Whitney Tilson’s email to investors discussing his Stock Idea of the Day, “Weight Watchers,” and Berkshire’s letter in which Buffett removed change in book value per share and explained why.
1) Today Stock Idea of the Day is Weight Watchers (NASDAQ:WTW), perhaps best known for its association with Oprah Winfrey, who owns 8% of the stock. The stock is cratering today after the company cut its 2019 profit guidance in half. It’s been on a wild ride the past two years, rising from $12 to over $100 last summer before giving almost all of it back, as you can see in this chart:
A friend who’s followed the company for decades and nailed the stock’s rise and fall over the past two years (even teaching it as a case study in one of our seminars last year) shared these comments with me last night:
All I can say is the web data told you this would happen. Kudos to the JPM sellside analyst who really nailed this. Longer-term, I believe they serve a giant need, the brand relevance and customer satisfaction is very much intact, and CEO Mindy Grossman is a gifted executive. Also, Oprah’s intuitive marketing prowess and influence is not to be underestimated. But because of the seasonality of the business, it is very hard for them to make much impact until 2020, so it’s probably too early to jump into the stock.
I’d welcome further thoughts/comments!
2) In recent emails I’ve discussed Berkshire’s annual letter and the company’s intrinsic value, so now let’s turn to Buffett’s letter, which was one of his shortest at only 7,000 words (vs. 8,500 last year and 11,900 in 2004).
I didn’t have a strong reaction to it. He hit a lot of his usual themes and I found it interesting how he broke down Berkshire’s value in five “groves” of “economic trees”:
- a) Non-insurance operating businesses, led by “two towering redwoods,” BNSF and BH Energy;
- b) Stocks, the five largest of which are Apple (AAPL), Bank of America (BAC), Wells Fargo (WFC), Coca-Cola (KO) and American Express (AXP);
- c) “A quartet of companies in which we share control with other parties – 26.7% of Kraft Heinz (KHC), 50% of Berkadia and Electric Transmission Texas, and 38.6% of Pilot Flying J”;
- d) “In our fourth grove, Berkshire held $112 billion at year end in U.S. Treasury bills and other cash equivalents, and another $20 billion in miscellaneous fixed-income instruments”; and
- e) Berkshire’s “huge and diverse insurance operation”
There was also a lengthy and well-deserved shout-out for GEICO’s former CEO, Tony Nicely, and the incredible job he did there over the last quarter-century. He concluded: “By my estimate, Tony’s management of GEICO has increased Berkshire’s intrinsic value by more than $50 billion.” Wow!
Lastly, there was one line that I didn’t understand: on page 8, Buffett wrote that Berkshire’s non-insurance businesses “earned pre-tax income in 2018 of $20.8 billion, a 24% increase over 2017.”
This number isn’t anywhere close to the segment numbers presented in footnote 26 (page K-106) of the annual report, which shows the following growth in pre-tax profits in 2018:
Service and retailing: +17.0%
BH Energy: -1.1%
In total, the pre-tax profits of all non-insurance businesses grew 9.6% – a healthy number, but a far cry from 24%.
To help solve this mystery, I emailed the company and Dan Jaksich, Berkshire’s Principal Accounting Officer, Vice President and Controller, was kind enough to reply. He wrote:
“The 24% increase in pre-tax earnings referred to on page 8 includes the effects of a number of corporate items, such as interest expense on corporate debt, foreign exchange gains/losses on the Euro denominated debt, and purchase accounting amortization related to these businesses.”
Fair enough. I don’t doubt that Buffett’s number is correct, but I think 9.6% better reflects the true growth of intrinsic value of this wonderful collection of businesses.
3) For further insight, I turned to Glenn Tongue, who wrote:
There wasn’t much new in this letter.
The performance record table is unchanged (they added the change in the stock price in the 2014 annual report).
He again discussed the value of Berkshire’s float and also how changes in the company’s stock portfolio hits earnings, which we’ve seen before. He removed change in book value per share and explained why. The most interesting point here is how buybacks done at prices above book value but below intrinsic value (which is where he’s been doing them recently, around 1.4x book) will reduce book value per share but increase intrinsic value per share, which increasingly makes the former a poor proxy for the latter.
I think one reason he introduced the framework of the five “groves” is so people incorporate the value in category 3 (“a quartet of companies in which we share control with other parties”), which can get lost due to equity accounting.
I think this is a good point:
Finally, a point of key and lasting importance: Berkshire’s value is maximized by our having assembled the five groves into a single entity. This arrangement allows us to seamlessly and objectively allocate major amounts of capital, eliminate enterprise risk, avoid insularity, fund assets at exceptionally low cost, occasionally take advantage of tax efficiencies, and minimize overhead.
At Berkshire, the whole is greater – considerably greater – than the sum of the parts.
He wrote quite a bit about stock repurchases. I wish he’d done more in Q4, but he explained this in his interview with CNBC on Monday, saying he was negotiating a large deal (which ultimately didn’t happen). I hope he really ramps this up in 2019 – it could be a significant value driver over time.
Finally, I like his section on “The American Tailwind.” In it, he reemphasizes the benefit of compounding and how small frictional costs become huge over time. I especially liked this paragraph:
Charlie and I happily acknowledge that much of Berkshire’s success has simply been a product of what I think should be called The American Tailwind. It is beyond arrogance for American businesses or individuals to boast that they have “done it alone.” The tidy rows of simple white crosses at Normandy should shame those who make such claims.
