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Three Big Ideas In Warren Buffett’s 2018 Letter To Berkshire Investors

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Investors expecting big changes in tone, or radical shifts in strategy from Warren Buffett and Charlie Munger in Berkshire Hathaway’s 2018 shareholder letter were once again disappointed. Berkshire didn’t unveil a dividend, both believe the whole of the conglomerate is worth more than the sum of its component parts, and they didn’t brag that hunting for acquisitions in today’s market was easy.

But there were a few important developments of note. For years, investors have studied succession plans at Berkshire for Buffett, 88, and Munger, 95, and this year’s letter gave further evidence of what they will be.

In 2018, Berkshire named Ajit Jain head of its sprawling insurance activities, led by GEICO, National Indemnity and its reinsurance operations, and Greg Abel as head of of its non-insurance operations. Those businesses span utilities, railroads, energy, chemicals, aviation, paints and housing and athletic wear, among others.

A year in, Buffett and Munger seem pleased with the performance of both, who are also now vice chairmen. “Berkshire is now far better managed than when I alone was supervising operations. Ajit and Greg have rare talents, and Berkshire blood flows through their veins,” the letter said. “These moves were overdue.”

In 2018, Berkshire’s insurance businesses returned to profitability and ended the year with a record $122 billion in float. Its railroad, utilities and energy business saw operating profits rise 30% to $7.8 billion and the bevy of other businesses that Abel was tasked with overseeing generated a further $9.3 billion in operating earnings, up 29%.

“Buffett threw a bone to those wanting more on succession by formalizing and endorsing the Ajit Jain and Greg Abel organization structure,” said Drew Wilson, a portfolio manager at Fenimore Asset Management, which has owned Berkshire shares with little turnover since around the time of the 1987 market rout.

However, this year Buffett and Munger didn’t mention their investing lieutenants Ted Weschler and Todd Combs by name in the shareholder letter. “I’m guessing we’ll get a lot of questions wanting more detail at the annual meeting,” added Wilson, who co-manages the $1.1 billion in assets FAM Value Fund.

Another wrinkle was Buffett’s decision to downplay Berkshire’s book value, an accounting metric that has headlined the company’s annual results for decades. “Long-time readers of our annual reports will have spotted the different way in which I opened this letter. For nearly three decades, the initial paragraph featured the percentage change in Berkshire’s per-share book value. It’s now time to abandon that practice,” said Buffett.

According to him, book value has lost relevance because Berkshire’s gargantuan $173 billion investment portfolio is a fraction of the firm’s overall assets, which are now weighted to operating businesses, led by insurance. New accounting rules, he argued, undervalue these operating businesses. Most important, Berkshire expects to repurchase a ton of stock, likely at prices well above book value.

“The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality,” Buffett said.

An unsurprising point, Buffett reiterated his belief that the easy buys of the post-recession market are gone. Thus Berkshire didn’t make major acquisitions in 2018, but bought $43 billion in public securities, primarily Apple. There were three finer points of Berkshires earnings and shareholder letter worth dwelling on.

Seeing The Forest From The Trees

No one wants to lose $25 billion in the span of 90-days, especially Buffett. But that’s exactly what Berkshire reported as it marked its books for a quarter in which U.S. stock markets slumped in October, and then plunged through December. Berkshire’s investment portfolio was marked down by $27 billion and it recorded a $3 billion impairment related to its share of Kraft Heinz’s recent $15.4 billion write down, where it’s a large holder.

That mark-to-market loss more than wiped out $5 billion plus in operating profits, driving a $25 billion quarterly loss. For 2018, Berkshire lost $17 billion on marks to its investment portfolio, though virtually all of those were on paper, thus overall net income was just $4 billion for the year, a 90% drop.

