Once a year almost every investor takes some time from their weekend to read the Berkshire Hathaway (BRK.B) annual letter to shareholders in hopes to glean some nuggets of wisdom from one of the best- and best-known investors around the world. Here are some thoughts after reading Warren Buffett’s 2018 Berkshire Hathaway letter to shareholders.

Bye-Bye Book Value

The letter noted that the company will no longer be using book value as the primary determinant of share value. In other words, when buying back shares, the company will not be using the book value of shares to determine whether the shares are over or underpriced. The reasoning behind this is due to the impacts of accounting where they do not feel book value reflects true value any longer due to issues such as assets not being able to be written up even though the value can be far greater than when an asset was initially purchased. 

Buffett has been telegraphing this change for some time now and this is really just closing the book on this chapter. Management will now be using intrinsic value, or the discounted value of cash flows from the company, to determine the value of the company.

While not a surprising turn of events, it is interesting because in our view, it is a step away from what is the traditionally simplistic (in a good way) view of valuing a company that Warren Buffett and so many of his admirers have taken, which was if the shares were below the value of the assets themselves, they should buy more shares. Going the ‘intrinsic value’ route requires a bit more in the way of assumptions such as what future cash flows are and what an appropriate discount or hurdle rate will be. Again, this change is really the approach most investors take, but is something many fans of the traditional Berkshire approach may be a bit more uncomfortable with.

Buffett Really Dislikes Generally Accepted Accounting Principles (GAAP)

Now that the investment portfolio is so large, the way that the holdings are accounted for is that the investments are marked to market. This means that the bottom line can see giant swings any given quarter due to the valuation of these securities, even if it has no bearing on the true value of the investments over the long-term. Further, these are only paper losses and gains. In other words, it is not a real hit or addition to actual cash flows. These swings tend to make earnings less reliable though. Because of this, Buffett urges investors to focus on operating earnings and not the bottom line.

One thing that strikes me here is that Buffett has for some time beaten up on metrics such as EBITDA and even does so in this letter. While an investor can have qualms with metrics that try to normalize profitability, this is a very similar change to what is being recommended by focusing on operating earnings. You are essentially being asked to ignore the ‘other stuff’, such as marking the investment portfolio to market. While I do not disagree with this idea, it is noteworthy that saying an investor should focus on operating earnings instead of net income is not far removed from focusing on adjusted earnings, EBITDA, or some other metric. Indeed, some of these metrics can be adjusted more egregiously, but this is not always the case.

Someone likes the word capricious 

For whatever reason, this word kept on jumping out at me throughout the letter. It seemed to get used a lot, especially for a word that you rarely hear! Regardless, we should all make a goal of trying to work the word ‘capricious’ into our daily vocabulary in 2019. Just for a chuckle.

Buffett truly is focused on the shareholder 

When reading this and most of these letters, the consistent focus on the shareholder and value creation for the end shareholder is very apparent. This devotion has never seemed to sway nor has it given way to other initiatives. We think this trait is one of those common traits you see in great CEOs. An unrelenting devotion to the shareholder. You see it in Berkshire and you see it in companies like Constellation Software (CSU). 

Don’t expect a big purchase in 2019

The heading speaks for itself but Buffett does not see a big deal happening in 2019. He notes that there is a lot of competition out there and it is hard to do a deal at a good price. One has to wonder also if the cash balance that BRK holds is a bit of a bad thing in these discussions. Certainly, most sellers would look at the balance sheet of BRK and think they can squeeze ‘just a bit more’ from the company to get a good deal done. Companies are likely reluctant to sell the business at a deal knowing that BRK has the finances to add in a bit of a sweetener. Going back to comments on devotion to the shareholder, this factor becomes all the more important because it can be easy to overpay for an investment to get a deal done when a company is flush with cash.

Don’t like debt 

Buffett has some good comments on debt in this letter. He notes how most times, taking on leverage may work but from time to time it is what will lead to the end of a business. He uses the metaphor of comparing debt to Russian roulette.

Coke is one of the largest equity holdings

Looking through the top investment holdings in the Berkshire portfolio, you see Coca-Cola as a top holding. This is interesting, particularly in the context of the recent events at Kraft Heinz. Both of these companies are the classic ‘moat’ stocks with high brand value and recognition. However, health food trends as well as private label pricing power have cut into market share for Kraft. We think it will be interesting to watch the Coke holding to see if it changes and Buffett becomes more concerned with shifts in consumer tastes and appetites. We think there are a lot of parallels an investor can make between KO and KHC. 

Looking at more cross border investments 

In the letter, Buffett noted that they are looking overseas for investments more and more. We think this is interesting. This ties in with comments on not being able to find deals in the US and also may hint at where the portfolio may start to shift over time. In fairness, the letter does close talking about the ‘American Tailwind’ and how the US economy has provided so much opportunity, so we do not think there will be a drastic change any time soon but new investments you hear about in the Berkshire portfolio such as Stoneco (STNE) might indicate a shift to other geographies.

Still no space for the heir apparent(s)

I am leaving this comment last as in my view it is the most important and the most critical. The elephant in the room for Berkshire is that of succession of Buffett and Munger and how much of the shares are valued against these key persons. Buffett has telegraphed at this point that Greg Abel and Ajit Jain will be the successors who run Berkshire. However, it does not appear that they are trying to do anything to help investors get comfortable with this transition.

We think it is clear that the investment style will be slightly different for these successors. This is apparent when looking at more and more tech investments that seem to work their way into the BRK portfolio. Not to mention, the investment style that BRK was built on is much harder to execute today than it was 20 years ago as markets get more and more efficient, not to mention that BRK is far larger than it was. This means that a bit of a shift in investing style will not only be likely but necessary. But are BRK shareholders ready for this? A simple few paragraphs on an investment the successors have made and their thought process could go a long way here. 

I continue to be surprised that the two successors are not each given at least a page in the annual letter to discuss how they see, think and invest. This could go a long way to providing comfort and familiarity with the new management team. Going back to devotion to the shareholders, taking deliberate steps to transition the management team is also best for shareholders as it will not be a shock if or when Buffett and Munger finally step back. It is the transparency and communication of the Berkshire investing style and views that has given the company such trust and leeway with investors and markets. If they do not build this same trust with the new team, there is less certainty that they will be forgiven if a quarter is missed or if a deal takes five years to get done. I think the longer these two successors are kept in the shadows, the more risk it adds to BRK. Perhaps Jain and Abel do not want the limelight and of course they are big shoes to fill, but this is also sort of what they signed up for and what should be done to help mitigate the key-person risk at BRK. Just for fun, Abel was mentioned five times in the letter and Jain was mentioned three times. Munger was mentioned 18 times.

As always, the annual letter is a great read and fun to dissect. Every year Buffett seems to drop gems for readers and his writing style and ability to simplify complex concepts should be taught in schools. The company does have a unique problem in that they are too big. We have had members ask us about the company and it does look to be more and more a proxy to the S&P 500. We think at this stage, where BRK will really add its value is in the next market crisis and the one after that. They have a ton of cash and the company will be able to be ‘greedy when others are fearful’. We think this is the reason an investor should own Berkshire Hathaway (BRK.A) if they are considering it. A company that will likely track the S&P 500 up and down but will be able to make good investments in really bad times to generate long-term shareholder returns and own good companies at a good price, if or when those good prices finally come.

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