Warren Buffett just released the latest edition of his annual letter to Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) shareholders. Investors all over the world follow Warren Buffett's letters closely, as they aren't just filled with details about Berkshire's operations, but often have some useful investing lessons and wisdom drawn from Buffett's experience.
This year's letter was shorter than usual at just 16 pages, but wasn't short on information. Buffett simply chose not to include a lengthy discussion of Berkshire's non-insurance businesses, a practice that he feels is becoming repetitive. Here are seven key takeaways from the letter that Berkshire shareholders and Buffett followers need to know.
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1. Berkshire's book value grew by 23%, but there's more to the story
During 2017, Berkshire's net worth jumped by $65.3 billion, a massive 23% gain. However, it's important for shareholders to know that this was a result of the combination of Berkshire's performance as well as the Tax Cuts and Jobs Act.
Specifically, we now know that $36 billion of the gain came from Berkshire's operations, with the other $29 billion a direct result of tax reform. In other words, tax reform caused Berkshire's book value to jump by 10% all by itself.
2. Future "earnings" numbers may be deceiving
Buffett wants to clarify to shareholders that a new accounting rule may render Berkshire's bottom-line earnings going forward. Specifically, unrealized investment gains (such as those in Berkshire's massive stock portfolio) will now be included in the company's net income figure. Buffett points out that the value of its stock portfolio can easily swing by $10 billion or more in either direction during a quarter, and that this is not representative of actual "earnings."
3. A growing cash "problem", and no good solutions (yet)
Berkshire's stockpile of cash has swelled to a staggering $116 billion at the end of 2017, a $7 billion gain in the fourth quarter alone.
By far, Berkshire's preferred use of its cash is acquisitions, and Buffett laid out the company's criteria for making stand-alone acquisitions, highlighting that a necessary component is a "sensible purchase price." Recently, this has been the hardest part to come by. Buffett said that there's a "purchasing frenzy" going on right now, and that cheap debt has driven the cost of acquisitions through the roof.
As Buffett puts it, "That last requirement (a sensible purchase price) proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers"
While many investors thought that the company may resort to a dividend or buybacks to deal with its growing stockpile of cash, Buffett still believes there will be opportunities to make large purchases in the future.
4. Why Buffett loves the insurance business
Buffett included a great discussion of why Berkshire got into the insurance business and why it's such a key component of the company's strategy, particularly reinsurance.
He highlighted the importance of "float," that is, insurance premiums that have been paid, but have not yet been paid out as claims. Meanwhile, the float can be invested while losses are gradually paid out over the life of an insurance policy. Reinsurance in particular is attractive in this respect because it insures against "long-tail" losses, which has allowed Berkshire to grow its float to an extraordinary level.
5. Berkshire's stock price has crashed before, and will probably do so again
One of the best lessons for investors to learn from this letter was Buffett's discussion of price randomness and short-term dips. Although Berkshire has done an amazing job of creating value over the long run (20.9% annualized growth over 54 years), there have been times when Berkshire's performance has been absolutely terrible.
Specifically, the stock lost 59.1% of its value over a 22-month period from 1973-1975, lost 37.1% over a 25-day period around Black Monday in 1987, lost 48.9% from June 1998 through March 2000, and dropped by 50.7% during the Great Recession from September 2008 through March 2009. And he cautions investors that declines like this will happen again.
The takeaway is that investing in stocks with debt can amplify these losses and lead to ruin, but debt-free investors can readily take advantage of these dips.
6. Ted and Todd now manage $25 billion of Berkshire's investments
Buffett's succession plan calls for his job to essentially be split into two functions after he's gone. Berkshire's next CEO will oversee operations, while the other half of his job, managing investments, will be given to someone else. (Note: Buffett gave a brief discussion of Berkshire's "post-Buffett" structure, but it was only included in the full annual report on page 22-23, not in Buffett's letter.)
On the investment front, the likely successors are Buffett's trusted stock-pickers, Ted Weschler and Todd Combs. Over the past few years, the pair have been given increasingly large amounts of Berkshire's capital to invest, and this grew again in 2017. At the end of 2016, Ted and Todd managed a combined $21 billion, and we learned that this figure has swelled to $25 billion at the end of 2017.
7. No big surprises
One of the biggest stories here is what was missing. There were no big surprises or key new developments involving some of the topics Berkshire shareholders are most concerned with -- specifically, the succession plan and Berkshire's cash problem.
There were rumors that we may get a little more color on who specifically might replace Buffett, or that Berkshire was planning to implement a dividend or buyback to put some cash to work, but these turned out to be just rumors and nothing more. Of course, there's a possibility that Buffett could be saving these for Berkshire's annual meeting on May 5, but for now we'll have to wait and see.
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