BRK 2024 Annual Report and Stuff

First of all, just some follow-up comments from my recent posts. Judging from the comments that came in about MKL, it makes me wonder if BRK is going to be a white knight (assuming it becomes necessary). Why would BRK expend capital on an underperformer? Does MKL need to be “saved”?

BRK did buy Alleghany in 2022. As a reminder, it was initiated by Buffett. Here is the snip from the merger proxy. By the way, merger proxies are always fun to read so I strongly recommend people spend time reading them, especially in industries they follow. The background of the merger can be interesting, as well as the valuation section, even though one can’t take too seriously work that is meant to justify a valuation to shareholders. But it can still be interesting to look at.

Here is the comparative valuation analysis for Y at the time:

$850 is 1.26x the above-referenced BPS of $673.39. Of course, BRK paid a premium price to the pre-announcement stock price. Here is that part of the analysis:

$850/share for Y was a 26% premium. So you can go and do the math for what it might take for BRK to get MKL, if they do. You can argue Y was doing solidly but certainly not outperforming the S&P 500 at the time. Here is the performance chart from their last 10-K:

It’s likely that Buffett really liked what he saw in the insurance business, and that may have been what this deal was about, as that is the most important for him. BRK / Buffett can handle the investments, but I guess what they want are strong businesses. So maybe past performance of the stock due to conservatism is not an issue. Of course, the price was also obviously attractive (or else the deal would not have happened!).

By the way, I asked ChatGPT what MKL would be worth in a takeover. It showed a chart of MKL’s stock price, mentioned the total market cap, and then:

“In the event of a takeover, the acquisition price would typically be based on this market capitalization, though it could be higher or lower depending on various factors such as strategic value, synergies, and negotiations between the acquiring and target companies.”

Pretty lame. Maybe investment banker jobs are safe for now.

By the way, in the MKL discussion, someone mentioned Fairfax. Yes, Fairfax has done really well in the past few years after a ‘disastrous’ run. The biggest mistake was hedging their equity exposure and losing out during a huge rally (tried to time the market!). The deflation trade was a big distraction, but didn’t really cost them all that much economically. I just read through the annual reports over the past three years, and it is amazing what they’ve achieved, growing in the insurance business. India, actually, looks more interesting than anything else. I do own both Fairfax and Fairfax India. Fairfax India looks really interesting but the biggest flaw / problem for BRK-heads like us is that Fairfax will get 20% of any profits (above 5%), so they price their investment management like a hedge fund. Obviously, something like that will make it hard for the stock to trade up to intrinsic value.

Anyway, here is the updated table including Fairfax. I used the adjusted stock price of FRFHF for simplicity:

Watsa still says he will never invest in technology (what was Blackberry?). This is the sort of dogma that I think can be unhelpful. I can understand not wanting to invest in, say, semiconductors, which is a very capital intensive, cyclical business. But as we keep talking about here, as more and more industries become tech-driven, move online etc., how can you ignore it? Go back 100+ years, and imagine you avoid anything related to the industrial revolution and the technology of the day? But OK, this is all personal preference, and surely, there are people out there doing well with no tech exposure at all.

Mag 7 Capex

We also talked about the $80-100 billion capex that MSFT, GOOG and others are doing. Won’t this make them capital intensive businesses and lower their returns on capital? This is a valid question, and I was curious so I took a look at some numbers. GOOG said they depreciate their servers over 6 years, and I think GOOG or MSFT said that half of their capex is going to longer term assets than servers; land and buildings to build data centers, for example. Pichai or Nadella also pointed out in the recent conference call that these servers/assets are fungible, so they can be used to support any number of businesses.

