, it then becomes a very dangerous concept to apply. The operating earnings of a company reflects to a large degree the cashflow that the company's assets earn when deployed in its primary activity. To get to the this true estimate, Buffet plays particular attention to the following:

When we say "earned," moreover, we are describing what remains after all income taxes, interest payments, managerial compensation (whether cash or stock-based), restructuring expenses, depreciation, amortization and home-office overhead.
That brand of earnings is a far cry from that frequently touted by Wall Street bankers and corporate CEOs. Too often, their presentations feature "adjusted EBITDA," a measure that redefines "earnings" to exclude a variety of all-too-real costs. ...
For example, managements sometimes assert that their company's stock-based compensation shouldn't be counted as an expense. (What else could it be - a gift from shareholders?) And restructuring expenses? Well, maybe last year's exact rearrangement won't recur. But restructurings of one sort or another are common in business - Berkshire has gone down that road dozens of times, and our shareholders have always borne the costs of doing so. ...
Charlie and I do contend that our acquisition-related amortization expenses of $1.4 billion (detailed on page K-84) are not a true economic cost. We add back such amortization "costs" to GAAP earnings when we are evaluating both private businesses and marketable stocks. In contrast, Berkshire's $8.4 billion depreciation charge understates our true economic cost. In fact, we need to spend more than this sum annually to simply remain competitive in our many operations. Beyond those "maintenance" capital expenditures, we spend large sums in pursuit of growth.

Berkshire's Earnings

Berkshire's intrinsic value can be ascertained by looking at the various collection of businesses that the company owns. Buffet segment these businesses in the following categories: 1) non-insurance businesses, 2) marketable equities, 3) minority Investments in companies where there is significant influence, and 4) cash and marketable securities. The operating earnings of the non-insurance business was approximately US$20Bn in 2018, companies where they are minority owners with influence provided US$1.3Bn, and the insurance segment provided US$2Bn.

Operating Income of Berkshire's Businesses

Berkshire's liquid portfolio of investments are as follows:

In closing, as investors look to navigate what started out as a volatile 2019, it doesn't hurt to take instruction from the greatest investor of our time. One of the key strategies to success in investing is understanding what you are paying for. In pursuit of this goal, the issue of valuation, and the understanding of true corporate earnings is important. Warren Buffet has explained how to evaluate Berkshire Hathaway and its various subsidiaries. Inherent in this explanation is the techniques you can use to evaluate your own stocks. These techniques could prove useful in a market that is very rich and volatile.

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