Tuesday, August 7, 2018

Berkshire 2018 Meeting Highlights - Part I

The following question was asked by Jack Ciesielski -- an accounting expert and Berkshire investor -- during  Berkshire Hathaway's (BRKa) most recent shareholder meeting:

"Mr. Buffett, in this year's shareholder letter you have harsh words for the new accounting rule that requires companies to use market value accounting for their investment holdings. 

'For analytical purposes,' you said, 'Berkshire’s bottom-line will be useless.' 

I'd like to argue with you about that. Shouldn't a company’s earnings report cite everything that happened to, and within, a company during an accounting period?"

The response...

Warren Buffett: "Well...we've got $170 billion of partly-owned companies, which we intend to own for decades, and which we expect to become worth more money over time, and where we reflect the market value in our balance sheet, does it make sense to, every quarter, mark those up and down through the income account, when at the same time we own businesses that have become worth far more money...take GEICO...we bought half the company for $50 million, roughly — do we want to be marking that up every quarter to the value — and having it run through the income account?

That becomes an appraisal process. There's nothing wrong with doing that, in terms of evaluation. But in terms of — and you can call it gain in net asset value or loss in net asset value — that's what a closed-end investment fund, or an open-investment fund would do.

But to run that through an income account — if I looked at our 60 or 70 businesses...and every quarter we marked those to market, we would have, obviously, a great many, in certain cases, where over time we’d have them at 10 times what we paid, but how quarter-by-quarter we should mark those up and run it through the income account, where 99 percent of investors probably look at net income as being meaningful, in terms of what has been produced from operations during the year, I think would be — well, I can say it would be enormously deceptive.

I mean, in the first quarter of this year — you saw the figures earlier — where we had the best what I would call operating earnings in our history, and our securities went — were down six billion, or whatever it was, to keep running that through the income account every day you would say that we might have made on Friday, we probably made 2 1/2 billion dollars. Well, if you have investors and commentators and analysts and everybody else working off those net income numbers and trying to project earnings for quarters, and earnings for future years, to the penny, I think you're doing a great disservice by running those through the income account.

I think it's fine to have marketable securities on the balance sheet — the information available as to their market value — but we have businesses there — if we — we never would do it — but if we were to sell half, we’ll say, of the BNSF railroad, we would receive more than we carried — carried for them — we would turn — we could turn it into a marketable security and it would look like we made a ton of money overnight. Or if we were to appraise it, you know, appraise it every three months and write it up and down, A, it could lead to all kinds of manipulation, but B, and it would just lead to the average — to any investor— being totally confused.

I don't want to receive data in that manner and therefore I don't want to send it out in that manner.


CHARLIE MUNGER: "Well, to me it's obvious that the change in valuation should be noted, and it is and always has been — it goes right into the net worth figures.

So the questioner doesn't understand his own profession. (Laughter and applause)

I’m not supposed to talk that way but it slips out once in a while." (Laughter)

Here's a prior post covering what Buffett had to say in the shareholder letter about the consequences of this new accounting rule.

As a direct result of the rule Berkshire's most recent earnings, as one might expect, produced headlines like:

Berkshire Hathaway posts surge in profits
- Warren Buffett’s Berkshire Hathaway profit soars in second quarter

These articles do attempt to explain what's behind such a substantial increase in quarterly earnings. Still, the new rule has real potential for misunderstanding.

To invest well one needs to understand accounting and the rules do necessarily change over time.

Yet that doesn't mean changes -- even if well-intended -- should make it more difficult for the investor to draw meaningful conclusions. That  doesn't mean those who otherwise are rather familiar with Generally Accepted Accounting Principles (GAAP) should need to keep up with changes that don't seem to add much value or, worse yet, create confusion.

The investing process is already difficult enough without such confusion.

Berkshire's operating earnings did indeed improve but much of it comes down to the new accounting rule -- a rule that's just as certain the produce future headlines like "massive decline in profits" the next time, inevitably, the market (or a specific stock in the portfolio) happens to drop dramatically.

Buffett explained the latest results this way:

"In 2018, due to a change in Generally Accepted Accounting Principles (“GAAP”), we are now required to include the changes in unrealized gains/losses of our equity security investments as a component of investment gains/losses in our earnings statements. In the table above, investment gains/losses in 2018 include a gain of approximately $4.5 billion in the second quarter and a loss of approximately $1.7 billion in the first six months of 2018 due to changes during the second quarter of 2018 and changes during the first six months of 2018 in the unrealized gains/losses of equity security investments held at June 30, 2018. In 2017 and in prior years, while changes in unrealized gains/losses were reflected in our shareholders’ equity, they were not included in our earnings statements. Accordingly, the following statement which has been included in each of Berkshire’s earnings releases for many years along with some additional comments (additional comments underlined) is even more important when analyzing Berkshire’s periodic results. The amount of investment gains/losses in any given quarter is usually meaningless and delivers figures for net earnings per share that can be misleading to investors who have little or no knowledge of accounting rules."

Note that Buffett is clarifying the numbers -- primarily by isolating short-term fluctuations "in unrealized gains/losses of our equity security investments" from the operating earnings -- so investors understand that the headline net earnings, due to the new rule, are far greater than what he considers the more meaningful but much lower Berkshire operating earnings. In other words, if in a future quarter he emphasizes that operating earnings are actually higher than the net earnings number it won't be because -- and unfortunately, this is too often the case -- he's trying to paint a rosier than reality picture.

History more than suggests that such behavior would be, to say the very least, unusual for Berkshire.

The goal here simply seems to be trying to communicate a number that's as meaningful as possible for investors.

Accounting is very useful but has its limits.

"...you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization...But you have to know enough about it to understand its limitations—because although accounting is the starting place, it's only a crude approximation. And it's not very hard to understand its limitations." - Charlie Munger at USC Business School in 1994

Confusion, at best, seems the most likely outcome that this new rule is going to produce.

Some of the limitations of accounting are inherent.

Others are not.


Long position in BRKb established at much lower than recent market prices

Related post:
Buffett: When a Non-Random Rule & Random Fluctuations "Swamp the Truly Important"
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