The loss, however, may go a long way in proving an important point in the shareholder letter. Buffett insisted investors look at the totality of Berkshire’s assets and the advantaged way in the way they’re housed. Said Buffett: “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… Fortunately, it’s not necessary to evaluate each tree individually to make a rough estimate of Berkshire’s intrinsic business value. That’s because our forest contains five “groves” of major importance, each of which can be appraised, with reasonable accuracy, in its entirety.”

The mark-to-market loss may prove the point. There are few, if any, entities on the planet that could bear such marks. In fact, Berkshire still saw its overall cash and book value grow for the year. Those stuck looking at trees might obsess over the daily or quarterly marks of Berkshire’s growing investment portfolio, or have doubts when specific stocks like Apple falter, but the bigger picture is that its portfolio is housed in a structure that can bear the market’s inherent volatility. It is one of the biggest advantages Buffett’s enjoyed in beating the market over many decades.

Stock Buybacks And Retained Earnings

There are many examples of companies who should be criticized for buying back their stock at overvalued prices thus wasting money, or simply spending cash they don’t have. The tens of billions of dollars that banks like Lehman, Bear , Goldman, Merrill, Morgan, Citigroup and BofA spent collectively to buy back their shares in 2007 and 2008 as the housing market began cratering is one of the unforgivable sins of the crisis. They didn’t have the money for buybacks, but used them to delay a reckoning. When each imploded, or had to dilute their stock in government rescues, the folly of Wall Street’s biggest financiers was astounding.

For companies that do have the money, however, buybacks can still be effective.

Buffett did a good job showing this, using Berkshire’s holdings in American Express. Berkshire hasn’t traded Amex in the past eight years, because the company bought tens of billions in stock Berkshire’s holding has gone from 12.6% of Amex’s shares outstanding to 17.9%. As a result, Berkshire’s portion of the $6.9 billion Amex earned was about $1.2 billion, in theory. “When earnings increase and shares outstanding decrease, owners – over time – usually do well,” said Buffett.

What was unique in this explanation is Buffett didn’t dwell on stock prices. Berkshire’s $1.2 billion theoretical claim on Amex’s 2018 profits is about equal to the $1.3 billion cost it paid for its shares.

The price at which buybacks occur does matter, but the most important element in this explanation is whether investors’ holdings are increasing in a sustainably profitable business. In the case of Amex, it is the company’s fundamentals over time that have likely proven more important to Berkshire’s gains than the exact price of buybacks. Failed buybacks come at bad prices, but mostly because the business is bad.

When Berkshire Invests It Isn’t Just Stocks And Elephant-Sized Deals

A theme that deserves more study at Berkshire is how it invests cash into its operating businesses. These divisions are becoming more sizable, so it should be no surprise the size of investments are growing. Last year, Berkshire recorded nearly $10 billion in depreciation and amortization on the assets of its operating businesses and invested a record $14.5 billion in plant, equipment and other fixed assets.

As Buffett notes, “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. Overall, Berkshire invested a record $14.5 billion last year in plant, equipment and other fixed assets, with 89% of that spent in America.”

This spending may well be among the conglomerate’s most important and highest return in coming years. As profitable as Berkshire’s operating businesses were last year, Buffett, Munger, Jain and Abel decided in favor of growth investment, over billions in added profits they could have recorded to impress shareholders.

What will be the outcome of growth capex at BNSF versus spending cuts by many of its rail peers, or at Berkshire Hathaway Energy for that matter? Don’t sleep on Jain and Abel as investors, Berkshire’s owned businesses generated $37.4 billion in operating cash flow last year.

-Antoine Gara; Forbes Staff

Billionaires

Tesla Vehicles Could Soon Become Completely Autonomous As Self-Driving Tech ‘Very Close’, Elon Musk Says

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Tesla vehicles could soon be completely autonomous as CEO Elon Musk said the electric vehicle firm is “very close” to achieving level 5 autonomous driving technology, during a virtual appearance at the World Artificial Intelligence Conference in Shanghai.

