Shareholder letters are invaluable educational and informational tools for both investors and those interested in understanding a company's operations and financial performance. These letters, often written by CEOs or top executives, provide insights into the company's strategy, challenges, and successes. They offer a transparent view of the company's financial health, explaining complex concepts like earnings, revenue, and market trends in an accessible manner.

Additionally, shareholder letters often share the management's vision and philosophy, making them a rich source of learning for investors who want to understand the nuances of investment decisions and corporate governance. They are also a unique way to gauge a company's culture and priorities, as they often include discussions on ethical considerations, corporate social responsibility, and long-term planning.

Overall, shareholder letters serve as a direct communication channel between the company and its stakeholders, making them an essential read for anyone interested in the financial world.

This year’s Berkshire Hathaway shareholder letter begins with a heartfelt tribute to Charlie Munger, who passed away on November 28, just shy of his 100th birthday. Warren Buffett acknowledges Munger as the architect behind Berkshire Hathaway’s transformation. Munger’s strategic shift from acquiring fair businesses at wonderful prices to buying wonderful businesses at fair prices marked a pivotal change in Berkshire’s investment philosophy. This foundational shift, guided by Munger’s foresight, steered the company towards sustainable growth and long-term value creation. His influence and partnership with Buffett were instrumental, with Munger often acting as a stabilizing force during moments of uncertainty.

One of the interesting arguments that Buffet makes in this year’s letter is the difference between net earnings and operating earnings.

What Are Operating Earnings?

Operating earnings represent the profit a company makes from its core business activities, excluding any income or expenses not directly related to the main operations of the business. This figure is calculated by subtracting operating expenses from gross profit. Operating earnings focus on the profitability of the company’s primary activities, providing insight into how well the core business is performing without the noise introduced by market volatility.

What Are Net Earnings?

Net earnings, also known as net income, represent the total profit of a company after all expenses have been deducted from total revenue. This includes operating expenses, interest, taxes, and any other one-time items. Net earnings are calculated by adding non-operating income and subtracting non-operating expenses and taxes from operating earnings. While net earnings provide a comprehensive view of a company's overall profitability, they can be more volatile due to the inclusion of all financial activities, including unrealized capital gains and losses.

Capital Gains and Their Impact

Capital gains are the profits that result from the sale of a capital asset, such as stocks, bonds, or real estate, when the selling price exceeds the purchase price. They can be classified into:

Realized Capital Gains: Profits from the actual sale of assets.

Unrealized Capital Gains: Potential profits on assets that have increased in value but have not yet been sold, also referred to as "paper gains."

Unrealized capital gains can significantly impact net earnings due to accounting standards that require these gains to be included in the calculation of net earnings. This inclusion can lead to substantial volatility in reported net earnings, making them less reliable for assessing the ongoing performance of a company’s core operations. As Buffet states, “The official annual report begins on K-1 and extends for 124 pages. It is filled with a vast amount of information – some important, some trivial. Among its disclosures many owners, along with financial reporters, will focus on page K-72. There, they will find the proverbial “bottom line” labeled “Net earnings (loss).” The numbers read $90 billion for 2021, ($23 billion) for 2022 and $96 billion for 2023.” But in a testament to Buffet’s commitment to honesty and integrity, he clarifies: “We, however, are left uncomfortable. At Berkshire, our view is that “earnings” should be a sensible concept.. Accordingly, Berkshire reports what we call “operating earnings.” Here is the story they tell: $27.6 billion for 2021; $30.9 billion for 2022 and $37.4 billion for 2023. The primary difference between the mandated figures and the ones Berkshire prefers is that we exclude unrealized capital gains or losses that at times can exceed $5 billion a day.”

Buffett’s Preference for Operating Earnings

Warren Buffett prefers to emphasize operating earnings over net earnings for several reasons:

1. Stability and Predictability:

Operating earnings exclude unrealized capital gains and losses, making them a more stable and predictable measure of a company’s core business performance.

This stability is crucial for long-term investors who are interested in the sustainable profitability of the company’s primary activities.

2. Clarity for Shareholders:

Operating earnings provide a clearer picture of the company’s ongoing operational performance, which is more useful for shareholders focused on the long-term sustainability and profitability of the business.

By focusing on operating earnings, Buffett avoids the misleading effects of temporary market fluctuations on net earnings.

Example from Berkshire Hathaway’s Financials

In the 2023 shareholder letter, Buffett highlights the difference between net earnings and operating earnings:

Net Earnings: Berkshire Hathaway reported net earnings of $96 billion for 2023, which include significant unrealized capital gains from investments. These gains can fluctuate greatly due to market conditions, making net earnings volatile.

Operating Earnings: For the same period, Berkshire reported operating earnings of $37.4 billion. This figure excludes the impact of unrealized capital gains and losses, providing a clearer view of the profitability from Berkshire’s core business operations.

Conclusion: The Importance of Focusing on Core Business Performance

Buffett’s emphasis on operating earnings over net earnings is rooted in his desire for stability, clarity, and a true reflection of the company’s core business performance. By focusing on operating earnings, investors and shareholders can gain a better understanding of the sustainable profitability and growth of Berkshire Hathaway, aligning with Buffett’s long-term investment strategy.

Charlie Munger’s legacy and strategic insights continue to guide Berkshire Hathaway’s financial reporting and investment philosophy, ensuring that the focus remains on the core operations that drive long-term value creation.