MSFT and GOOG had EBIT/Net PPE of 80% and 65%, respectively, in their most recent fiscal years. Nice, solid figures. Now, assuming they invest $75 billion and $100 billion respectively in capex, and they have similar depreciation AND their EBIT doesn’t change at all, it remains the same, except for the higher depreciation (so their EBIT will actually be lower), their EBIT/net PPE after this year would be 56% and 42% respectively, so a big move down in return on PPE. 80% -> 56% for MSFT, and 65% -> 42% for GOOG. But, remember, this is assuming flat earnings, or lower earnings including the new depreciation. That’s a pretty harsh assumption for these guys who have been growing steadily for a while. But when you consider the monumental scale of the investment, and the harsh assumption of no new EBIT coming from it and no growth from existing businesses, these figures are not bad at all; these are still pretty high returns. Also, keep in mind, some of us are surprised at the huge capex figures, but they have been increasing a lot over time, so it’s not like anyone is going from $20 billion capex to $100 billion in a year.

I also looked at EBIT/net PPE over time. I’m too lazy to give you a complete table so I just looked at 2014 and 2019 (to avoid the Covid distortion in 2020).

EBIT/net PPE for MSFT was 215% and 119% in 2014 and 2019.

The same for GOOG was 55% and 46% in 2014 and 2019.

You will notice that for GOOG, their EBIT/net PPE was always in this range, and that makes sense as they require an enormous amount of server/data center capacity to run their search engines, Google Workspace, YouTube etc. Whereas the EBIT/net PPE has come down a lot for MSFT and this makes sense too as they used to be a software provider; they didn’t really need much in terms of servers/data centers. They just created a software product, had it manufactured (for cheap) and sold at a nice fat margin with almost zero marginal cost. Once they started Azure, Windows 365 and other cloud businesses, of course, their returns on capital started to come down to where GOOG is, and AMZN. I left out AMZN because all those delivery trucks and distribution centers will make it hard to compare with the rest of the Mag 7.

Anyway, the conclusion from all of this is that, yes, all this capex makes these businesses more and more capital intensive, but for the folks like GOOG, it has always sort of been capital intensive.

Back to BRK

OK, so back to the BRK annual report. It’s interesting that Buffett points out to people that most of BRK’s assets is still in equities. I pointed this out years ago, and will try to illustrate it again. But below, he explains he is still very invested and also talks about how equities is sort of an inflation hedge. I know he’s talked about how inflation is not good for stocks, but over time, and through cycles, it is an inflation hedge. That’s what he says below.

BRK has $650 billion in shareholders’ equity, and $272 billion is invested in stocks. Sure, that looks low, but a lot of BRK net worth is tied up in equity of their wholly-owned/consolidated and equity-method investments. For example, the Railroad, Utilities and Energy segment has equity of $130 billion. That’s as much ‘equity’ as stocks (but just not marked to market every day). That brings up the total equity exposure to $402 billion.

The last time the Manufacturing, Services and Retail had their own balance sheet reported was in 2016, and then, it was $92 billion. It is probably much higher than that now due to acquisitions since then. But let’s just say it’s $92 billion. Add that and we get to $494 billion.

And then there are the equity method holdings like KHC and OXY. Just because they are not included in stock holdings section does not make them any less ‘equity’. Together, they’re on the books at $31 billion, so that takes us up to $525 billion. Yes, market value is lower than that, but since we are comparing this to book value, we will use carrying value. That’s already 80% of BRK’s shareholders equity exposed to equity. Not quite the conservatism you would imagine from the $300+ billion of cash on the books.

There are probably some things I missed, but BRK is exposed to ‘equity’ by more than what you see in the Investments in equity securities. Plus, we don’t typically look at BRK this way, but if you look at net cash, the amount is very low (deduct all current liabilities of $311 billion from cash and cash equivalents), which implies a very normal level of leverage to ‘equity’. Of course, we can argue all day about this or that item in current assets/liabilities, but this is just a quick, mechanical way of looking at it.

