Background
The accounting figures are often not realistic.
A new GAAP rule requires that we include the last item in earnings. As I emphasized in the annual report for 2017, neither Berkshire's deputy chairman, Charlie Munger, nor I think that the rule is reasonable. Rather, we both consistently thought that in Berkshire, this mark-to-market change would produce what I described as "wild and whimsical swings in our bottom line."
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Our advice? Focus on operating profit, pay little attention to gains or loss of any variation. My saying that in no way reduces the importance of our investments to Berkshire. Over time, Charlie and I seem to be delivering significant gains, albeit with very irregular timing.
Either way, a set of accounting figures does not work to tell the truth to any kind of business, let alone the unique business model at Berkshire Hathaway (BRK.A, BRK.B). This reminds investors of the necessity of adapting analyzes to specific stocks and / or situations.
For example, many global companies, such as Waters (WAT), Amgen (AMGN), reported a sharp decline in net revenue for 2017 due to the impact of the tax reform, while investors should really focus on EBT (pre-tax earnings) and margin for to measure business growth (profit before tax actually improved on both WAT and AMGN that year).
In addition, consumer-facing brick companies, such as Starbucks (SBUX) and Ross Stores (ROST), demonstrate their growth potential through so-called store sales or comparable. Nevertheless, the same store sales are not so comparable, as the definition only excludes stores opened within one year, while many stores even after the first year still have abnormally rapid growth. This distortion would lift the point of sale for a complete store, especially when the companies have opened a large number of new stores in recent years. Remember Starbucks opened a store every 15 hours in China, and Ross Stores plans to open 100 new locations in the US this year? Look better and dig deeper into their growth figures later.
Beware of Wall Street Jargon
When we say "deserved", we also describe what remains after all income taxes, interest payments, management compensation (either cash or stock based), restructuring costs, depreciation, amortization, and home office.
The mark of revenue is far from what is often traced by Wall Street bankers and business executives. Too often, the presentations present their "adjusted EBITDA", a goal that redefines "earnings" to exclude a range of overly real costs.
Wall Street fellows find each way to sell, sometimes using many "innovative" terms (such as EV / EBITDA, non-GAAP EPS) to embellish the valuations. EBITDA (profit before tax, depreciation and depreciation) and "adjusted" net income does a very bad job of uncovering management's erroneous strategies or capital allocations, such as M&A that destroy the value, but a pretty decent job to cover many important costs that shareholders need to bear, such as stock options. [19659014] Unfortunately, the development of congested adjusted earnings can continue – as shown in the table below, increasing the share of S & P 500 companies beating analysts' estimates on an adjusted basis, giving CEOs incentives to promote non-GAAP figures.
Source: Bloomberg ; data from and including 8/2018
In my factor-based model, only three types of income are considered –
- Gross income / margin: the indication of the company's pricing; [19659018] Operating income / margin: to measure how well the company operates day-to-day;
- Net income / margin: assessment of how the business is managed together, including influence, investment and taxation (only occasionally the net margin is adjusted – for example, the decision on the profit margin before tax in the light of the tax reform).
In addition, the model heavily analyzes the cash flow (eg free cash flow) of the business, which will be more difficult to manipulate.
Retained earnings are the secret sauce
GAAP – which dictates the earnings we report – does not allow us to include the retained earnings from investors in our financial accounts. But these earnings are of great value to us: Over the years, earnings have retained by our investors (seen as a group) ultimately given capital gains to Berkshire which accounted for more than a dollar for every dollar these companies reinvested for us.
This not only echoes the imperfection of the accounting system discussed earlier, but also involves what defines a great business and means most for long-term investment. Opportunities and abilities to reinvest retained earnings at high prices are often neglected and rarely mentioned among investors, such as the media, Wall Street and corporate governance are placing greater emphasis on near-time revenue and growth.
Although rarely referenced by professionals, they return reinvested / retained earnings can easily be calculated (as done by my factor-based model) for investors to uncover management's capital allocation skills earlier. Predicting future opportunities for reinvestment at high prices is far more complicated and sometimes a matter of art, in my opinion: investors will need a more comprehensive understanding of lasting competitive advantage, dynamic industry, competitive landscape, market positioning, and business strategy to do business a bet (hopefully with a certain margin of safety).
Valuations are still fierce
In the years to come, we hope to move much of our excess liquidity to businesses that Berkshire will permanently own. However, the immediate prospects for that are not good. Prices are high for companies that have decent long-term prospects.
Many readers remember the article "The Warren Buffett Indicator Doesn't Tell You to Bet on America," which was written when the indicator (ie, market share capital) stood at nearly 150%. More than a year passed, today the ratio is 138% according to GuruFocus (shown below), indicating still expensive aggregate stock prices.
Source: GuruFocus; data as of 3/14/2019
In my portfolio review in January, I expressed the same concern about skyrocketing values that have led to fewer and fewer opportunities to stay on the table for buying and keeping, quality-focused investors. Value is what you get, the price is what you pay. Any stock purchase with a long-term time horizon (like me) should ask for more volatility to come at this stage.
Never Sell Your Winners
It would be foolish for us to sell some of our amazing companies even if No Tax would be paid on sale. Really good businesses are very hard to find. Selling everything you are fortunate enough to own, makes no sense at all.
