Like every year, the eagerly awaited letter to Berkshire Hathaway shareholders’ arrived and Warren Buffett, in addition to presenting the company results for the year 2018, gave us his truly useful insights both on the economy and his value investing approach.
In this article, we are going look at:
- Why mark to market is not that accurate in assessing the value of a business
- How Buffett suggest to behave with price fluctuations due to market volatility
- The importance of keeping the focus on the business and its earnings
- Why having cash is vital for investing opportunities
- The power of compounding and Berkshire Hathaway strategy
There are so many important lessons to learn from the wisdom of of the greatest investors of all time, as always, Warren Buffett is an endless source of inspiration.
Mark To Market, Volatility and Investment Value
Berkshire Hathaway results for 2018 show a revenue of $247.8 billion with a record high operating earnings of $24.8 billion. Despite that, Berkshire earned “just” $4.0 billion in GAAP profits. One of the major causes is the unexpected write-down at Kraft Heinz and unrealized investment losses in the investing holdings, that accounted for a $20.6 billion loss.
This was described by the Wall Street Journal as one of the worst years for Warren Buffett, but that is only part of the story.
This big loss was mainly due to a change in GAAP rules that require to include unrealized losses in the earning. The inevitable consequence of this kind reporting are substantial fluctuations in valuations while the underlying businesses don’t change that much:
As I emphasized in the 2017 annual report, neither Berkshire’s Vice Chairman, Charlie Munger, nor I believe that rule to be sensible. Rather, both of us have consistently thought that at Berkshire this mark-to-market change would produce what I described as “wild and capricious swings in our bottom line.”
The accuracy of that prediction can be suggested by our quarterly results during 2018. In the first and fourth quarters, we reported GAAP losses of $1.1 billion and $25.4 billion respectively. In the second and third quarters, we reported profits of $12 billion and $18.5 billion. In complete contrast to these gyrations, the many businesses that Berkshire owns delivered consistent and satisfactory operating earnings in all quarters.
For the year, those earnings exceeded their 2016 high of $17.6 billion by 41%.
Yes, this rule does not offer any accurate indication or prediction about the company situation. In the case of the huge equity portfolio of Berkshire Hathaway (valued at nearly $173 billion at the end of 2018), this brings to price fluctuations of $2 billion or more that must be reported in earnings.
They also highlight how, during a period of high volatility in stock prices like the end of 2018, they experienced several days with a “profit” or “loss” of more than $4 billion.
Note that Buffett describes those as “profits” and “losses”, using quotes, because they are not any real profit or loss, everything is just on paper.
Their advice on that?
Focus on operating earnings, paying little attention to gains or losses of any variety. My saying that in no way diminishes the importance of our investments to Berkshire. Over time, Charlie and I expect them to deliver substantial gains, albeit with highly irregular timing.
Clear and simple. Ignore the massime MTM fluctuations and focus on businesses and their earning, because over time investment performance converges with business performance.
A portfolio of businesses, not stocks
When talking about their equity portfolio, Buffett emphasizes the importance of their common stock investments saying that:
Charlie and I do not view the $172.8 billion detailed above as a collection of ticker symbols – a financial dalliance to be terminated because of downgrades by “the Street,” expected Federal Reserve actions, possible political developments, forecasts by economists or whatever else might be the subject du jour.
What we see in our holdings, rather, is an assembly of companies that we partly own and that, on a weighted basis, are earning about 20% on the net tangible equity capital required to run their businesses. These companies, also, earn their profits without employing excessive levels of debt.”
The focus here is clearly on the business, the message is that in selecting their investments they don’t care about forecasts, interest rates, political developments, etc… The focus is only on businesses that have durable economic characteristics, making the purchases at sensible prices.
The fact that these companies don’t have excessive level of debt is another indication of their stability because leverage could be a big threat to businesses when economic conditions turn around.
The returns coming from this strategy of investing in large, established and understandable businesses are
remarkable under any circumstances and truly mind-blowing when compared against the return that many investors have accepted on bonds over the last decade – 3% or less on 30-year U.S. Treasury bonds, for example.
Cash accumulation and Investing Opportunities
Right now Berkshire Hathaway is sitting on a massive pile of cash waiting for investing opportunities that amounts to $112 billion, mostly in the form of T-bills and other fixed income assets.
This is something noteworthy that and goes perfectly with Warren Buffett investing style and above all shows:
- Difficulty to find good investment opportunities – they invest only in strong businesses with good and durable economics perspectives and they do that at a reasonable price. In fact, although they say that in the years ahead they hope to move excess liquidity into businesses that Berkshire will permanently own, the immediate prospects for that, however, are not good: “prices are sky-high for businesses possessing decent long-term prospects“.
- The intention to never risk getting caught short of cash – as an integral part of Buffett investing style, is mandatory to have a huge cash position in order to be ready when investing opportunities arrive
Those two are very significative of the investment style and if you make the sum of the two, you easily see how Berkshire Hathaway has been a compounding machine over time:
This approach to investments is one of the basis of Warren Buffett success and this is something that you, as an investor, should consider.
Let me try to summarize some of the main concepts that you get from this investing strategy:
- You can stay out of the market and sometimes is very convenient to do so
- Investments should be made only when there are valuable investing opportunities, otherwise you have to be patient and wait while you accumulate cash for the future when opportunities arises
- Buy only when prices are sensible for long-term returns. It is not enough to spot a good business, the price for that business must be reasonable in order to allow for long-term returns, that is why “On occasion, a ridiculously-high purchase price for a given stock will cause a splendid business to become a poor investment – if not permanently, at least for a painfully long period.” It is not enough to by a good business, the price must also provide a margin of safety for a good investment return.
- Having cash available for investments is a key in order to be ready when investing opportunities arise
It is not a coincidence is Buffett has a huge cash position before economic recessions, and given the current position there are actually many indicators in the economy that say the same thing.
Accumulating cash, retaining all earnings for a very long time worked extremely well and allowed to purchase and development of valuable businesses that generate remarkable earnings.
Warren Buffett has its own investing style, it is not the only way to invest but it certainly proved to deliver amazing returns over the long-term. This year shareholders’ letter gave us many suggestions about investments value and Berkshire Hathaway investing approach that made it one of the most successful companies.
We saw how mark to market results in huge fluctuations of the paper value of investments while the underlying businesses don’t change that much, instead, they continue to deliver stable earnings over all quarters.
It is not a chance that over the years Buffett did well whatever happened, his suggestion is to focus on large, established and understandable businesses that deliver substantial levels of earnings because over time the investment performance converges with business performance.
Besides a ton of research, in order to have good returns the purchases must be made at a reasonable price, and his point of view on current market prices it that they are sky-high for business possessing decent long-term returns.
Meanwhile, if the market doesn’t offer good investing opportunities, the key is to accumulate cash, a lot of cash, in order invest when the opportunity arises (right now Berkshire Hathaway has $112 billion in cash that is sitting there waiting to be invested). This, coupled with the retention of all earnings, over time allows compounding to work at its best, which is one of the key that made Warren Buffett the legendary investor that we know today.
You can read the full letter here.
This article is for informational purposes only, it should not be considered financial advice.
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