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Berkshire Hathaway 2012 letter

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I'm a Warren Buffett fanboy, so eagerly wait for his annual letters to shareholders. What I've done in this note, is isolate the areas of insight he shared, which I found most useful.

2013 letter to Berkshire Hathaway shareholders

As a serious investor, I love it when Buffett shares accounting insights! The operating expense numbers he shows do not conform to GAAP (Generally Accepted Accounting Principles)... "In particular, they exclude some purchase-accounting items, primarily the amortization of certain intangible assets. We present the data in this manner because Charlie and I believe the adjusted numbers more accurately reflect the real expenses and profits of the businesses aggregated in the table...serious investors should understand the disparate nature of intangible assets: Some truly deplete over time while others never lose value. With software, for example, amortization charges are very real expenses. Charges against other intangibles such as the amortization of customer relationships, however, arise through purchase-accounting rules and are clearly not real expenses. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when calculating earnings – even though from an investor's viewpoint they could not be more different. In the GAAP-compliant figures we show on page 29, amortization charges of $600 million for the companies included in this section are deducted as expenses. We would call about 20% of these "real" – and indeed that is the portion we have included in the table above – and the rest not. This difference has become significant because of the many acquisitions we have made. "Non-real" amortization expense also looms large at some of our major investees. IBM has made many small acquisitions in recent years and now regularly reports "adjusted operating earnings," a non-GAAP figure that excludes certain purchase-accounting adjustments. Analysts focus on this number, as they should.

A "non-real" amortization charge at Wells Fargo, however, is not highlighted by the company and never, to my knowledge, has been noted in analyst reports. The earnings that Wells Fargo reports are heavily burdened by an "amortization of core deposits" charge, the implication being that these deposits are disappearing at a fairly rapid clip. Yet core deposits regularly increase. The charge last year was about $1.5 billion. In no sense, except GAAP accounting, is this whopping charge an expense."


"During the past fifteen months, we acquired 28 daily newspapers at a cost of $344 million. This may puzzle you for two reasons:

  1. I have long told you in these letters and at our annual meetings that the circulation, advertising and profits of the newspaper industry overall are certain to decline. That prediction still holds.

  2. The properties we purchased fell far short of meeting our oft-stated size requirements for acquisitions. We can address the second point easily. Charlie and I love newspapers and, if their economics make sense, will buy them even when they fall far short of the size threshold we would require for the purchase of, say, a widget company.

Addressing the first point requires me to provide a more elaborate explanation, including some history. News, to put it simply, is what people don't know that they want to know. And people will seek their news– what's important to them – from whatever sources provide the best combination of immediacy, ease of access, reliability, comprehensiveness and low cost. The relative importance of these factors varies with the nature of the news and the person wanting it.

Before television and the Internet, newspapers were the primary source for an incredible variety of news, a fact that made them indispensable to a very high percentage of the population. Whether your interests were international, national, local, sports or financial quotations, your newspaper usually was first to tell you the latest information. Indeed, your paper contained so much you wanted to learn that you received your money's worth, even if only a small number of its pages spoke to your specific interests. Better yet, advertisers typically paid almost all of the product's cost, and readers rode their coattails. Additionally, the ads themselves delivered information of vital interest to hordes of readers, in effect providing even more "news." Editors would cringe at the thought, but for many readers learning what jobs or apartments were available, what supermarkets were carrying which weekend specials, or what movies were showing where and when was far more important than the views expressed on the editorial page.

In turn, the local paper was indispensable to advertisers. If Sears or Safeway built stores in Omaha, they required a "megaphone" to tell the city's residents why their stores should be visited today. Indeed, big department stores and grocers vied to outshout their competition with multi-page spreads, knowing that the goods they advertised would fly off the shelves. With no other megaphone remotely comparable to that of the newspaper, ads sold themselves. As long as a newspaper was the only one in its community, its profits were certain to be extraordinary; whether it was managed well or poorly made little difference. (As one Southern publisher famously confessed, "I owe my exalted position in life to two great American institutions – nepotism and monopoly.")

Over the years, almost all cities became one-newspaper towns (or harbored two competing papers that joined forces to operate as a single economic unit). This contraction was inevitable because most people wished to read and pay for only one paper. When competition existed, the paper that gained a significant lead in circulation almost automatically received the most ads. That left ads drawing readers and readers drawing ads. This symbiotic process spelled doom for the weaker paper and became known as "survival of the fattest."

