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Berkshire Hathaway Inc. (NYSE: BRK-A) has released its annual report, and the results from the fourth quarter are putting dark clouds over Warren Buffett’s annual letter to shareholders. Berkshire Hathaway’s shares have been underperforming the broader market of late. And some big losses in the key stocks have not helped matters. At stake here was much more than just an earnings report for Berkshire Hathaway. There are some big changes that Buffett watchers should take note of.

Buffett has warned shareholders for years that the company’s book value per share matters to him much more than any quarterly or annual earnings per share results. He has pointed to the initial paragraph opening about book value per share for nearly three decades, but the 2018 report says that it’s now time to abandon that practice as the metric has lost the relevance it once had. Buffett’s annual letter, which was very difficult to get because the Berkshire Hathaway website couldn’t handle the traffic, said in bold: “Focus on the Forest – Forget the Trees.”

Investors need to be paying attention to what is happening inside Berkshire Hathaway’s investment portfolio to get a feel for what’s happening here. This week’s major bombshell report from Kraft Heinz Co. (NASDAQ: KHC) helped create a 2% loss on Friday, despite the broader market rally, as Berkshire Hathaway is a huge shareholder, along with 3G. Buffett and his team also had taken a beating on Apple Inc. (NASDAQ: AAPL), and Buffett gradually has pared down his massive stake in Wells Fargo & Co. (NYSE: WFC) and adding in additional stakes of Bank of America Corp. (NYSE: BAC), JPMorgan Chase & Co. (NYSE: JPM) and other large banks. Unfortunately, Buffett’s famous stock holdings took a beating with the market in late 2018, with his 13F filing with the SEC (the Buffett stocks) having a $221 billion balance as of September 30, 2018 — dropping down to $183 billion as of December 31, 2018.

Of the top equity holdings by gains, Berkshire Hathaway’s 2018 year-end balances were impressive, and it’s one reason that Buffett has been considered one of the greatest long-term investors of the modern era. Those 15 positions (from dozens of overall equity positions) had a purchase value of $102.867 billion and a marketable value at the end of 2018 as $172.757 billion.

Before getting into the tempo of Buffett’s annual letter to shareholders, it’s important to consider some issues from the earnings report. Berkshire Hathaway’s fourth quarter of 2018 brought a net loss attributable to shareholders of $25.392 billion, versus fourth quarter of 2017 earnings of $32.551 billion. And for all of 2018, Berkshire Hathaway’s net income was just $4.021 billion, compared with net income of $44.94 billion for all of 2017.

To show just how much the investments dragged down the numbers here, note that Berkshire Hathaway’s operating earnings from its actual companies and subsidiaries was $5.72 billion in the fourth quarter of 2018, versus $3.338 billion for the fourth quarter of 2017. And the annual numbers were better on operating earnings as well, with operating income of $24.781 billion in 2018 over $14.457 billion in 2017. Again, it’s the huge stock holdings as a drag. The earnings report even said:

In the table (above), investment gains (losses) in 2018 include losses of approximately $28.5 billion in the fourth quarter and approximately $20.6 billion for the full year of 2018 from a reduction in the amount of unrealized gains that existed in our equity security investment holdings and are net of taxable gains on sales of investments of approximately $460 million in the fourth quarter and approximately $2.8 billion for the full year. In 2017 and in prior years, while changes in unrealized gains/losses were reflected in our shareholders’ equity, they were not included in our earnings statements.

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Now it’s time to get back to focusing on the forest and forgetting the trees in Buffett’s annual letter to shareholders.

On why the book value metric is being abandoned, or at least the public communication that the rationale, Buffett is communicating that Berkshire Hathaway has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses. Two additional reasons:

While our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years. … [And] it is likely that – over time – Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value.

It’s that last part that matters. There had been a rough estimate circulating on Wall Street that Berkshire Hathaway may have repurchased some $2 billion worth of its own shares after Buffett and Charlie Munger loosened the criteria for when the company could buy back its own stock. The company appears to have spent a little more than $400 million on buybacks in the fourth quarter, less than expected and less than in the third quarter, despite a declining share price. On that final matter of stock buybacks, Buffett clarified:

The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality.