4) Here’s Doug Kass’s take on Buffett’s letter (it’s available only to Real Money Pro subscribers, but he gave me permission to share):
- Strong operating results seen, adjusted for the accounting (and loss) from marketable securities
- More flaws became apparent in the company's investing portfolio - as moats in several large positions have been damaged (most notably Kraft Heinz)
- As I did when I appeared at the company's Annual Meeting, I continue to (respectfully) question the investment process at Berkshire (that has, in certain high profile instances, failed to identify the loss of pricing power in a changing and more competitive business landscape)
- 2018 uncovered more evidence that Berkshire Hathaway has become so large that, going forward, it will continue to resemble an S&P Index Fund
Here is the complete letter.
1. It was shorter than usual.
2. He changed the first page metric in which he has compared Berkshire's (BRK.B) yearly book value change with the change in the S&P 500 Index. Now he will be comparing Berkshire's common share price to the annual change in the S&P share price. This is a something that I had continually recommended (in my Diary) before and after I appeared with Charlie and Warren on the stage at the 2013 Annual Meeting. (I had argued that comparing the change in Berkshire's book value v. the S&P price change was an Apples to Oranges comparison).
There are several reasons why this makes sense:
- As Berkshire buys more stock it reduces per share book value (and increases the company's intrinsic value).
- Berkshire's wholly owned businesses now dwarf its stock portfolio.
- Berkshire's wholly owned businesses' book value (required by its accountants) has lost relevance as their "real economic value" is much higher.
3. Berkshire's marketable investment portfolio got whacked. Which gets back to two questions I had asked him and Charlie back in 2013 - about the difficulty in outperforming the markets (S&P) as he got larger and the issue of analytical process:
Question No. 1 -- Size Matters
Q: As it is said, Warren, "Size matters!"
In the past, Berkshire bought cheap or wholesale -- for instance, Geico, MidAmerican Energy, the initial Coca-Cola (KO) purchase and Benjamin Moore. Arguably, your company has shifted to becoming a buyer of pricier and more mature businesses -- for instance, IBM (IBM), Burlington Northern Santa Fe, Heinz (HNZ) and Lubrizol, which were done at prices to sales, earnings and book value multiples well above the prior acquisitions and after the stock prices rose.
Many of the recent buys might be great additions to Berkshire's portfolio of companies, however, the relatively high prices paid for these investments could potentially result in a lower return on invested capital. In the past you hunted gazelles, but now you are hunting elephants.
To me, the recent buys look like preparation for your legacy, creating a more mature, slower-growing enterprise. Is Berkshire morphing into a stock that has begun to resemble an index fund that is more appropriate for widows and orphans rather than past investors who sought out differentiated and superior compounded growth?
In the past, you have quoted Benjamin Graham, saying "price is what you pay -- value is what you get." Are your recent deals and large investments bringing Berkshire less value than the deals done previously?
A: Warren admitted that Berkshire won't grow as rapidly in the future as it has in the past but it will still generate a lot of incremental value. "We think we will do better than the giants of the past," he said. Charlie chimed in and said much of the same. Warren then exclaimed, "Doug, you haven't convinced me to sell the stock, but keep trying!"
Question No. 4 -- Has Your Investment Process Become Less Intense?
Q: Mae West once said, "The score never interested me, only the game."
Are you at that point now where the game interests you more than the score?
But before you answer, let me explain why I asked.
In the past, your research has been all-encompassing, whether measured in time devoted to selecting investments and acquisitions or in the intensity of analysis.
You were interested, in the old days, of knowing the slightest minutia about a company.
You once said in characterizing Ben Rosner, "Intensity is the price of excellence."
Your research style seems to have morphed over time from a sleuth-like analysis -- American Express (AXP) comes to mind, when you hired Henry Brandt (father of Ruane, Cunniff & Goldfarb's Jonathan on today's panel!); you and he conducted weeks of analysis, in site visits and channel checks.
Now, not so much in later investments. As an example, you famously thought of making the Bank of America (BAC) investment in your bathtub.
There is an investment message of this transformation from being intense to less intense. Would you please explain the degree it has to do with the market, Berkshire's size or other factors?
A: Warren responded by saying that he finds running Berkshire to be the most interesting thing to do. "I have every bit of the intensity, though it's not manifested in the same way," he said. "I love thinking about Berkshire, about its investments, about its business. It's a part of me."
Charlie said, "It [research] is all cumulative."
In response to my Bank of America/bathtub reference, Warren quipped, "The bathtub wasn't the most important part!"
4. While the 4Q headline number was ugly (as mark to market of Berkshire's investment portfolio mired results), operating profits were reasonably strong, the portfolio of marketable investments did poorly and the company's cash position has never been larger (float at a record $123 billion).
GEICO had a big year over year improvement - with sales +13% and profits shifting from a $200 million loss to a $2.4 billion profit. Losses in the reinsurance business was markedly reduced as the company reduced it's book size. Investment income was +13%. BNSF profits +13%, retail and service +17%, BH Energy down modestly and McLane -18%.
Overall, pretax income (excluding investment income) was +49% (reduced to +10% adjusted for the big change in insurance profits).
For the full year Berkshire repurchased only $1.3 billion of its stock. Book value rose by +0.4% and the share price of Berkshire increased by +2.8% compared to the S&P's drop of -4.4%.
No one in history will repeat Warren Buffett's success at Berkshire Hathaway.
But where do we go from here?
Berkshire is a well run industrial giant but it has grown too large to outperform the S&P Index.
Owning Berkshire is now, more than ever, like owning a diversified S&P Index fund. Some years it will modestly outperforming the markets, other years it modestly underperform. But the days of superior outperformance are now over.
5) Lastly, here are two articles about Buffett’s letter:
- New York Times: Kraft Heinz, the U.S. Budget, and Big Stock Losses Feature in Warren Buffett’s Letter
- Institutional Investor: Is Warren Buffett Just Mailing It In?