Buffett is a great teacher. He has an ability to synthesize very complex issues into simple stories that are easy to understand. For this reason I think reading the Berkshire annual report is a great course on investing.
For many investors, the letter is boring. Reasons abound, including it is repetitive, Buffett is full of it, etc. That is ok. There are people who don’t think Buffett is the real deal and some that just think that they won’t get much out of reading another similar letter. All of that is ok.
I still read everything he writes since I get a lot out of it (or so I believe).
Here are some comments and thoughts on the 2018 annual report and his subsequent interview with Becky Quick.
Buffett has provided a new valuation method for Berkshire. For years, the method he recommended was the 2-column method, which was basically adding the value of wholly-owned subs to the liquid assets (cash, bonds and equities).
Now, Buffett has provided a new method which he referred to as the 5 groves. The five groves are: 1) wholly-owned subs, 2) equities, 3) shared control companies, 4) cash & fixed income and 5) insurance. Adding the values of the first four groves should give us an approximation of intrinsic value. Insurance is a source of “cost-free” funding. So far it has been even better than that as the combined ratio has averaged <100% and float has grown.
I used this method with my approximation of value for the different “groves” and came up with an estimated Intrinsic Value. Value of liquid investments are as of 12/31 so it might be reasonable to adjust upwards.
1) Wholly-Owned Subsidiaries: $320BN
2) Equities: $158BN (after subtracting $14.7BN in deferred taxes)
3) Shared Control Investments: $17BN
4) Cash, Equivalents & FI: $132BN
5) Insurance: 0
Berkshire Value: $627BN (BRK-A $382,119; BRK-B $254.75)
Float & Low Expectations
Float continues to be the fuel that pushes Berkshire forward. Back in 2011, Buffett stated the following: “It’s unlikely that our float will grow much – if at all – from its current level.” At the time, float was $70.6bn. In 2018, float hit $122.7bn. So float has grown at a CAGR of 8.5% since 2011. Many investors thought float was peaking when Buffett made that statement. Once again, he lowered expectations and outperformed.
Float has grown while being better than cost-free. In 2017, due to various catastrophes, underwriting losses before taxes were $3.2bn. Since 2011, that is the only year with an underwriting loss. Adding up all the underwriting results since 2011, we get to a total pre-tax gain of $12.1bn. Pretty attractive funding source!
Buffett thanked Tony Nicely for his work at Geico. In his comments he gave us interesting information on Geico´s estimated value. He mentioned: “By my estimate, Tony’s management of GEICO has increased Berkshire’s intrinsic value by more than $50 billion.”
So we know, Buffett thinks Geico si worth at least $50bn. Probably more than that, since Nicely became CEO in 1993 and in 1995 Berkshire valued Geico at $4.6bn in its acquisition of the 50% interest the company did not own.
For now, let´s assume Geico is worth at least $50bn. That represents mora than 3x Geico´s surplus. Pretty amazing how much value has been created here and it continues to grow. Premiums written grew 12% in 2018, reflecting 3.3% policies-in-force growth and 6.4% premium per auto policy growth.
Geico is another important reason why intrinsic value is higher than book value, and also why book value has lost relevance.
Missing the December Market Dip
After Berkshire released its 13-f, many investors were disappointed. Buffett made very few investments during the 4q18 market dip. Trying to find an explanation for this lack of activity, some investors argued that he probably was busy repurchasing his own shares. To the surprise of many, Berkshire released its repruchase activity on saturday and figures were underwhelming. Berkshire repurchased less than $500mm during this period.
Now we know why the numbers were so disappointing. Apparently, Buffett was trying to close a large acquisition and the deal fell through. I have no idea what type of elephant he was aiming at. But we know it was a failed attempt…
Buffett also said there were many opportunities in the market during November & December…what a shame.
Buffett loves banks. That is obvious. He has maxed out his position in BAC, WFC, USB and possibly on its way with JPM. Of the large US banks the only one he does not “like” is Citi.
When asked why so much exposure to the sector? He mentioned how they are great businesses earning 15-17% ROTE but are trading at undemanding valuations. Then he went on to give an example. For how much would you sell a fictional bank account that paid 15% on your deposits, forever? He thought that account was worth more than 3x book value in a world of 3% rates. Of course, the required return for the equity investor in a bank is more than 5%, but we also get to reinvest a portion of the earnings at that 15% return. I like large US banks and found this analysis interesting.
