Buffett’s Annual Letter: Berkshire Records $29 Billion Gain From Tax Law
Posted February 26, 2018 1:55 p.m. EST
Berkshire Hathaway’s bottom line for 2017 got a big lift from the new tax law.
In an annual letter to Berkshire’s shareholders Saturday, the company’s chief executive, Warren Buffett, said the conglomerate recorded a more than $29 billion gain related to the tax overhaul that became law in December.
He also said that a “purchasing frenzy” had raised deal prices to a level that the company could not stomach. That was why, he said, Berkshire had largely avoided big acquisitions last year.
Here’s a look at some of the highlights from the letter:
Berkshire recorded a hefty windfall from the tax bill that Congress passed at the end of last year. The annual report said the tax overhaul produced a $29.6 billion gain that was offset slightly by $1.4 billion of tax payments on repatriated foreign earnings. The tax gain contributed nearly two-thirds of Berkshire’s $44.9 billion in net earnings for 2017.
Each year, Buffett highlights the change in Berkshire’s book value, a measure of the company’s net worth. The company’s book value rose by $65.3 billion to $348 billion in 2017, a 23 percent gain from $282 billion at the end of 2016. The tax benefit made up a hefty 45 percent of the book value increase. In commenting on the contribution from lower taxes, Buffett said: “The $65 billion gain is nonetheless real — rest assured of that.”
Buffett did not use his widely read shareholders’ letter to expand on his recent criticisms of certain types of tax cuts.
— Deal Making
WhileBuffett didn’t say stocks were overvalued, as he has done in past letters, he did say that acquisitions have gotten too pricey.
One of main ways that Berkshire has grown over the years is by spending large sums to acquire other companies.
But the company hasn’t done a big deal for some time. While that may make it harder for Berkshire to grow, Buffett said acquisitions have to have “a sensible purchase price.” That requirement, he said, “proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.”
Buffett singled out a driver of the acquisition boom: Acquirers could borrow money at low interest rates to finance their deals. And he added, “At Berkshire, in contrast, we evaluate acquisitions on an all-equity basis, knowing that our taste for overall debt is very low.” Some investors in Berkshire may become impatient if it doesn’t do some big deals. The company’s cash pile had increased to $116 billion at the end of 2017, much of which was held in U.S. Treasuries. Still Buffett said he and Charles T. Munger, Berkshire’s vice chairman, were happy to sit on the sidelines: "Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need.”
“Despite our recent drought of acquisitions, Charlie and I believe that from time to time Berkshire will have opportunities to make very large purchases. In the meantime, we will stick with our simple guideline: The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.”
— Berkshire vs. S&P 500
Buffett has long set the goal of beating the Standard & Poor’s 500 index and, in 2017, Berkshire did just that.
The company’s book value rose 23 percent, while its stock price climbed 21.9 percent. The S&P 500 climbed 21.8 percent.
For years, Berkshire’s book value was Buffett’s preferred measure for comparing Berkshire’s performance to the S&P 500, and he highlighted the comparison on a table on the first page of the letter. But outperforming the S&P 500 has become more difficult as Berkshire has grown and shifted to buying whole companies. A few years ago, Buffett added Berkshire’s annual stock price performance to the table.
— Hurricanes and ‘Mega-cats’
The insurance segment of Buffett’s letter contains an interesting discussion on hurricane losses. It says that the hurricanes that hit Texas, Florida and Puerto Rico last year will lead to $100 billion of losses for insurers. Berkshire estimates that its hit will total $2 billion after taxes, or less than 1 percent of its net worth. That percentage, according to Berkshire, is far below the 7 to 15 percent losses suffered by some reinsurance companies.
Buffett puts a 2 percent annual probability on the occurrence of a “mega-catastrophe” causing losses of $400 billion or more, but he said the risk could rise. “No one, of course, knows the correct probability,” he wrote. “We do know, however, that the risk increases over time because of growth in both the number and value of structures located in catastrophe-vulnerable areas.” And according to Buffett, Berkshire need not fear a mega-cat. “No company comes close to Berkshire in being financially prepared for a $400 billion mega-cat. Our share of such a loss might be $12 billion or so, an amount far below the annual earnings we expect from our non-insurance activities,” he wrote.
— Impact of Accounting Changes
Early in the letter, Buffett rails against a new accounting rule that will affect future quarterly and annual reports. This change requires companies to include in their earnings the gains and losses on the stocks they hold but have not sold. These paper gains and losses will change each quarter as the prices of the stocks change, and Buffett said that because Berkshire holds $170 billion of stocks, the impact on Berkshire’s bottom line could be significant.
“That requirement will produce some truly wild and capricious swings in our GAAP bottom-line,” he said, referring to the corporate accounting method known as generally accepted accounting principles. Buffett said Berkshire would help investors tune out the noise created by the unrealized gains and losses. “We will take pains every quarter to explain the adjustments you need in order to make sense of our numbers,” he wrote.
It would indeed be notable if Berkshire started to publish “adjusted earnings,” or financial statements that exclude certain items. In last year’s annual report, Buffett criticized companies that publish adjusted earnings that leave out costs such as stock awards to executives.
— Buffett’s Hedge Fund Wager
Buffett has long railed against the fees that hedge funds and money managers collect from investors. A decade ago, he made a $1 million wager that an index fund that tracks the S&P 500 would outperform a basket of hedge funds over the next 10 years.
The bet is now complete and Buffett won. The S&P 500 index fund that Buffett picked is up nearly 126 percent, easily outpacing the returns of five funds of hedge funds, which were up 2.8 to 87.7 percent. The big winner of the bet was Girls Inc. of Omaha. The charity received $2.2 million last month rather than the planned $1 million.
The reason? Buffett and Protégé Partners had originally invested $318,250 each in U.S. Treasuries, with the expectation that the investment would appreciate to $1 million over the life of the bet. But in 2012, they sold the bonds and bought shares of Berkshire. That proved a wise move.
— Quips and Quotes
Buffett’s annual letter is combed over for its investment advice and folksy wisdom as well as a few corny jokes. Here are some the best lines from the latest one:
On one reason deal prices are so high: “In part, it’s because the CEO job self-selects for “can-do” types. If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.”
On why Berkshire avoids using debt to finance acquisitions: “Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need. We held this view 50 years ago when we each ran an investment partnership, funded by a few friends and relatives who trusted us. We also hold it today after a million or so “partners” have joined us at Berkshire.”
On the risks of using debt to buy stocks: “There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”
On investing: “Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals.”