……….
Excerpts:
Intrinsic Business
Value
As much as Charlie and I talk about intrinsic business
value, we cannot tell you precisely what that number is for Berkshire shares
(or, for that matter, any other stock). In our 2010 annual report, however, we
laid out the three elements – one of which was qualitative – that we believe
are the keys to a sensible estimate of Berkshire’s intrinsic value. That
discussion is reproduced in full on pages 104-105.
Here is an update of the two quantitative factors: In 2012
our per-share investments increased 15.7% to $113,786, and our per-share
pre-tax earnings from businesses other than insurance and investments also increased
15.7% to $8,085.
Since 1970, our per-share investments have increased at a
rate of 19.4% compounded annually, and our per-share earnings figure has grown
at a 20.8% clip. It is no coincidence that the price of Berkshire stock over
the 42-year period has increased at a rate very similar to that of our two
measures of value. Charlie and I like to see gains in both areas, but our
strong emphasis will always be on building operating earnings.
…
So how does our attractive float affect the calculations of
intrinsic value? When Berkshire’s book value is calculated, the full amount of our float is deducted as
a liability, just as if we had to pay it out tomorrow and were unable to
replenish it. But that’s an incorrect way to look at float, which should
instead be viewed as a revolving fund. If float is both costless and
long-enduring, which I believe Berkshire’s will be, the true value of this
liability is dramatically less than
the accounting liability.
A partial offset to this overstated liability is $15.5
billion of “goodwill” that is attributable to our insurance companies and
included in book value as an asset. In effect, this goodwill represents the
price we paid for the float-generating capabilities of our insurance
operations. The cost of the goodwill, however, has no bearing on its true value. For example, if an insurance business
sustains large and prolonged underwriting losses, any goodwill asset carried on
the books should be deemed valueless, whatever its original cost.
Fortunately, that’s not the case at Berkshire. Charlie and I
believe the true economic value of our insurance goodwill – what we would
happily pay to purchase an insurance operation producing float of similar quality – to be far in excess of
its historic carrying value. The value of our float is one reason – a huge
reason – why we believe Berkshire’s intrinsic business value substantially
exceeds its book value.
Let me emphasize once again that cost-free float is not an outcome to be expected for the
P/C industry as a whole: There is very little “Berkshire-quality” float
existing in the insurance world. In 37 of the 45 years ending in 2011, the
industry’s premiums have been inadequate to cover claims plus expenses. Consequently,
the industry’s overall return on tangible equity has for many decades fallen
far short of the average return realized by American industry, a sorry
performance almost certain to continue.
A further unpleasant reality adds to the industry’s dim
prospects: Insurance earnings are now benefitting from “legacy” bond portfolios
that deliver much higher yields than will be available when funds are reinvested
during the next few years – and perhaps for many years beyond that. Today’s
bond portfolios are, in effect, wasting assets. Earnings of insurers will be
hurt in a significant way as bonds mature and are rolled over.
…..
At bottom, a sound insurance operation needs to adhere to
four disciplines. It must (1) understand all exposures that might cause a
policy to incur losses; (2) conservatively assess the likelihood of any
exposure actually causing a loss and the probable cost if it does; (3) set a
premium that, on average, will deliver a profit after both prospective loss
costs and operating expenses are covered; and (4) be willing to walk away if
the appropriate premium can’t be obtained.
Many insurers pass the first three tests and flunk the
fourth. They simply can’t turn their back on business that is being eagerly
written by their competitors. That old line, “The other guy is doing it, so we
must as well,” spells trouble in any business, but none more so than insurance.
…..
Regulated,
Capital-Intensive Businesses
We have two major operations, BNSF and MidAmerican Energy,
that have important common characteristics distinguishing them from our other
businesses. Consequently, we assign them their own section in this letter and
split out their combined financial statistics in our GAAP balance sheet and
income statement.
A key characteristic of both companies is their huge
investment in very long-lived, regulated assets, with these partially funded by
large amounts of long-term debt that is not
guaranteed by Berkshire. Our credit is in fact not needed because each business
has earning power that even under terrible conditions amply covers its interest
requirements. In last year’s tepid economy, for example, BNSF’s interest
coverage was 9.6x. (Our definition of coverage is pre-tax earnings/interest, not EBITDA/interest, a commonly-used measure
we view as deeply flawed.)
…..
[Manufacturing, Service and Retailing Operations]
The crowd of companies in this section sell products ranging
from lollipops to jet airplanes. Some of the businesses enjoy terrific
economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%.
Others produce good returns in the area of 12-20%. A few, however, have very
poor returns, a result of some serious mistakes I made in my job of capital
allocation.
More than 50 years ago, Charlie told me that it was far
better to buy a wonderful business at a fair price than to buy a fair business
at a wonderful price. Despite the compelling logic of his position, I have sometimes
reverted to my old habit of bargain-hunting, with results ranging from
tolerable to terrible. Fortunately, my mistakes have usually occurred when I
made smaller purchases. Our large acquisitions have generally worked out well
and, in a few cases, more than well.
Viewed as a single entity, therefore, the companies in this
group are an excellent business. They employ $22.6 billion of net tangible
assets and, on that base, earned 16.3% after-tax.
Of course, a business with terrific economics can be a bad
investment if the price paid is excessive. We have paid substantial premiums to
net tangible assets for most of our businesses, a cost that is reflected in the
large figure we show for intangible assets. Overall, however, we are getting a
decent return on the capital we have deployed in this sector. Furthermore, the
intrinsic value of the businesses, in aggregate, exceeds their carrying value by
a good margin. Even so, the difference between intrinsic value and carrying
value in the insurance and regulated-industry segments is far greater. It is there that the huge winners reside.
…..
We continue to wind down the part of our derivatives
portfolio that involved the assumption by Berkshire of insurance-like risks.
(Our electric and gas utility businesses, however, will continue to use
derivatives for operational purposes.) New commitments would require us to post
collateral and, with minor exceptions, we are unwilling to do that. Markets can
behave in extraordinary ways, and we have no interest in exposing Berkshire to some
out-of-the-blue event in the financial world that might require our posting mountains
of cash on a moment’s notice.
Charlie and I believe in operating with many redundant
layers of liquidity, and we avoid any sort of obligation that could drain our
cash in a material way. That reduces our returns in 99 years out of 100. But we
will survive in the 100th while many others fail. And we will sleep well in all
100.
…..
The third use of funds – repurchases – is sensible for a
company when its shares sell at a meaningful discount to conservatively
calculated intrinsic value. Indeed, disciplined repurchases are the surest way to use funds intelligently:
It’s hard to go wrong when you’re buying dollar bills for 80¢ or less. We explained
our criteria for repurchases in last year’s report and, if the opportunity
presents itself, we will buy large quantities of our stock. We originally said
we would not pay more than 110% of book value, but that proved unrealistic.
Therefore, we increased the limit to 120% in December when a large block became
available at about 116% of book value.
But never forget: In repurchase decisions, price is
all-important. Value is destroyed when purchases are made above intrinsic
value. The directors and I believe that continuing shareholders are benefitted
in a meaningful way by purchases up to our 120% limit.
And that brings us to dividends. Here we have to make a few
assumptions and use some math. The numbers will require careful reading, but
they are essential to understanding the case for and against dividends. So bear
with me.
[Very worthwhile
section on dividends, but too long to post here.]