Tuesday, March 25, 2014

Thoughts on Warren Buffett's 2013 Shareholder Letter

Below are my thoughts on portions of the 2013 Berkshire Hathaway Annual Shareholder Letter.

To read the entire letter CLICK HERE.

As I’ve long told you, Berkshire’s intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That’s why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount.

The writing on the wall doesn't get any clearer than this. Buffett thinks that Berkshire (BRK) is worth much, much more than book value and he will be aggressive at buying back stock at the 120% level from any shareholder willing to sell.  This is interesting because BRK is selling at 131% of book value. It was selling for around 120% of book value earlier this year.  Do what you want with that but the implications are clear.

Over the stock market cycle between yearends 2007 and 2013, we overperformed the S&P. Through full cycles in future years, we expect to do that again. If we fail to do so, we will not have earned our pay. After all, you could always own an index fund and be assured of S&P results.

This is an interesting comment because Buffett has laid out some guidelines in the back of the annual report on a 5 year yardstick that compares BRK's performance to that of the S&P 500.  It is true that BRK did not meet this test and that Buffett seems to have changed his yardstick to 6 years now.   

Over the past 5 years the per share book value of BRK has risen 91% while the S&P 500 index has gained 127%.  What I find interesting is that the per share book value of the S&P 500 has risen roughly only 50% over that same period.

Take from that what you want but to me the implications are clear.  Either BRK is cheap, the S&P 500 is overvalued, or some combination of the two.  My vote is BRK is cheap.

We completed two large acquisitions, spending almost $18 billion to purchase all of NV Energy and a major interest in H. J. Heinz. Both companies fit us well and will be prospering a century from now.

Going by our yearend holdings, our portion of the “Big Four’s” 2013 earnings amounted to $4.4 billion. In the earnings we report to you, however, we include only the dividends we receive – about $1.4 billion last year. But make no mistake: The $3 billion of their earnings we don’t report is every bit as valuable to us as the portion Berkshire records.

This is what I love about owning Berkshire.  They continually make good long term investments, which ensure good long term results.  BRK is a conglomerate that will be prospering a century from now... long after Buffett is dead and gone.  The market is currently willing to value the latest hot tech stock at absurd levels while BRK underperforms the broader market.  Let's be clear, BRK is built to last. 

Berkshire’s extensive insurance operation again operated at an underwriting profit in 2013 – that makes 11 years in a row – and increased its float. During that 11-year stretch, our float – money that doesn’t belong to us but that we can invest for Berkshire’s benefit – has grown from $41 billion to $77 billion. Concurrently, our underwriting profit has aggregated $22 billion pre-tax, including $3 billion realized in 2013. And all of this all began with our 1967 purchase of National Indemnity for $8.6 million.

So how does our float affect intrinsic value? When Berkshire’s book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think of float as strictly a liability is incorrect; it should instead be viewed as a revolving fund... 

If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability. 

To put this is simple language, BRK has a $77 billion revolving fund (or loan).  I like to think of it as a loan but a loan that has a number of unique features.  First you never have to pay it back, so long as BRK's insurance companies are still operating.  Second, the loan has a negative interest rate.  In 2013 BRK was paid 3.9% to hold this loan.  Talk about having your cake and eating it too!

Now the lingering question in my mind is what is a loan like this worth, specifically one that has an indefinite term and a zero interest rate (assuming a long term combined ratio of 100%)? 

To give a simple answer this from a financial perspective you must turn to the perpetuity formula, where PV= C/d.  "PV" is the present value, "C" is the annual investment return, and "d" is the discount rate.  Assuming BRK can earn 10% on it's float and it doesn't grow from here, the annual investment return would be $7.7 billion. 

From here it is easy to see that choosing a discount rate of 10% gives a present value of $77 billion dollars for the float.  If we choose a 15% discount rate the present value is $51 billion.  Similarly if we choose a 5% discount rate the float is worth $154 billion. 

So what is the true value the float?  Make your own assumptions but Buffett makes it clear that the true value of this liability is dramatically less than the accounting liability.  I totally agree and in the past, given the investment returns it has generated for BRK, the liability was perhaps ZERO.

