Buffett puts the last nail in the coffin of book value


Warren Buffett, head of fantasy investing at insurance conglomerate Berkshire Hathaway, released his annual letter to investors on Saturday.

Amid the traditional market commentary, there was one particularly revealing passage about a financial metric value-oriented investors have sworn in for the past fifty years: book value.

Of the letter [with out emphasis]

Long-time readers of our annual reports will have noticed the different way I opened this letter. For nearly three decades, the original paragraph presented the percentage change in Berkshire’s book value per share. Now is the time to give up this practice.

The point is, the annual change in Berkshire’s book value – which makes its farewell appearance on page 2 – is a metric that has lost the relevance it once had. Three circumstances did it. First, Berkshire has gradually transformed from a company whose assets are concentrated in marketable stocks to a company whose primary value lies in operating businesses. Charlie and I expect this remodeling to continue on an irregular basis. Second, while our equity holdings are valued at market prices, accounting rules require that our collection of operating companies be included in the book value at an amount much less than their present value, an error that has become more pronounced. these last years. Third, it is likely that over time Berkshire will be a significant buyback of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The calculation of these purchases is simple: each transaction increases the intrinsic value per share, while the book value per share decreases. This combination causes the book value scorecard to become increasingly disconnected from economic reality.

In the next tables of our financial results, we plan to focus on the Berkshire market price. The markets can be extremely temperamental: just look at the 54 year history shown on page 2. Over time, however, the Berkshire stock price will provide the best measure of trading performance.

It’s hard to overstate how important this is a change from Buffett and his longtime partner, and king of snark, Charlie Munger, and what that means for the centuries-old tradition of value investing.

Consider Buffet’s formal business education. In his early teens, having already mastered the basics of newspaper trading and peddling Coca-Cola door-to-door, Buffett discovered the investing writings of a small New York fund manager. called Benjamin Graham.

Graham, like many investors of his generation, was marked by the stock collapse between 1929 and 1932, in which the Dow Jones fell nearly 90% as the Great Depression brought the US economy to its knees. .

Many of the high-flying growth stocks of the 1920s, such as Radio Corporation of America and International Match, collapsed as the promise of high future earnings dwindled with employment and the availability of credit. To counter this, Graham developed a style of investment analysis that focused first and foremost on capital retention. Extract from his book The Smart Investor:

An investment transaction is an operation which, after careful analysis, promises security in principle and an adequate return. Transactions that do not meet these requirements are speculative.

One of the ways Graham sought to do this was to measure a company’s book value, defined as the money left over after a company’s assets were liquidated and debt paid off. If you could find a stock below that number, at a book price below 1, then it was a relatively safe investment. And, in the 1930s, an era of information scarcity and stock market desperation, these companies were a dime a dozen.

Buffett became addicted to Graham’s writing, consuming his investment book Security Analysis (written with Professor David Dodd) several times before enrolling in Colombia’s MBA in the early 1950s where Graham taught a class of same name.

So Buffett didn’t just grow up on book value: it ran through his blood. After its insane success (in part due to a one-time rise in stocks in a generation), the sidekicks followed, seeking to build on the Graham and Dodd mantra of buying a stock below its immediate and achievable value.

Book value, like many investment measures, has always had its limits. It fails to capture intangible assets (like brand value or intellectual property) that are either invisible or undervalued on balance sheets, and it becomes less relevant as the economy grows larger. more deindustrialized, digitized and service-oriented, reducing the need for companies to own durable goods such as factories, real estate and machinery.

But recently this has not only lost its relevance as a measure, but also as the basis of an investment style. Check out this chart from FT’s ‘quant king’ Robin Wigglesworth on how Russell 3000 growth stocks have performed against value stocks since the financial crisis:

This underperformance has sparked a lot of soul-searching from the value investing community. However, the value ‘factor’ has had a losing streak several times before, as Blackrock’s Andrew Ang pointed out in an excellent blog post last year. Fortunes reversed soon after.

The idea that Graham and Dodd are dead has a checkered history, CNBC’s Jim Cramer (and Alphaville’s favorite) made the same point at the height of the dot-com bubble in 2000.

But it looks different.

For Warren Buffett, giving up investing in value is as if the Pope is renouncing his faith: an act so great that it is important enough to provoke a crisis of faith even among the most committed of the faithful.

Some might argue that Buffett has long abandoned investing in value versus book price. After all, he owns Coca-Cola, Apple, Oracle, and American Express – businesses with few tangible assets. But doing something different is one thing, and saying it is another.

Although, let’s note, Buffett’s move to “intrinsic value” appears to allow Berkshire to buy back its shares at a higher price. Previously, Buffett had said Berkshire would only repurchase its shares at around 1.2 times book value. Following this renunciation, it is now out the window.

So maybe it’s not about dropping a metric at all. Rather, it could be an attempt to transform Berkshire’s status as a financial services company, with a stock portfolio, into an industrial conglomerate. With a conglomerate, of course, comes financial engineering. So, after more buyouts, will we finally see a breakup? The door is now ajar.



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