Tuesday, April 3, 2012

Buffett on Berkshire's Earnings Mix: Operating Earnings Versus Gains from the Sale of Securities

Analyzing Berkshire Hathaway's (BRKa) earnings isn't always straightforward.

The year 1985 wasn't especially confusing compared to other years but serves as a useful example. The shareholder letter from that year shows that Berkshire's pre-tax earnings grew substantially year over year from $ 200.5 million to $ 613.4 million.

On the surface a great year but, unfortunately, that bottom line number doesn't reveal much about what Berkshire's true earnings power was at the time.

It was, in fact, a very good year but not nearly as good as the tripling would indicate.

The reason? Much of the increase came from the sale of marketable securities. Here's how the picture looked that year with gains from the sale of securities separated from the earnings (in millions) from Berkshire's operating businesses:*

                                                              1984              1985
Operating earnings                       $ 87.7          $125.4
Gain from Sale of Securities    $104.7         $468.9
Other                                                  $    8.1           $  19.0
Total Earnings                                $200.5        $613.4

Here's how Warren Buffett explained the year over year performance in the 1985 shareholder letter:

"Our 1985 results include unusually large earnings from the sale of securities. This fact, in itself, does not mean that we had a particularly good year (though, of course, we did). Security profits in a given year bear similarities to a college graduation ceremony in which the knowledge gained over four years is recognized on a day when nothing further is learned. We may hold a stock for a decade or more, and during that period it may grow quite consistently in both business and market value. In the year in which we finally sell it there may be no increase in value, or there may even be a decrease. But all growth in value since purchase will be reflected in the accounting earnings of the year of sale. (If the stock owned is in our insurance subsidiaries, however, any gain or loss in market value will be reflected in net worth annually.) Thus, reported capital gains or losses in any given year are meaningless as a measure of how well we have done in the current year."

The bulk of that gain from sale of securities was the result of selling General Foods.

Now, Berkshire had bought General Foods at what they viewed to be a substantial discount to per share business value back in 1980. Also, the business had fine underlying economics and, according to Buffett, a management that was focused on increasing that business value.

Shares bought cheap compared to 1980 value and, as a result of attractive underlying economics along with sound management, intrinsic value grew substantially over the five years or so.

None of the above led to a reported gain while the next thing that happened did. Philip Morris (now Altria: MO) came along and made a nice buyout offer for the shares of General Foods. More from the letter:

"We thus benefited from four factors: a bargain purchase price, a business with fine underlying economics, an able management concentrating on the interests of shareholders, and a buyer willing to pay full business value. While that last factor is the only one that produces reported earnings, we consider identification of the first three to be the key to building value for Berkshire shareholders. In selecting common stocks, we devote our attention to attractive purchases, not to the possibility of attractive sales."

So value was enhanced over many years but the gains had to be recognized all at once as accounting earnings in that one year.

Adam

Long position in BRKb and MO established at less than recent market prices

* Earnings do not include the amortization of Goodwill. From the letter: "...amortization of Goodwill is not charged against the specific businesses but, for reasons outlined in the Appendix to my letter in the 1983 annual report, is aggregated as a separate item." The reason comes down to the difference between economic and accounting Goodwill. The Appendix in the 1983 letter does a nice job of explaining this.
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