Berkshire's "Powerhouse Five" Businesses
Berkshire's five most profitable non-insurance businesses are BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy.
Of these five, Berkshire only owned MidAmerican Energy as of eight years ago. At that time, MidAmerican earned just under $ 400 million pre-tax.
In acquiring the other four businesses since, Berkshire has used mostly cash to do so.
In fact, the company added just 6.1% to shares outstanding as a result of the BNSF deal. Otherwise, the deals were done with cash.
Well, those five businesses earned $ 10.1 billion pre-tax in 2012. Last year, Buffett had said he expected this to happen and, well, it did.
So a rather substantial $ 9.7 billion increase in pre-tax earnings while adding few shares outstanding. More from the letter:
"...the $9.7 billion gain in annual earnings delivered Berkshire by the five companies has been accompanied by only minor dilution.That satisfies our goal of not simply growing, but rather increasing per-share results."
Not all dilution is equal.
Dilution can make sense if it increases per-share value.
Dilution can make sense if investors get at least sufficient value per-share relative to what's being given up in value per-share.
Buffett covers this in the 1982 letter:
"...we will not issue shares unless we receive as much intrinsic business value as we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that."
The above acquisitions, at least in combination, clearly worked out just fine on a per-share basis for investors.
Still, as Buffett explained in the 1997 letter, it's not often going to make sense to use Berkshire's stock as a currency in acquisitions:
"For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event -- except when the team must trade a .380 hitter to make the deal.
Because our roster is filled with .380 hitters, we have tried to pay cash for acquisitions..."
In all too many deals, getting sufficient value in return is hardly the norm. A particular acquisition may result in a larger entity overall, but ends up not necessarily making sense on a per-share intrinsic value basis. In fact, per-share value too often gets destroyed in pursuit of an expanded domain.
Naturally, what a transaction does to intrinsic value on a per-share basis is ultimately what matters to investors.
Page 104-105 of the 2012 Annual Report provides an explanation of the elements that Buffett thinks should go into an - even if necessarily imprecise -- estimate of Berkshire's intrinsic value.*
Two of the elements are quantitative:
- Investments in stocks, bonds, and cash. These investments are funded by retained earnings and "float". If Berkshire ends up breakeven on insurance underwriting that float is free. Of course, over their history they've generated underwriting profits so those funds have actually been better than free. (That means they've, in fact, been paid to hold the money.) Well, if Berkshire is just breakeven going forward on their insurance underwriting results, then the investments can be considered an element of value. Key measure: per-share value of investments.
- Earnings that come from sources other than investments and insurance underwriting. Key measure: per-share earnings from non-insurance businesses.
One element is not:
- How well will Berkshire's retained earnings be deployed over time. That's, of course, necessarily more subjective, difficult to measure, yet hardly unimportant.
Berkshire's "Big Four" Investments
American Express (AXP), Coca-Cola (KO), IBM (IBM) and Wells Fargo (WFC).
Berkshire's ownership interest in each increased during the year. That happened even though they purchased additional shares of only two of them:
"We purchased additional shares of Wells Fargo (our ownership now is 8.7% versus 7.6% at yearend 2011) and IBM (6.0% versus 5.5%). Meanwhile, stock repurchases at Coca-Cola and American Express raised our percentage ownership. Our equity in Coca-Cola grew from 8.8% to 8.9% and our interest at American Express from 13.0% to 13.7%."
Buffett then makes the following point:
"At Berkshire we much prefer owning a non-controlling but substantial portion of a wonderful business to owning 100% of a so-so business. Our flexibility in capital allocation gives us a significant advantage over companies that limit themselves only to acquisitions they can operate."
Berkshire's portion of the "Big Four's" 2012 earnings was $ 3.9 billion but a whole lot less than that $ 3.9 billion shows up on Berkshire's income statement. That doesn't make them any less real from a business economics point of view:
"In the earnings we report to you, however, we include only the dividends we receive – about $1.1 billion. But make no mistake: The $2.8 billion of earnings we do not report is every bit as valuable to us as what we record.
The earnings that the four companies retain are often used for repurchases – which enhance our share of future earnings – and also for funding business opportunities that are usually advantageous. Over time we expect substantially greater earnings from these four investees. If we are correct, dividends to Berkshire will increase and, even more important, so will our unrealized capital gains (which, for the four, totaled $26.7 billion at yearend)."
Buffett later points out that, since 1970, Berkshire has increased per-share investments 19.4% annually while increasing per-share earnings 20.8% annually. In the letter Buffett points out:
"It is no coincidence that the price of Berkshire stock over the 42-year period has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both areas, but our strong emphasis will always be on building operating earnings."
An important part of Berkshire's advantage, of course, is the generally costless (in fact, often better-than-costless) and enduring float they get from the insurance businesses. As mentioned above, what ends up essentially being free money if they can just breakeven on underwriting.
Well, for the tenth consecutive year they had an underwriting gain. More on that in a follow-up.
* Initially this was covered in the 2010 Annual Report (pages 6 and 7 of the letter).