Mistakes Fade Away

By the way, it was interesting to see this comment in the annual report, which sort of reminds me of the story I told in a recent post; my friend who got rich just buying stocks and never selling. He didn’t care about the dogs. I guess in Buffett’s words, those mistakes just fade away. And the few big winners he had made him rich.

Of course, this doesn’t mean one should just go out and buy all sorts of crap, hoping something will become a winner.

This reminds me of another story. I remember talking to a special situations analyst doing a lot of work on merger arb, stubs, index additions/deletions and other things like that. I asked him about index additions/deletions as that used to rock the markets long way back and we had some index positions in our trading book. And he said his studies show that, yes, stocks added to major indices do outperform the index, but so do the ones that were dropped (after the initial post-announce fall). So he said, the strategy is to actually, not only buy the new added stock, but the dropped one too (I forgot if he said to buy the dropped name on the effective date of the deletion). I wonder what a portfolio like that would look like over the past 20 or 50 years… past 100 years… Of course, some of the dropped names would probably end up going bust, but maybe a few of those winners would more than make up for it.

What Does Buffett Expect the Market To Do?

Buffett, of course, has no idea what the market will do, but he is, as usual, bullish America. We all try to read into his actions. I am still looking at the column for Investments in fixed maturity securities, and it went down from $24 billion to $15 billion, so obviously, he still hates bonds, even at close to 5%. He was not even nibbling.

He didn’t sell any AAPL in the most recent period, so is he OK with the valuation? He is happy with 32-35x P/E? Of course, the fact that he is not selling does not mean he would buy here. Selling requires a little bit of a hurdle, right? The hassle to sell, pay taxes etc. Buffett mentioned Moody’s (MCO), which trades at 44x trailing, and 35x ntm earnings, and he still owns it. Of course, this does not mean one should buy these stocks at these valuations, but maybe these valuations aren’t the “What was I thinking?” (KO) prices for Buffett. But I don’t know. Let’s not all start buying these stocks at these levels assuming Buffett approves!

But there is another place to look for what Buffett might be thinking about the markets. I remember he shook his head at the major corporations who had pension disclosures with expected LT returns of 10-12% or maybe it was 8-10%. That got me curious about what BRK has been saying in that section in the recent past. I don’t know much about accounting/disclosure rules, but I can’t seem to find this info going back to the 80s and 90s. So here is a table of it from 2005 on (too lazy to do every year, so I did every five years instead… this stuff shouldn’t change all that much year to year…).

What comes out of the 10-K’s is the top two areas, the discount rate/return assumptions and assets. The % invested in equities and 10-year interest rates, I just put there for reference. You can make of it what you will.

Buffett said long ago that the return on the S&P 500 index is basically the dividend yield plus the nominal economic growth rate. With the dividend yield at 1.1%, and nominal GDP growth over time expected to be around 4-5%, that gets the S&P return to around 5.1-6.1%. With interest rates under 5%, is he expecting a higher return on the equity portfolio?

OK, this is getting a little silly, trying to read too much into things.

Buffett Slowing Down

At the end of the letter, as usual, Buffett talks about the annual meeting, and surprisingly (or not), the Q&A will end at 1:00 pm instead of 4:00 pm. But the net time of taking questions is not 3 hours shorter as the Q&A will start an hour earlier, and the break will be 30 minutes instead of an hour for lunch. So we are going from a 5 hour 45 minutes Q&A session to 4 hours and 30 minutes.

The other thing that might have surprised me more was something recently in the press when Buffett was asked a question, and he said at his age, bridge is not the only thing they have to slow down for him. Meaning, he can’t keep up in a regular-paced bridge game? I don’t know anything about bridge, but that was a little shocking to me. I didn’t really know that his mental capacity, his ability to process information was slowing. Of course, at age 94, all sorts of things happen. This may not be an issue for purposes of investing, but I guess we have to assume he is going through a lot less material than he used to.

Anyway, OK, that’s enough for now. I may have more to say and write about is we start to get more annual reports coming out over the next few weeks.