Our subsidiaries spent a record $11 billion on plant and equipment during 2013, roughly twice our depreciation charge.

In layman's terms, If BRK can earn 10% on that incremental invested capital beyond the depreciation charge, it will add approximately $550 million in annual earnings. 

In a year in which most equity managers found it impossible to outperform the S&P 500, both Todd Combs and Ted Weschler handily did so. Each now runs a portfolio exceeding $7 billion. They’ve earned it.

I must again confess that their investments outperformed mine. (Charlie says I should add “by a lot.”) If such humiliating comparisons continue, I’ll have no choice but to cease talking about them. 

Todd and Ted have also created significant value for you in several matters unrelated to their portfolio activities. Their contributions are just beginning: Both men have Berkshire blood in their veins. 

Looks like BRK has some top notch talent in line to take over the equity portfolio.  I find the comment in the last paragraph quite interesting.  To me it is foreshadowing a larger role in the company for either Todd or Ted.  Perhaps one will be the next CEO.

Going by our yearend holdings, our portion of the “Big Four’s” 2013 earnings amounted to $4.4 billion. In the earnings we report to you, however, we include only the dividends we receive – about $1.4 billion last year. But make no mistake: The $3 billion of their earnings we don’t report is every bit as valuable to us as the portion Berkshire records.

Buffett here is describing the "look through" earnings of the companies which BRK is a part owner of(common stock).  I wonder how many investors could actually tell you the "look through" earnings of their own portfolio?  That result might prove to be an interesting for many so called value investors. 


There is another fantastic portion of the BRK annual letter that I would highly recommend.  It is an essay entitled, "Some Thoughts About Investing".  In this essay Buffett compares buying a 400 acre farm north of Omaha and a commercial real estate investment to investing in common stocks.  The principles are exactly the same.

At the end of the annual report you will find the two page offer Buffett took over to purchase Nebraska Furniture Mart in 1983, the Financial Statement for Nebraska Furniture Mart for the yearend 1946, and a fantastic memo on the "Pitfalls of Pension Promises" by Buffett from 1975.  Click Here to read these sections.  They are located at the end of the annual report.   

Best Regards,

Kevin Graham

Disclosure - long BRK.b

Tuesday, March 4, 2014

2013 US Bank Asset Quality

Citigroup finally released their 10-K this past weekend allowing me to compare the asset quality of the four large banks in the US.  I always like to see what percentage of the assets are the so call "marked to fantasy" assets.  These assets, also called Level 3 Assets, are valued by management WITHOUT any market comparables.  Management basically values them at whatever they want so long as they can convince the auditors that the rationale is not unreasonable. 

This year Bank of America takes top honors, while JPM comes in last.  The rankings haven't changed much over the years other than BAC has overtaken WFC for top spot. 

I am amazed at how quickly Brian Moynihan has cleaned up the books at BAC.  Level 3 assets were around two and half times the current amount only two years ago.  Today, even if you discount the book value by the $32 billion of mark to fantasy assets, you can still buy the company at an $11 billion dollar discount.  I can't resist a bargain. 

I have commented on balance sheet of JPM in the past.  In particular, I noted before the London Whale incident that you could drive a truck through their balance sheet (Read Here: Bank of America & Europe).  Then after the losses from the incident were exposed, I couldn't resist and bought a whole bunch of JPM (Read Here: Why JPM Is Cheap). 

As I read the annual reports of the various banks I found the disclosure this year is better than ever.  The US financials have never been in better shape.  They are soundly capitalized and the quality of the assets have never been better.

The results of the stress tests can't come soon enough. 

Best Regards,

Disclosure: Long WFC, BAC Class A warrants and JPM warrants


Saturday, March 1, 2014

2013 Berkshire Hathaway's Shareholder Letter

Today is the day Warren Buffett releases his annual letter to shareholders.  Grab a coffee and enjoy the words of wisdom from this investment icon. 




Disclosure - Long BRK.b