Buffett 2018 — "We are gloriously lucky to have that force at our back"

The headline number from Berkshire's 2018 annual report is $4 billion — GAAP net income for the year. Buffett spent the letter's opening paragraphs explaining why that figure is nearly meaningless, and why investors should largely ignore it going forward. That kind of pre-emptive disclaimer, applied to one's own reported earnings, is unusual enough in corporate America to warrant attention on its own terms. 1

But the $4 billion is not what will be quoted from this letter in twenty years. That distinction belongs to a short essay tucked near the end, in which Buffett revisits his very first investment — $114.75 spent in March 1942, when he was eleven years old — and traces what would have happened to it if he had simply bought an index fund and never touched it. The answer is $606,811, as of January 31, 2019. A 5,288-fold return, delivered not by genius but by patience and a nation that kept compounding.

The 2018 letter is built around three related arguments: that accounting rules now require Berkshire to report numbers that actively mislead investors about the business; that the right yardstick — per-share book value — has lost the relevance it once had; and that underneath all the accounting noise, the actual engine running Berkshire has never been stronger. Operating earnings reached $24.8 billion, a 41% improvement over the 2016 record, achieved while the stock portfolio produced a reported loss on paper. 1

A change in U.S. accounting standards took effect in 2018, requiring companies to mark their equity holdings to market through the income statement each quarter. For most corporations, this is a modest inconvenience. For Berkshire, which held a $173 billion equity portfolio, it turned the income statement into a document of almost pure noise. 1

The 2018 GAAP figures broke down as follows:

The $20.6 billion subtraction — the line that turned a $24.8 billion operating year into a $4 billion reported year — reflects nothing more than the fact that Berkshire's stock portfolio fell in value during 2018's volatile fourth quarter. No business was sold. No capital was lost. The portfolio simply declined on paper, and the new rule required that decline to flow through earnings. 1

The quarterly picture makes the distortion even more vivid. In Q3, when markets rose, Berkshire reported a GAAP profit of $18.5 billion. In Q4, when they fell, it reported a GAAP loss of $25.4 billion. The underlying businesses produced consistent, satisfactory results in every quarter. Buffett had flagged this rule in the 2017 letter, calling it not sensible. Having now lived through it for a full year, he was direct: "Wide swings in our quarterly GAAP earnings will inevitably continue." 1 His prescription to investors was to focus on operating earnings and pay little attention to gains or losses of any variety.

Buffett's position amounts to this: the official required measure of his company's performance is a figure he has instructed shareholders to ignore. This is not the complaint of a manager trying to escape accountability. Berkshire's operating earnings were fully disclosed and historically high. The objection was to a new rule that required the merging of two genuinely different things — the cash-generating capacity of owned businesses, and the daily price fluctuations of a $173 billion portfolio — into a single reported number that captures neither clearly.

The 2018 letter announced something that had been coming for several years: the official retirement of per-share book value as Berkshire's primary performance metric. For nearly three decades, every Berkshire annual report opened with a table comparing per-share book value growth against the S&P 500. That table made its "farewell appearance," as Buffett put it, on page 2 of the 2018 report. 1

The retirement was not sentimental. Buffett gave three reasons, each structural:

First, Berkshire has transformed from a company concentrated in marketable stocks — where book value closely tracked intrinsic value — into a conglomerate whose major value resides in operating businesses. Those businesses appear on the balance sheet at historical cost, not at what a willing buyer would pay today.

Second, accounting rules require that operating subsidiaries be carried at book values far below their current economic worth. BNSF (Berkshire's transcontinental railroad) and Berkshire Hathaway Energy, for instance, generate combined pre-tax income of roughly $9.3 billion annually. 1 Their book carrying values bear no reasonable relationship to that earnings power.

Third, and most counterintuitive: future share repurchases conducted at prices above book value but below intrinsic value will cause per-share book value to decline while per-share intrinsic value rises. A metric that moves in the wrong direction when value-creating repurchases occur has outlived its usefulness.

For the record, the final tally from the departing table: $1 in 1964 grew to $10,920 in market value by year-end 2018 — a compounded annual gain of 20.5%. The S&P 500 with dividends reinvested gained 9.7% annualized over the same period. 1

With book value retired, the 2018 letter offered something to replace it — not a single metric but a framework. Buffett described Berkshire as a forest containing five distinct groves, each of which can be valued approximately but whose aggregate worth exceeds what any sum-of-parts analysis would suggest. 1

The five groves, with their 2018 figures:

All figures from the 2018 Annual Report. 1

The framework's contribution is conceptual as much as numerical. Berkshire's float — the $122.7 billion in insurance premiums collected but not yet paid out as claims — shows up as a liability on the balance sheet, not as an asset. As a result, book value systematically understates Berkshire's economic position. The float earns investment returns while it sits on Berkshire's books; and as long as insurance underwriting remains profitable, Berkshire is, in Buffett's words, being paid to hold it. In 2018, Berkshire posted an underwriting profit of $2 billion, its 15th profitable underwriting year in 16 attempts. 1

The float chart, now updated through 2018:

Berkshire insurance float, 1970–2018. 1

Buffett's summary of what the five-grove structure actually enables: "At Berkshire, the whole is greater — considerably greater — than the sum of the parts." 1 The conglomerate can redeploy cash from one grove to another without tax friction, can self-insure across its operations, and can keep $132 billion in reserve as an opportunistic war chest without the carrying cost that would cripple a conventional firm.