Admittedly, it would be tempting for investors to sell the winners too early (and to keep the losers too long), which is often called outline Bias, closely linked to Loss / Regret Aversion Bias. In the financial market, there are so many phenomena like this that show that investors are just their own worst enemies.
Having dealt with many businesses through various roles over the years, I would recommend that turnaround strategies are often overridden in terms of viability and that the momentum for improving the business base is likely to continue to go further than investors normally think. In the business world, it is not uncommon for the winners to just win before the power of average reversal finally takes place. Then cut your losses and let the profits run.
Share purchase is not always good
True is the upside from buyback very small for those who go. That's because careful buying of us will minimize any impact on Berkshire's stock price. Nevertheless, there is some benefit to the sellers having an additional buyer in the market.
For secondary shareholders, the benefit is obvious: if the market prices of a departure partner's interest, for example, 90 ¢ on the dollar, shareholders continue to increase equity per share with each repurchase of the company. Obviously, buybacks should be price-sensitive: Blind purchase of overpriced stock is worthwhile, a fact lost on many promotional or ever-optimistic CEOs.
Warren Buffett again raised questions about the leadership capital allocation skills. Managers are responsible for choosing between internal projects, M&A, debt reduction, dividend payout and share repurchase to distribute retained capitals. Today, share buyer cheers are obviously exaggerated, while control of the prices on which shares are bought back is a lack of investors.
Factors of return on reinvested capital in my stock ranking model assess the managers' capital allocation decisions over the 5- and 10-year timeframes. In general, I favor a return of at least 20% in that regard.
Guidance and Analyst Guidelines are Often Bad
Over the years, Charlie and I have seen all kinds of poor business behavior, both accounting and operational, induced by management's desire to meet Wall Street expectations. What begins as an "innocent" fudge not to disappoint "The Street" – say, quarterly trading burden, blind eye to increasing insurance losses or to pull down a "cookie-jar" reserve – can be the first step toward full-fledged fraud . Playing with the numbers "just this time" may well be the CEO's intention; It is rarely the end result. And if it's okay for the boss to cheat a little, it is easy for subordinates to rationalize similar behavior.
Warren Buffett has, among other things, been the incredible critic of quarterly and claimed that it encouraged short-term thinking of business leaders. The idea of meeting the Street estimates for the coming quarters plays a similar role here and prevents long-term effective strategic planning that will create shareholder value.
Interestingly, the friendly acquisition strategy at Berkshire Hathaway is carefully crafted to address this issue by taking good companies private and retaining clear management teams to do business in the long run.
Fees kills more than you think
Let's put numbers to that claim: If my $ 114.75 had been invested in a S&P 500 index fund fee and all dividends had been reinvested, my ownership would have grown to be worth (before tax) $ 606,811 on January 31, 2019 (the latest data available before printing this letter). There is a gain of 5 288 for 1. Meanwhile, a $ 1 million investment by a tax-exempt institution of that time – say pension fund or college contribution – will have grown to around $ 5.3 billion.
Let me add another extra calculation that I think will shock you: If the hypothetical institution had only paid 1% of the assets annually to various "helpers", such as investment managers and consultants, the gain would have been reduced to half to 2 , $ 65 billion. That is what happens over 77 years when the 11.8% annual return actually achieved by S & P 500, is converted to 10.8%.
Many investors like Berkshire shares, as it seems like a "no-fee" mutual / hedge fund. In the long run, taxes often kill investors' ideas more than they think. In my last article, "Here's why and how each investor has a chance to beat Wall Street," I said taxes are the most prominent factor that causes fund managers while being picked up in their own pockets to deliver poor results to their customers.
The solution? Buy low cost index funds over time (or even "zero cost" those days – check Fidelity ZERO Total Market Index Fund (FZROX) and Fidelity ZERO International Index Fund (FZILX)). Especially for those who do not actively care about managing their money, this strategy should only work well by beating most professionals on the street.
Macro-optimism works well
Those who regularly proclaim doom because of the government Budget deficit (which I regularly did myself for many years) may notice that our country's government debt has risen about 400 times over the past 77 years. That's 40,000%! Suppose you had anticipated this increase and panic on the prospect of a deficit and a worthless currency. To "protect" yourself, you might have eschewed stocks and opted instead to buy 31/4 grams of gold with your $ 114.75.
And what would it have assumed that the protection had delivered? You will now have an asset worth around $ 4,200, less than 1% of what would have been realized from a simple uncontrolled investment in US business. The magic metal was no match for the American mette.
In my observation and experience over the years, macro-optimists with micro-security give better returns than pessimists in terms of inventory investment. If you believe that the world should only go from generation to generation, be a capitalist by owning good businesses (in whole or in part), should be your best bet for your wealth. Otherwise, you wouldn't really have the opportunity to make any difference, for all the financial financial wealth in your account probably means nothing in a truly doomed world. So why not just bet on the bright side?
Summary
I always like to read Warren Buffet's annual letter and listen to his (and Charlie Munger's) questions and answers to the annual meeting. Often many lessons from him are understated, but valuable. Omaha Oracle shows us his good leadership and entrepreneurial spirit. With economic capabilities as the hot topic of our young generation today, in my opinion, these two elements are the key to truly separating large-scale finance from average Joe's.
Enlightenment: I am / we are long ROST, BRK .B, AMGN, WAT. I wrote this article myself, and it expresses my own opinions. I do not receive compensation for it (other than from Seeking Alpha). I have no business relationship with a company whose stock is mentioned in this article.
