Happiness! Another year passes and with it comes the opportunity to read one more of Warren Buffett’s Letters to Shareholders. On Saturday, Berkshire Hathaway published its 2017 Annual Report, and I was excited to read it.
For more information about the company, I have written about Berkshire Hathaway several times:
Let’s see how the company did in 2017…
- 23% gain in net worth, a $65.3 billion increase in book value during 2017. $36b of these were due to Berkshire’s operations, while $29b were due to the changes in the US tax code enacted in December, which decreased the US corporate tax rate from 35% to 21%, and states that unrealised gains and losses in stocks held by the company must now be included in all net income figures reported to shareholders (page 3);
- Purchase of a 38.6% partnership interest in Pilot Flying J (PFJ), a privately held chain of truck stops in the United States and Canada with annual sales of $20b. Berkshire also has a contract to increase its interest to 80% in 2023, with the founding Haslam family retaining 20% (page 5);
- Several bolt-on acquisitions by Clayton Homes, Shaw Industries, HomeServices and Precision Castparts (pages 5 and 6);
- Insurance float of $114.5b and premium volume of $60.6b, which were boosted by a huge deal in which Berkshire reinsured up to $20b of long-tail losses that AIG had incurred. The premium for this was $10.2b, a world record not likely to be repeated (page 7);
- Operations other than insurance had a pre-tax net income of $20b in 2017, an increase of $950m over 2016 (up 5%), with 44% of this income coming from BNSF and Berkshire Hathaway Energy (page 8);
- The market value of the company’s stock investments at yearend 2017 was $170.5b, with the five biggest positions being Wells Fargo, Apple, Bank of America, Coca-Cola and American Express. The Kraft Heinz holding had a market value of $25.3b (page 9);
- The following sections entitled “The bet is over and has delivered an unforeseen investment lesson”, “Owner-related business principles”, “Intrinsic Value”, and “Berkshire Hathaway Inc. Acquisition Criteria”, provide invaluable lessons and insights into how Warren makes investments and manages his company. Reading these provides more value than a year at university, and I would like to address them, but here I will focus on the company’s performance during 2017 (pages 11-23);
- BNSF’s share of the Western US rail traffic in 2017 was about 50.9% and its primary rail competitor is the Union Pacific Railroad Company (page K-6);
- Shareholder equity of $348b at yearend 2017 (page K-23);
- The company has a stock repurchase programme in place that allows it to repurchase Class A and Class B shares at a price no higher than a 20% premium over the book value of the shares. This puts a floor on the value of the company at $417.6b ($348b x 120%). Since there are about 1.645 million outstanding equivalent A shares, this is equal to a floor price of about $254,000 per A share ($417.6b / 1.645), or about $169 per B share ($254,000 / 1,500) (page K-23);
- Total revenue of $242b, up 8% from $223.6b in 2016 (page K-31);
- Net earnings of $45b, up 86.7% from $24b in 2016, mainly due to the one-time $29.1b tax benefit (page K-31);
- Net earnings per share of $27,326, up 86.7% from $14,645 in 2016 (page K-31);
- Shareholders equity of $348.3b, up 23.5% from $282b in 2016. Without the one-time benefit mentioned above, equity would have risen a more modest but still very good 13.2% to $319.2b (page K-31);
- The tax benefit includes about $29.6b and consists of a one-time non-cash reduction of Berkshire’s net deferred income tax liabilities due to the reduction in the US corporate tax rate from 35% to 21% (page K-32);
- Total comprehensive income of $66.2b, up 142% from $27.4b in 2016, mainly due to the one-time tax benefit of $29.1b and a $30.5b change in unrealised appreciation of investments (contributing to this was the stock market rise of over 20% last year) (page K-65).
- First year of underwriting losses, losing $3.2b pre-tax, after 14 years of underwriting profits. The cost of average float was 3% (pages 8 and K-5);
- $116b in cash and US Treasury Bills, up 34% from $86.4b at yearend 2016. I consider this a Con because, even though it’s a very large amount of cash providing safety and liquidity to Berkshire, it is earning a very low rate of return, since Warren has not found suitable businesses that he could buy at reasonable prices (page 9);
- Although the changes in the US tax code provided Berkshire with a $29b one-time increase in net worth in 2017, the obligation to include all the changes in the fair value of equity securities (realised or unrealised) on their consolidated statement of earnings going forward, instead of on other comprehensive income, will cause its earnings to become more volatile and make it more difficult to correctly analyse its true operating performance (page K-23);
- Net earnings increased 86.7% yoy to $45b, but without the $29.1b one-time tax benefit, earnings would actually have fallen 33% from $24b in 2016 to $15.9b in 2017! A very weak operational performance, mainly due to the insurance underwriting loss and lower investment and derivative gains. (page K-32).
An exceptionally good year for Berkshire Hathaway, with 16 Pros and only 4 Cons, mainly due to the changes in the US tax code and the rise in the value of its equity investments. Although the $29.1b tax benefit is very real, I’m not going to consider it in my valuation of the company since I have been already considering the tax liability it refers to as fictitious. It would only be realised if Warren were to sell these shares (which he wouldn’t exactly because of the capital gains tax he would incur).
That being said, I will continue to value BH according to its three main value pillars (as in my first valuation post):
- Value of investments (cash equivalents, bonds and equities);
- Operating earnings (excluding investments and insurance);
- Effective future deployment of retained earnings.
At yearend 2017 cash, cash equivalents and US Treasury Bills totalled $116b; investments in fixed income securities totalled $21.4b; investments in equity securities were valued at $164b; and the Kraft Heinz holding was valued at $25.3b. The total value of this pillar is $326.7 billion.
Net earnings from operations excluding insurance and investments totalled $13,585 million in 2017. Applying a PE ratio of 12, matching the 12% growth rate in net earnings from operations in the last five years, gives me a value of $163 billion for this second pillar.
The third pillar is very hard to estimate, but I would say that it is evenly matched against the danger of Warren dying, and of the value of Berkshire’s equity investments crashing 30% or more in a volatile stock market.
Therefore, considering only the first two pillars, my estimate of Berkshire’s value comes to $489.7 billion ($326.7b + $163b), giving me a value of about $297,690 per Class A share, or $198.46 per Class B share. Today, Berkshire’s B shares closed at $210.62, a premium of 6.1% over my fair value estimate.
Since I would like to buy B shares with a 20% discount, my buying price would be $158.77 ($198.46 x 80%), which is even lower than the $169 at which Warren would repurchase its stock, making it impossible to buy it at my desired price. This presents an interesting dilemma: would I buy at $169, knowing that it wouldn’t go any lower? It’s still a 15% discount over my fair value estimate of $198.46…
Yes, I would buy it, if I had no better ideas. I love this company. And because I also like round numbers, I would even pay a bit more.
Therefore, I am updating my purchase price to $170.