The moral center of the 2018 letter is a two-page essay near the end, in which Buffett traces the arc of his first investment. In March 1942, at eleven years old, he spent $114.75 to buy three shares of Cities Service preferred stock (a large Oklahoma oil company) — his entire savings. 1

The exercise he runs from that starting point is not about his own career. It is about the simplest possible decision: buying an index fund, reinvesting the dividends, and leaving it alone.

If that $114.75 had been placed in a no-fee S&P 500 index fund on the day he made his first investment, it would have been worth $606,811 by January 31, 2019 — a return of more than 5,000-fold over 77 years. A $1 million institutional investment made the same way would have grown to roughly $5.3 billion. 1

For comparison: the same $114.75 invested in gold — then the preferred alternative for those skeptical of American enterprise — would have purchased roughly 3.25 ounces of the metal. By early 2019, those ounces were worth about $4,200. As Buffett put it: "The magical metal was no match for the American mettle." 1

The essay's argument is structural, not sentimental. The 77 years that produced this result included seven Republican presidents and seven Democratic presidents. They included long stretches of inflation, a period when the prime lending rate reached 21%, the Vietnam War, the savings and loan crisis, the dot-com collapse, September 11, the 2008 financial crisis, and multiple recessions. Buffett's point is that none of these events altered the fundamental trajectory because none of them fundamentally altered the American capacity to produce and innovate.

He drew two conclusions, one modest and one that borders on rebuke:

The modest conclusion: "We are lucky — gloriously lucky — to have that force at our back." Berkshire's success, he wrote, has been substantially a byproduct of American prosperity rather than a product of any singular genius at its helm.

The rebuke: "It is beyond arrogance for American businesses or individuals to boast that they have 'done it alone.' The tidy rows of simple white crosses at Normandy should shame those who make such claims." 1

The essay closes with a quotation from the epitaph of Christopher Wren, the architect of St. Paul's Cathedral in London: Si monumentum requiris, circumspice — "If you seek his monument, look around you." Buffett applied it to anyone inclined toward pessimism about America's future: the monument is already visible, if you care to look.

On accounting noise. The new GAAP mark-to-market rule did not change the way Berkshire's businesses operate. It changed only how those operations are reported. For companies with large equity portfolios, the lesson from 2018 is that reported earnings — which swung from a $25.4 billion loss in Q4 to a $18.5 billion gain in Q3 — can tell you almost nothing about business performance. Operating earnings, which are less glamorous and get less media coverage, are the figure worth tracking. The Berkshire case makes this point vividly, but the same principle applies to any holding company or financial firm with significant mark-to-market exposure.

On the buyback test. The 2018 letter contains Buffett's clearest statement of when repurchases create value: when shares trade at a discount to intrinsic value, buying them is mathematically equivalent to purchasing an entire business at a below-fair-price. "If the market prices a departing partner's interest at 90 cents on the dollar," he wrote, continuing holders capture the difference. 1 The flip side is equally clear: "Blindly buying an overpriced stock is value-destructive, a fact lost on many promotional or ever-optimistic CEOs." The same test that makes a good buyback good is the one that makes a bad buyback destructive, and the distinguishing factor is price relative to intrinsic value — not earnings per share impact, not market expectations, not analyst ratings.

On the invisible earnings. Buffett's table of five major investees' retained earnings is worth reviewing carefully. GAAP requires Berkshire to report only dividends received from these holdings — roughly $3.0 billion in 2018. But the retained earnings attributable to Berkshire's stakes totaled $6.8 billion, more than double the dividends. 1 These retained earnings are invisible in the income statement but not in the stock price over time. Investors who evaluate holdings only by dividend yield are systematically undercounting the value being accumulated inside the companies they own.

On the tailwind thesis. The $114.75 calculation is a reminder about the base rate before any selection skill enters the picture. Buffett has beaten that base rate substantially. His argument is not that you don't need skill — it is that even without skill, exposure to American enterprise over long time horizons has historically been sufficient to build wealth. The implication for most investors is the same one embedded in his ten-year bet conclusion and his 2017 risk discussion: the largest enemy of long-term returns is not volatility or recession. It is the costs and frictions that compound annually, turning a reasonable gross return into a disappointing net one.

The 2018 letter was published on February 23, 2019. It is the year Berkshire officially stopped measuring itself with the book-value yardstick it had used since the 1960s, the year the new accounting rule converted a record operating year into an ostensibly modest one, and the year Buffett wrote the clearest version of a case he has been building for decades: that the foundational investment decision — trusting American enterprise over a long enough horizon — requires no particular skill and yet has almost always been enough. In 2018, Apple displaced Wells Fargo as Berkshire's largest single equity holding, with 255.3 million shares worth $40.3 billion. The float crossed $122.7 billion. Cash stood at $132 billion, with Buffett noting that "prices are sky-high for businesses possessing decent long-term prospects" and that he was still waiting for what he called, with characteristic self-awareness, a purchase large enough to make his pulse rate soar. 1