This week Berkshire Hathaway published their investor newsletter. It’s widely read and many people look to the newsletter for clues on how to invest. Warren Buffett and Charlie Munger are legendary in their sustained performance. The company has been conservative and continues to build cash reserves. They haven’t made a major acquisition in nearly 3 years. The part that I noticed in the newsletter has nothing to do with investing, but instead on financial reporting. With the latest changes in GAAP rules, it will become increasingly difficult for investors to make sense of what is happening with a company.
In 2018, Berkshire Hathaway reported 24.8B in operating earnings, a 3B non cash loss from its interest in Kraft Heinz, a $2.8B cash gain on the sale of assets, and a $20.6B loss from a reduction in unrealized capital gains. The net result of all those items is a report of only $4B in net income, down from $44.94B a year earlier. So here’s the problem, the company reported a record in terms of operating earnings, but rather dismal results against GAAP earnings.
A new GAAP rule requires the company to include the a reduction in unrealized capital gains as part of their earnings. Both Warren Buffett and Charlie Munger, believe that rule is silly. They argue that the new rule would produce wild swings in their bottom line.
Let’s look at their quarterly results during 2018. In the first and fourth quarters, they reported GAAP losses of $1.1 billion and $25.4 billion respectively. In the second and third quarters, they reported profits of $12 billion and $18.5 billion. In complete contrast to these gyrations, the many businesses that Berkshire owns delivered consistent and satisfactory operating earnings in all quarters. For the year, those earnings exceeded their 2016 high of $17.6 billion by 41%.
What is Warren Buffet’s advice? Focus on operating earnings, paying little attention to gains or losses of any variety.
So here’s the problem. Investor shave long since had a hard time making sense of corporate financials. The emphasis has been on operating earnings for a long time. But a complete set of financials requires a look at the income statement and the balance sheet. If you ignore the balance sheet, you can hide an awful lot of really important facts about the company in balance sheet transactions.
When you add another layer of noise on top of the accounting to include unrealized gains or losses, it makes the balance sheet virtually impossible to use as a tool. I know why the accounting profession has added this rule. Many companies have avoided making prudent transactions in order to avoid declaring losses. This will force an additional level of transparency. But the quarterly report will cease to be a meaningful trend indicator when you consider the level of stock market volatility. The financial statements will be valid for only a few hours. After that, they will cease to be a meaningful representation of what is happening at a company.
We live in an era of fake news. We have now entered an era of fake financials.
