In it, Buffett warns of the overpriced market for acquisitions and why he’s opting to increase the size of Berkshire’s equity portfolio; he defends stock buybacks; he acknowledges the massive write-down from Kraft Heinz; and he addresses government debt and deficits while also taking a jab at gold-touting doomsayers.
The letter accompanied news that Berkshire Hathaway booked a $25 billion loss in Q4, an unusual blemish largely driven by paper losses on stock holdings during a period of unusual market volatility.
To kick things off, however, Buffett points to a big change he’s made in the format of his letter.
“Long-time readers of our annual reports will have spotted the different way in which I opened this letter,” he said at the top. “For nearly three decades, the initial paragraph featured the percentage change in Berkshire’s per-share book value. It’s now time to abandon that practice.”
Buffett said that reporting that metric “has lost the relevance it once had.” He pointed to three reasons why: 1) “Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses”; 2) “while our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years”; and 3) “it is likely that – over time – Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value.”
On that final matter of stock buybacks, Buffett clarified: “The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality.”
Berkshire is buying more stocks, but it’s not a market call
One of the ongoing the questions Berkshire investors have is how will management deploy some of the company’s massive $112 billion in cash. In the past, Buffett and Charlie Munger, his right-hand man and vice chair of Berkshire Hathaway, have characterized that elusive target as an “elephant-sized” acquisition.
Unfortunately, Buffett believes the market looks expensive.
“In the years ahead, we hope to move much of our excess liquidity into businesses that Berkshire will permanently own,” he said. “The immediate prospects for that, however, are not good: Prices are sky-high for businesses possessing decent long-term prospects.”
Not only are those big opportunities elusive, the return on sitting on cash remains unattractive.
“That disappointing reality means that 2019 will likely see us again expanding our holdings of marketable equities,” he said. In other words, they’re going to buy more stocks in the market.
However, this is not Buffett’s way of telling the world that investors should necessarily go “overweight” the stock market because it’s a “strong buy.”
“My expectation of more stock purchases is not a market call,” he clarified. “Charlie and I have no idea as to how stocks will behave next week or next year. Predictions of that sort have never been a part of our activities. Our thinking, rather, is focused on calculating whether a portion of an attractive business is worth more than its market price.”
Buybacks have an obvious advantage
Stock buybacks have become highly politicized in recent weeks. But it’s clear that Buffett will continue to block out the noise and continue to focus on what he believes is best for the company.
"For continuing shareholders, the advantage is obvious: If the market prices a departing partner’s interest at, say, 90¢ on the dollar, continuing shareholders reap an increase in per-share intrinsic value with every repurchase by the company. Obviously, repurchases should be price-sensitive: Blindly buying an overpriced stock is value-destructive, a fact lost on many promotional or ever-optimistic CEOs," he wrote.
"When a company says that it contemplates repurchases, it's vital that all shareholder-partners be given information they need to make an intelligent estimate of value,” he added. “Providing that information is what Charlie and I try to do in this report. We do not want a partner to sell shares back to the company because he or she has been misled or inadequately informed."
Buffett acknowledges multi-billion dollar non-cash loss on Kraft Heinz
Recently, Berkshire Hathaway’s portfolio has seen some stumbles. On Friday, Kraft Heinz (KHC) shares plummeted amid news that earnings disappointed, the company’s dividend would be cut, intangible assets were written down, and the company was subpoenaed by the SEC. As of the end of 2018, Berkshire owned 26.7% of the company.
Buffett provided no additional color on the stock except to say that in Q4, Berkshire took “a $3.0 billion non-cash loss from an impairment of intangible assets (arising almost entirely from our equity interest in Kraft Heinz).”
“At year end, our Kraft Heinz holding had a market value of $14 billion and a cost basis of $9.8 billion,” he said.
While nobody likes to get hit with losses, Buffett tends to think in long-term time horizons.
"Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now,” Buffett said in 1996.
Furthermore, he and his team may see Kraft’s sell-off as an opportunity to buy more shares.
“The best thing that happens to us is when a great company gets into temporary trouble,” Buffett said in 1998. “We want to buy them when they're on the operating table.“
Gold wouldn’t have helped you amid the ballooning U.S. debt
Novice and expert investors alike around the world, young and old, follow Buffett with the hope of better understanding how the Oracle of Omaha makes his bets. And those who follow him know that he is unflinchingly bullish on the U.S., its economy, and its financial markets.
In his letter, he addresses the market’s perma-bears and the economy’s naysayer. In particular, he calls out the worrywarts who constantly point to the U.S. debt and deficits.
“Those who regularly preach doom because of government budget deficits (as I regularly did myself for many years) might note that our country’s national debt has increased roughly 400-fold during the last of my 77-year periods,” Buffett said.
“That’s 40,000%! Suppose you had foreseen this increase and panicked at the prospect of runaway deficits and a worthless currency. To ‘protect’ yourself, you might have eschewed stocks and opted instead to buy [3.25] ounces of gold with your $114.75.
“And what would that supposed protection have delivered? You would now have an asset worth about $4,200, less than 1% of what would have been realized from a simple unmanaged investment in American business. The magical metal was no match for the American mettle.”
Sam Ro is managing editor at Yahoo Finance. Follow him on Twitter: @SamRo