Part III: Buffett’s Letter to Berkshire Shareholders
publication date: Feb 28, 2019
author/source: Brian Nelson, CFA
Part III of our analysis of Buffett’s Letter to Berkshire Shareholders emphasizes the importance of companies buying back stock at prices below estimated intrinsic value. We talk about how the Oracle thinks about his excess cash, and why he always seems to be there ready to bail out trouble when the financial markets head south. His thoughts on the market are included, too.
By Brian Nelson, CFA
In the first part of our analysis of Buffett’s Letter to Berkshire Shareholders, released February 23, we emphasized how book value doesn’t make much sense in the equity valuation process for the valuation of non-financial operating companies, the importance of evaluating the price-to-fair value estimate ratio, and how to think about share buybacks in the context of creating long-term value for continuing shareholders. The general rule of thumb for buybacks is that management should seek to execute them at prices below a reasonable fair value estimate. Read Part I >>
In the second part of our analysis of Buffett’s Letter to Berkshire Shareholders, we talked about the stiff competition in the private-equity ranks, but we also think there’s enough room for an elephant-sized purchase. Some are talking about Southwest (LUV) being a potential target of the Oracle’s. Though we think shares of Southwest are fairly valued at the moment, the market is still providing select opportunities, and we keep working to identify them for members.
In Part II, we also talked about Buffett’s disgust for EBITDA, how that relates to our views on the midstream MLP’s definition of distributable cash flow, and we parted with one of his favorite quotes: “'If you call a dog’s tail a leg, how many legs does it have?’ and then answered his own query: ‘Four, because calling a tail a leg doesn’t make it one.’ Abe would have felt lonely on Wall Street.” To us, this quote is very applicable to what has become commonly known as the quant value factor. If quants aren’t measuring price-to-fair value, they aren’t measuring value, but only a component of it. Read Part II >>
This is now Part III. Buffett again emphasized the importance of thinking about company buybacks in the context of an intrinsic value estimate, something that we calculate every day at Valuentum. Here’s again what the Oracle of Omaha had to say about buybacks: “All of our major holdings enjoy excellent economics, and most use a portion of their retained earnings to repurchase their shares. We very much like that: If Charlie and I think an investee’s stock is underpriced, we rejoice when management employs some of its earnings to increase Berkshire’s ownership percentage.”
The wisdom of Buffett shines through in every shareholder letter. Although Berkshire is still looking for that proverbial elephant-sized purchase, the company retained roughly $112 billion at year-end 2018 in Treasury bills and other cash equivalents (not including another $20 billion in other fixed income instruments). Mr. Buffett is incredibly smart. He has “marked” $20 billion in cash and cash equivalents as “untouchable,” meaning that this cash will be used as a safeguard “against external calamities.”
As I highlight in my book Value Trap: Theory of Universal Valuation, there is a reason Warren Buffett was there to bail out Long-Term Capital Management, a quantitative hedge fund in the late 1990s that went belly-up. There’s a reason why Warren Buffett was there to bail out the banks during the Financial Crisis. That’s because value investing is among the most socially-responsible investing of all, and oftentimes, the nature of a value investor is to position oneself away from debt and in the security of excess net cash. The Oracle is preparing for the next crisis, whenever it may be. In his words:
Berkshire will forever remain a financial fortress. In managing, I will make expensive mistakes of commission and will also miss many opportunities, some of which should have been obvious to me. At times, our stock will tumble as investors flee from equities. But I will never risk getting caught short of cash.
Wow is he super smart. As we wrap up Part III of our evaluation of Warren Buffett’s Letter to Berkshire Shareholders, it’s important to emphasize that he thinks the “immediate prospects” for putting his excess liquidity to work aren’t that great. He even goes on to say that “prices are sky-high for businesses possessing decent long-term prospects.”
Now, don’t jump to conclusions. There are a lot of excellent companies out there at great prices. It’s just that these companies won’t be taken under the Berkshire umbrella, unless at a substantial premium (something the Oracle may not want to do). This is making things a bit more difficult for Warren Buffett to get deals done at the prices he wants. Investors should still expect Berkshire to expand its holdings in marketable securities, even as the Buffett and Munger duo “hope for an elephant-sized acquisition.”
That’s it for Part III. Don’t forget to read Value Trap: Theory of Universal Valuation, and I’d be so grateful if you would review it on Amazon, too! We’re making quite the buzz with the new book, and it is all because of you. Thank you! As always, please be sure to let me know if you have any questions. Always my very best and stay tuned!
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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.