KEY FACTS

  • “I’m extremely confident that level 5 or essentially complete autonomy will happen and I think will happen very quickly,” Musk said.
  • He added that he is confident “basic functionality” for level 5 complete autonomy will be achieved this year.
  • The technology will allow vehicles to drive on roads without driver input.
  • Tesla, the world’s highest-valued carmaker after overtaking Toyota last week, already operates an Autopilot system that uses external cameras, radars and sensors, but it is driver assisted and does not make the vehicle autonomous.

KEY BACKGROUND

Tech firms, including Uber and Alphabet-owned Waymo, have pumped billions into developing self-driving cars, a futuristic idea that many had predicted would be ready by this year. But limitations around AI have stalled development of the technology. Last month, Waymo and Volvo announced they were teaming up to develop driverless cars for ride-hailing use.

TANGENT

In February, the National Transportation Safety Board found Tesla’s autopilot driver assistance was likely to blame for a fatal 2018 crash in California, leading to the board calling for more regulation of the technology, and for the company to better educate drivers on its limitations.

ADDITIONAL INFO

The road to completely autonomous driving has five levels: Level 0 describes no automation i.e. everyday cars. Level 1 represents features such as adaptive cruise control, while level 2 describes partial automation features that control speed and steering, such as those seen in Tesla vehicles. Level 3 and 4 represent limited driverless capabilities. Level 5 is the point at which a driverless vehicle can navigate all road conditions without human input, according to True Car.

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Elon Musk, Kim Kardashian Endorse Kanye West Running For President

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After years of hints, Kanye West formally announced he is running for president this year in a challenge to Trump, who he once supported, and Democratic rival Joe Biden, winning support from his friend and Tesla CEO Elon Musk.

KEY FACTS

  • Rounding off his Fourth of July, West tweeted on Saturday night: “We must now realize the promise of America by trusting God, unifying our vision and building our future. I am running for president of the United States! #2020VISION.”
  • Musk tweeted in response: “You have my full support!”
  • Wife Kim Kardashian also publicly pledged her support, retweeting West’s statement and adding a U.S. flag emoji.
  • West’s announcement follows years of hints that he would run for office this year which he later postponed to 2024, after publicly declaring at a Fast Company event in 2019: “When I run for president in 2024…We would create so many jobs! I’m not going to run, I’m going to walk.”
  • But the rapper, who recently inked a 10-year deal with Gap through his Yeezy brand, is reportedly yet to file any paperwork to get on state election ballots, while he has missed the deadline for states including Texas, New York, and Indiana.
  • It is not known how serious West’s intentions are this time around, however, he still has time to file as an independent candidate across most states, according to Ballotpedia.
  • West’s declaration was met with skepticism on social media, while some commentators pointed out that it could work out in Trump’s favour.

KEY BACKGROUND

West’s declaration suggests the rapper is looking to cement political ambitions he has expressed throughout Trump’s presidency. West previously forged alliances with Trump, and was pictured in the Oval Office in 2018 wearing a signature Trump ‘Make America Great Again’ cap. He once called the president his “brother” and previously hit back at criticism towards his support for Trump, likening the backlash to racial discrimination. Although he says he didn’t vote in 2016, West later said he “would have voted for Trump”, and earlier this year doubled down, suggesting he would vote for him in November. But that could very well change given Saturday’s announcement.

American rapper and producer Kanye West embraces real estate developer and US President Donald Trump in the White House’s Oval Office, Washington DC, October 11, 2018. West wears a red baseball cap that reads ‘Make America Great Again,’ Trump’s campaign slogan. (Photo by Ron Sachs/Consolidated News Pictures/Getty Images)

TANGENT

West and Musk were pictured together on July 1st, with West tweeting: “When you go to your boys [sic] house and you’re both wearing orange.”

Isabel Togoh, Forbes Staff, Business

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Billionaires

Quote Of The Day

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We have grown past the stage of fairy-tale. As women, we have one common front and that is to succeed. We have to take the bull by the horn and make the change happen by ourselves.

– Folorunso Alakija, Billionaire Businesswoman

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