Now the world has changed. Stock market quotes and the details of national sports events are old news long before the presses begin to roll. The Internet offers extensive information about both available jobs and homes. Television bombards viewers with political, national and international news. In one area of interest after another, newspapers have therefore lost their "primacy." And, as their audiences have fallen, so has advertising. (Revenues from "help wanted" classified ads – long a huge source of income for newspapers – have plunged more than 90% in the past 12 years.)

Newspapers continue to reign supreme, however, in the delivery of local news. If you want to know what's going on in your town – whether the news is about the mayor or taxes or high school football – there is no substitute for a local newspaper that is doing its job. A reader's eyes may glaze over after they take in a couple of paragraphs about Canadian tariffs or political developments in Pakistan; a story about the reader himself or his neighbors will be read to the end. Wherever there is a pervasive sense of community, a paper that serves the special informational needs of that community will remain indispensable to a significant portion of its residents.

Even a valuable product, however, can self-destruct from a faulty business strategy. And that process has been underway during the past decade at almost all papers of size. Publishers – including Berkshire in Buffalo– have offered their paper free on the Internet while charging meaningful sums for the physical specimen. How could this lead to anything other than a sharp and steady drop in sales of the printed product? Falling circulation, moreover, makes a paper less essential to advertisers. Under these conditions, the "virtuous circle" of the past reverses. The Wall Street Journal went to a pay model early. But the main exemplar for local newspapers is the Arkansas Democrat-Gazette, published by Walter Hussman, Jr. Walter also adopted a pay format early, and over the past decade his paper has retained its circulation far better than any other large paper in the country. Despite Walter's powerful example, it's only been in the last year or so that other papers, including Berkshire's, have explored pay arrangements. Whatever works best – and the answer is not yet clear – will be copied widely.
* * * * * * * * * * * *
Charlie and I believe that papers delivering comprehensive and reliable information to tightly-bound communities and having a sensible Internet strategy will remain viable for a long time. We do not believe that success will come from cutting either the news content or frequency of publication. Indeed, skimpy news coverage will almost certainly lead to skimpy readership. And the less-than-daily publication that is now being tried in some large towns or cities – while it may improve profits in the short term – seems certain to diminish the papers' relevance over time. Our goal is to keep our papers loaded with content of interest to our readers and to be paid appropriately by those who find us useful, whether the product they view is in their hands or on the Internet.

Our confidence is buttressed by the availability of Terry Kroeger's outstanding management group at the Omaha World-Herald, a team that has the ability to oversee a large group of papers. The individual papers, however, will be independent in their news coverage and editorial opinions. (I voted for Obama; of our 12 dailies that endorsed a presidential candidate, 10 opted for Romney.)

Our newspapers are certainly not insulated from the forces that have been driving revenues downward. Still, the six small dailies we owned throughout 2012 had unchanged revenues for the year, a result far superior to that experienced by big-city dailies. Moreover, the two large papers we operated throughout the year – The Buffalo News and the Omaha World-Herald – held their revenue loss to 3%, which was also an above-average outcome. Among newspapers in America's 50 largest metropolitan areas, our Buffalo and Omaha papers rank near the top in circulation penetration of their home territories.
This popularity is no accident: Credit the editors of those papers – Margaret Sullivan at the News and Mike Reilly at the World-Herald — for delivering information that has made their publications indispensable to community-interested readers. (Margaret, I regret to say, recently left us to join The New York Times, whose job offers are tough to turn down. That paper made a great hire, and we wish her the best.)

Berkshire's cash earnings from its papers will almost certainly trend downward over time. Even a sensible Internet strategy will not be able to prevent modest erosion. At our cost, however, I believe these papers will meet or exceed our economic test for acquisitions. Results to date support that belief. Charlie and I, however, still operate under economic principle 11 (detailed on page 99) and will not
continue the operation of any business doomed to unending losses. One daily paper that we acquired in a bulk purchase from Media General was significantly unprofitable under that company's ownership. After analyzing the paper's results, we saw no remedy for the losses and reluctantly shut it down. All of our remaining dailies, however, should be profitable for a long time to come. (They are listed on page 108.) At appropriate prices – and that means at a very low multiple of current earnings – we will purchase more papers of the type we like."

