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Notes on Berkshire Hathaway’s 50th Anniversary Letter [Part One]

**This post first appeared on ValueWalk.com.

With over 43 pages of text, the Berkshire 50th anniversary letter cannot be summed up easily. Nevertheless, below are a selection of key quotes from the Oracle of Omaha‘s anniversary letter, which value investors may find useful.

If you’re looking for a complete analysis of the Berkshire letter, I would highly recommend heading over to the Wall Street Journal. The publication as gathered three dozen Buffettologists, Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) shareholders, value investors and academics together to analyze the letter and puts its contents — including annotations — online for readers to study.

Berkshire Hathaway: A new way to measure performance

After some commentators started to call out Buffett last year over his poor performance, he has now presented Berkshire Hathaway’s returns in a different light. Last year, it emerged last year that Berkshire’s book value growth (Buffett’s favored measure of performance) had, for the first five-year period in the group’s life, “failed to surpass” returns generated by the S&P 500.

A year later and Buffett has changed his reporting style, adding a column to the performance tables noting Berkshire Hathaway’s “Per Share Market Value”. Using this metric, as seen in the table below, Berkshire has outperformed the S&P 500 for four of the past five years. Considering the fact that Berkshire Hathaway is in this game for the ultra long-term, the group’s performance over five years is not really relevant. Compound growth of around 20% per annum for the past 40 to 50 years is the relevant factor here.

berkshire returns

Berkshire Hathaway: Intrinsic value

The intrinsic value of a business is a huge part of Buffett’s investment philosophy (becoming so after Charlie Munger came to Berkshire). So, it makes sense that Buffett should comment on the intrinsic value of Berkshire Hathaway within his annual letter.

The marketable securities on Berkshire Hathaway’s balance sheet are valued on the group’s balance sheet at market prices, so any gains – including those unrealized – are immediately reflected. However, the value of businesses acquired are never revalued upward.  The unrecorded gains in the value of Berkshire’s subsidiaries have become huge, with these growing at a particularly fast pace in the last decade.

GEICO is the perfect example. As I cover later, GEICO’s size gives it a huge advantage over its peers, and Buffett believes that Geico, which is carried on the books at $2 to 3 billion, has true economic goodwill approaching $20 billion — this appears to be a conservative estimate, others have valued the business at $50 billion.

GEICO is the US’s second-largest auto insurer, with premiums of $21 billion, underwriting gains of $1.2 billion, and industry leading expense ratio of 16.6% versus an industry average of 26%, float of $13.5 billion and the fastest policies-in-force growth of all major auto insurance carriers. Something investors should bear in mind when looking at any business, “how much is the moat worth”? It can often be more than meets the eye.

IBM

On a personal note, it always struck me as odd that the majority of Wall Street has been calling out Buffett on his IBM stake for much of the past year. Anyone who has done any research on Buffett’s past will find that he is not one to sell after only a year of underperformance. Buffett added to Berkshire’s International Business Machines Corp. (NYSE:IBM) holding during 2014 — Q4 — and he is unlikely to make a decision to sell anytime soon. Berkshire Hathaway’s interest in IBM during the year rose from 6.3% to 7.8%. Unlike Tesco, which Buffett sold out of during 2014 (see below) IBM has continued to impress the Oracle of Omaha, a potential vote of confidence for beleaguered CEO Ginni Rometty?

A big mistake

Tesco was Buffett’s big sale of the year. Previously making it into the list of Berkshire’s largest common stock investments, by the end of 2014 the Tesco holding had been completely sold:

“In 2013, I soured somewhat on the company’s then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior “thumb-sucking.” (Considering what my delay cost us, he is being kind.)

During 2014, Tesco’s problems worsened by the month. The company’s market share fell, its margins contracted and accounting problems surfaced. In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.

We sold Tesco shares throughout the year and are now out of the position. (The company, we should mention, has hired new management, and we wish them well.)” — Warren Buffett Berkshire 2014 letter.

Tesco’s problems, for the most part, can be traced to its previous management (the one that was in place when Buffett first started to build his position). The fact that Buffett started to sour on the management installed during 2013 is only due to timing. Indeed, the previous CEO had lead years of overexpansion into international markets, underinvestment in the company’s home market and had installed a poor working culture into the Tesco business. This story highlights the importance of selling a position as fast as possible if things start to move against you.

Berkshire Hathaway: A history lesson

Berkshire Hathaway’s 50th anniversary letter is more of a history lesson than annual report. One of the most important lessons the letter covers is Berkshire Hathaway’s most important acquisition, National Indemnity and its sister company, National Fire & Marine, for $8.6 million. Today, based on GAAP principles, these businesses are worth $111 billion, a value which exceeds that of any other insurer in the world.

National Indemnity provided Buffett with more than just an insurance business:

“One reason we were attracted to the property-casualty business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume…”Warren Buffett Berkshire 2014 letter.

Buffett has sought out additional float from the moment he made his first investment in American Express Company (NYSE:AXP) in the wake of the Salad Oil Scandal. He found float soon after in casualty insurance, and later in Blue Chip Stamps. With these floats behind him, Buffett has been able to use Berkshire in a way no other investment manager would have been able too. In the words of legendary value investor, Walter Schloss:

“By setting up Berkshire Hathaway Inc., Warren has done everything very rationally.

1. By having insurance companies, he is able to use stocks as well as bonds as reserves. By having large reserves he doesn’t have to pay dividend[s]. If Berkshire was only a very profitable manufacturing company with no insurance companies it would have to pay out some dividends.

2.By keeping all the earnings, Berkshire can keep reinvesting their profits and compound their results. By owning a growth stock, he is able to increase the value of the company…Since it is [Berkshire] in effect a closed-end investment company, Warren doesn’t have to worry about investors redeeming their shares…”

Berkshire Hathaway also has the benefit of size on its hands. As Buffett notes in the letter, the majority of the insurance industry operates at a loss on the underwriting level but due to the size of GEICO, the company can undercut many competitors on pricing:

“When I was first introduced to GEICO in January 1951, I was blown away by the huge cost advantage the company enjoyed compared to the expenses borne by the giants of the industry. It was clear to me that GEICO would succeed because it deserved to succeed. No one likes to buy auto insurance. Almost everyone, though, likes to drive…GEICO’s cost advantage is the factor that has enabled the company to gobble up market share year after year. (We ended 2014 at 10.8% compared to 2.5% in 1995, when Berkshire acquired control of GEICO.) The company’s low costs create a moat – an enduring one – that competitors are unable to cross…” — Warren Buffett Berkshire 2014 letter.

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