Savvy investors wait every year for the last winter month, because that's when Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) CEO Warren Buffett publishes its annual letter to Berkshire shareholders. The missive accompanies the insurance giant's financial results for the full year of the exercise and investors are inevitably looking into Berkshire's performance in assessing the health of the overall market.
This year, you'll find that many stocks report profits made by Berkshire in 2018 and much smaller than those of previous years. Yet much of this change comes from a single factor, and Buffett himself not only predicted that something like this would happen, but also rebelled against what had provoked it. In the end, a simple accounting change made Berkshire's results virtually meaningless, and it is important to look at other measures of success to get an accurate picture of Buffett's actual performance.
The big change
If you look only at the results of Berkshire Hathaway, this would seem to explain the dismay that reigns among the people who follow the company. Berkshire reported net profit of $ 4.02 billion for 2018, down 91% from 2017, mainly due to massive losses in the fourth quarter.
Yet, if you look at the fundamental operational performance of Berkshire's business, you will get a very different picture. Operating profit was $ 24.78 billion in 2018 – including a huge increase of 71% in the fourth quarter.
Buffett explained the disparity between the two numbers. To calculate the reported net income, Berkshire had to:
- Take his $ 24.78 billion operating profit.
- Reduce it by approximately $ 3 billion to reflect goodwill impairment losses, mainly related to Berkshire's interest in Kraft Heinz (NASDAQ: KHC).
- Add $ 2.8 billion in capital gains realized on the sale of various investment securities.
- Eliminate $ 20.6 billion in losses, which represents a reduction in the amount of unrealized capital gains in Berkshire's investment portfolio.
It is this last figure that Buffett finds particularly problematic. The Oracle of Omaha has announced the new accounting rule that requires Berkshire to mark its investment securities on a quarterly basis, with changes in market value reflected in the results every three months. This removes the long-term nature of Buffett's investment strategy, forcing Berkshire to include volatile fluctuations in his investments four times a year – which the Berkshire CEO has described as "truly wild and capricious fluctuations in our GAAP financial results ".
Buffett was even more candid about the change in accounting shareholder letter from last year:
I must first tell you about a new accounting rule: in the future, quarterly and annual reports will seriously distort Berkshire's net income figures and will often mislead commentators and investors. … With the new rule on unrealized gains exacerbating the distortion caused by existing rules applying to realized gains, we will strive every quarter to explain the adjustments needed to make sense of our numbers. However, television commentaries on earnings releases are often instantaneous, and newspaper headlines almost always focus on the 12-month change in net earnings under GAAP. As a result, media reports sometimes highlight characters that unnecessarily frighten or encourage many readers or viewers.
What investors need to do about the accounting rule
With one year of rule under the Berkshire belt, Buffett can rely on empirical evidence to support his claims. In the first quarter of 2018, Berkshire published a GAAP loss of $ 1.1 billion in light of the fading stock market. The ensuing market rebound helped Berkshire realize profits from $ 12 billion in the second quarter and $ 18.5 billion in the third quarter. Then, the stock market crash in the fourth quarter resulted in a loss of $ 25.4 billion.
Buffett does not see the end of profit volatility, but he has a solution: focus on operating profits. These figures highlight the strength of the companies that make up Berkshire Hathaway and are less sensitive to the accounting tricks currently required in the reported basic figures. Even though Buffett expects the investment activity to have a significant positive long-term impact on Berkshire's overall performance, this will only be apparent over many years – and the quarterly growth of these figures does not make sense.
For many, key figures highlighting Berkshire's significant gains affected by market moves will be the only points to remember from the insurance giant's report. But by listening to Warren Buffett's warnings about the questionable value of the profits affected by the new accounting rules, you'll have a better idea of Berkshire Hathaway's actual performance.