Part I: Berkshire’s 2018 Shareholder Letter Does Not Disappoint
publication date: Feb 23, 2019
author/source: Brian Nelson, CFA
Warren Buffett was on point in his most recent letter to Berkshire Hathaway shareholders. The company remains one of our favorite ideas in the Best Ideas Newsletter portfolio.
By Brian Nelson, CFA
Warren Buffett wasted little time getting to the point in his 2018 letter to Berkshire Hathaway (BRK.A, BRK.B) shareholders, released February 23:
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.
Brian here. Those that have read my book Value Trap: Theory of Universal Valuation might have predicted as much. Warren Buffett is one of the smartest investors around. There may be no other match out there, not anyone even close. Mr. Buffett speaks with the utmost candor as well, and to me, it was just a matter of time before Berkshire did away with presenting the significance of such a metric. The conglomerate has expanded to an operating entity given the number of non-financial, non-insurance related enterprises it now holds, and valuing it in the context of enterprise valuation as opposed to any measure of book value has started to make more and more sense. If you ask me, it always has made sense.
Here’s what Warren Buffett had to say about the change:
The fact is that the annual change in Berkshire’s book value…is a metric that has lost the relevance it once had. Three circumstances have made that so. First, Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses…Second, while our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years. Third, it is likely that – over time – Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic 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.
The third point is especially important. I dedicate a subchapter in Value Trap: Theory of Universal Valuation on the concept of buybacks and intrinsic value. The rule of thumb outlined in the book is very straightforward: Executive teams that are interested in generating value for continuing shareholders via buybacks should look to buy back stock only at prices below estimated intrinsic value. Because, in this case, the reduction in the number of shares outstanding has a greater positive impact than the reduction in cash on the balance sheet has a negative impact, the fair value of the company increases, all else equal. This is completely consistent with Warren Buffett’s views.
No matter what, the major takeaway is clear: Book equity is almost completely irrelevant when it comes to intrinsic value estimation or buyback analysis. As the field of fundamental analysis moves away from book equity as a valuation consideration for non-financial operating entities, it has become equally important that traditional quant finance move beyond book equity, too. Unfortunately, there are decades of source material in academia that may make this impossible. A disruption is inevitable, in my opinion, however. As for Berkshire’s capital deployment strategy, it remains unchanged after all these years: “to buy ably-managed businesses, in whole or part, that possess favorable and durable economic characteristics. We also need to make these purchases at sensible prices.”
The key emphasis is on “purchases at sensible prices.” Price simply matters. On that note, please be sure to keep paying attention to the price-to-fair value (P/V) metric we publish on our website for companies we follow. Stay tuned for Part II of my thoughts on Berkshire’s 2018 Shareholder Letter in the coming days. Thank you for reading.
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.