2012 letter to Berkshire Hathaway shareholders

Buffett measures performance by the rate of gain in Berkshire's per-share intrinsic business value, but as he has no way to pinpoint intrinsic value, he uses per-share book value which he believes is an understated proxy for intrinsic value.

This yardstick is meaningless at most companies. At Berkshire, however, book value very roughly tracks business values. That's because the amount by which Berkshire's intrinsic value exceeds book value does not swing wildly from year to year, though it increases in most years. Over time, the divergence will likely become ever more substantial in absolute terms, remaining reasonably steady, however, on a percentage basis as both the numerator and denominator of the business-value/book-value equation increase.

From the Berkshire 2012 annual report: "There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills. This "what-will-they-do-with-the-money" factor must always be evaluated along with the "what-do-we-have-now" calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value. That's because an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company's current value; if the CEO's talents or motives are suspect, today's value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck's or Montgomery Ward's CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton".

Insurance float

Property/casualty insurers receive premiums upfront and pay claims later. This collect-now, pay-later model leaves Berkshire holding large sums ("float") – that will eventually go to others. Though individual policies and claims come and go, the amount of float they hold remains relatively stable in relation to premium volume. Float is invested for Berkshire's benefit. If Berkshire pay out less in losses and expenses than we receive in premiums, they additionally earn an underwriting profit, meaning the float costs them less than nothing. Though they are sure to have underwriting losses from time to time, they've now had 9 consecutive years of underwriting profits.

Cost-free float is not an outcome to be expected for the property/casualty industry as a whole: Buffett doesn't think there is much "Berkshire-quality" float existing in the insurance world. "In most years, including 2011, the industry's premiums have been inadequate to cover claims plus expenses. Consequently, the industry's overall return on tangible equity has for many decades fallen far short of the average return realized by American industry, a sorry performance almost certain to continue. Berkshire's outstanding economics exist only because we have some terrific managers running some extraordinary insurance operations".

Buffett the praise-singer

Part of his Buffett's genius is playing the role of praise-singer of his managers, although I find this does leave a shareholder looking for answers shortchanged.  For instance not a word about the $714m loss at BH Reinsurance, but 12 lines singing Jain's (the boss of BH Reinsurance) praises.  

Regulated, Capital-Intensive Businesses

BNSF & MidAmerican Energy have huge investments in very long-lived, regulated assets, partially funded by large amounts of long-term debt.

Railroads are the circulatory system of the US economy. BNSF invests far more than its depreciation charge (the 3 other major US railroads are making similar outlays).

MidAmerican has a stability of earnings inherent in its exclusively offering an essential service & a diversity of earnings streams, which shield it from the actions of any single regulatory body:

Manufacturing, Service & Retailing Operations

This group of companies sells products ranging from jet airplanes to lollipops.

Earnings on unleveraged net tangible assets

Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12-20%. A few have poor returns, as Buffett "misjudged either the competitive strength of the business being purchased or the future economics of the industry in which it operated". Buffett tries to "look out 10 or 20 years when making an acquisition". If the business will likely be a cash drain over the longer term, or if labor strife is endemic – we will take prompt and decisive action (dispose of it).

Buy commodities, sell brands

"Buy commodities, sell brands" has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886 and Wrigley since 1891. On a smaller scale, Berkshire have enjoyed good fortune with this approach at See's Candy.

Appreciation of depreciation

I like the way that Buffett clearly sets out the depreciation which is included in the operating expenses of these businesses. An appreciation of what depreciation is versus what the true expenses to maintain the business's current level of earnings, is key to calculating owner earnings and valuing a business.

Derivative positions

Though Berkshire's existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, Berkshire will not be initiating any major derivatives positions. They shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with their primary objectives of redundant liquidity and unquestioned financial strength.

Share repurchases

Buffett favours share repurchases when 2 conditions are met:

  1. a company has ample funds to take care of the operational and liquidity needs of its business;

  2. shares are selling at a material discount to the company's intrinsic business value, conservatively calculated. It doesn't suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; Buffett recommends reading his annual letter.

Access to new Berkshire information simultaneously

Buffett believes that all shareholders should have access to new Berkshire information simultaneously and should also have adequate time to analyze it, which is why they try to issue financial information after the market closes on a Friday. They do not talk one-on-one to large institutional investors or analysts.

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