Buffett is arguing that the required return equity investors are asking for large banks is probably too high…and that is ok since banks are large repurchasers of their own stock.
On a side note, he mentioned how this year banks won´t have to pay quarterly surcharges that cover FDIC costs. That, coupled with the tax reform, will continue to help large banks.
Results at the railroad continue to be impressive. Revenue grew 12%, helped by 4.1% volume growth and 6.2% revenue per car/unit growth. The economy has helped, but the story here continues to be pricing. Railroads have been able to reprice many of their contracts while maintaining volume growth. That combination has been great for shareholders.
Another interesting aspect has been how free cash flow has exploded in the past 3-4 years. In 2015, BNSF invested $5.8bn in capex, this figure has declined dramatically to $3.4bn in 2018 and expected to be $3.6bn in 2019. This is attractive since the railroad continues to grow, and at a nice rate. In 2015, EBITDA was $9.7bn while in 2018 this number expanded to $10.2bn. So this combination of cash flow growth with declining capex has meant an explosion in free cash flow generation. Before paying interest and taxes, free cash flow has grown from $3.9bn in 2015 to $6.8bn in 2018. That is 75% growth in 3 years!
Also, it is important to highlight that this expansion if free cash flow is not due to underinvestment. Union Pacific, which is a similarly sized railroad, invested less than BNSF last year. To be specific, 2018 capex for UNP was $3.2bn.
Kraft Heinz Debacle
In 2017, KHC was trading at $90/share when the financial world was in love with the 3G model. At the time, the stock traded at roughly 30x earnings for a no growth business. The market thought KHC could keep growing by acquiring other companies and repeating the cost-cutting process. Well, that did not happen as multiples were too high for a sector that had no top-line growth and declining margins. During these last few years, the industry has gone through a rough patch as private label offerings have taken share, retailers have toughened up on pricing, etc.
KHC has gotten destroyed by the market, falling 70%. This decline is well deserved given the deterioration in financial results. Also, last week the company announced an SEC investigation into its accounting and internal control, a dividend cut and a $15bn impairment. Woof.
Ok, so that is the story of KHC.
Berkshire owns 27% and has been a cheerleader of the Brazilian team. So headlines were all over this, understandably so. In an interview, 2 days after releasing the shareholder´s letter, Buffett talked about KHC and he was very honest, as usual.
“We overpaid for Kraft…”
Buffett was very specific in mentioning that they paid too much for Kraft, but not for Heinz. So the first deal was good, but not the second.
He mentioned how they misjudged the leverage retailers were gaining over them and the competitive position of the Kraft brands.
Buffet accepted his mistake but did not talk about the result of the Berkshire investment. Surprisingly, they have not been bad (so far).
Heinz bought Kraft by paying with an arguably overvalued stock that some analysts estimated was priced at 4x the cost basis of the original Berkshire-3G investment. So at the moment, they were using that currency to buy scale in the sector. Unfortunately they had to pay too much and the economics of the target deteriorated over the following years. But my point is that by using their pricy stock, instead of only cash, the final outcome is not as bad as it could have been. In a perfect world they would have not bought Kraft, but still results at standalone Heinz might have followed a similar path as the CPG sector.
Something that is very interesting about this mess, is the way Buffett structured the deal. And this is classic Buffett. In 2013, 3G approached Berkshire about buying Heinz. They agrred to the following structure, Berkshire would invest $12.3bn, out of that amount $8bn would be in 9% preferreds. Berkshire also got some warrants. So he was protecting his downside by buying a fixed income security but also looking at the upside with the warrants. In 2015, when Heinz acquired Kraft, Berkshire exercised the warrants and invested an additional $5.3bn.
3 years after the initial investment, KHC redeemed the 9% preferred paying a $300mm premium. For years, before the dividend cut, Berkshire received annual dividends that amounted to high-single digit percent of the invested amount. Applying the current market price, KHC is worth $11.3bn to Berskhire compared to the invested amount of $9.6bn.
Yes, KHC is a mess right now and there is not a lot of hope, but Berkshire has not done bad with this investment. Results have been pretty decent in part due to the way Buffett structured the original deal.
Buffett is 88 and he seems to be as sharp and mentally agile as ever. It was great to see that.