It has been several years since Buffett made a “whale of a deal,” buying another major operating company. Buffett’s letter points to buying stocks in instances over entire companies:

Many stocks have offered far more for our money than we could obtain by purchasing businesses in their entirety. That disparity led us to buy about $43 billion of marketable equities last year, while selling only $19 billion. Charlie and I believe the companies in which we invested offered excellent value, far exceeding that available in takeover transactions. … As noted earlier, our equity investments were worth nearly $173 billion at yearend, an amount far above their cost. If the portfolio had been sold at its yearend valuation, federal income tax of about $14.7 billion would have been payable on the gain. In all likelihood, we will hold most of these stocks for a long time. Eventually, however, gains generate taxes at whatever rate prevails at the time of sale. … All of our major holdings enjoy excellent economics, and most use a portion of their retained earnings to repurchase their shares. We very much like that.

Buffett still has plenty of cash outside of the value of his and his portfolio managers’ equity investments to make an acquisition if the opportunity arises. The letter showed that Berkshire held $112 billion at year-end in U.S. Treasury bills and other cash equivalents, plus another $20 billion in miscellaneous fixed-income instruments. He maintained his stance on the $20 billion cash floor:

We consider a portion of that stash to be untouchable, having pledged to always hold at least $20 billion in cash equivalents to guard against external calamities. We have also promised to avoid any activities that could threaten our maintaining that buffer.

Berkshire will forever remain a financial fortress. In managing, I will make expensive mistakes of commission and will also miss many opportunities, some of which should have been obvious to me. At times, our stock will tumble as investors flee from equities. But I will never risk getting caught short of cash.

In the years ahead, we hope to move much of our excess liquidity into businesses that Berkshire will permanently own. The immediate prospects for that, however, are not good: Prices are sky-high for businesses possessing decent long-term prospects.

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Buffett also has signaled that he and Munger (and his additional portfolio managers) likely will be larger buyers of public equities in 2019 rather than making a whale of a deal to buy entire companies at higher prices:

That disappointing reality means that 2019 will likely see us again expanding our holdings of marketable equities. We continue, nevertheless, to hope for an elephant-sized acquisition. Even at our ages of 88 and 95 – I’m the young one – that prospect is what causes my heart and Charlie’s to beat faster. (Just writing about the possibility of a huge purchase has caused my pulse rate to soar.)

My expectation of more stock purchases is not a market call. Charlie and I have no idea as to how stocks will behave next week or next year. Predictions of that sort have never been a part of our activities. Our thinking, rather, is focused on calculating whether a portion of an attractive business is worth more than its market price.

Buffett further addressed his non-insurance businesses under the Berkshire umbrella as being the most valuable grove in the forest. Buffett said:

Viewed as a group, these businesses earned pre-tax income in 2018 of $20.8 billion, a 24% increase over 2017. Acquisitions we made in 2018 delivered only a trivial amount of that gain. … But our after-tax gain in 2018 from these businesses was far greater – 47% – thanks in large part to the cut in the corporate tax rate that became effective at the beginning of that year. Let’s look at why the impact was so dramatic. … Our two towering redwoods in this grove are BNSF and Berkshire Hathaway Energy (90.9% owned). Combined, they earned $9.3 billion before tax last year, up 6% from 2017. … Our next five non-insurance subsidiaries, as ranked by earnings (but presented here alphabetically), Clayton Homes, International Metalworking, Lubrizol, Marmon and Precision Castparts, had aggregate pre-tax income in 2018 of $6.4 billion, up from the $5.5 billion these companies earned in 2017.

Buffett also showed specifics about the property and casualty insurance operations have grown. He showed the float had increased to $122.73 billion by the end of 2018, up from $65.83 billion in 2010 and $27.87 billion in 2000. That float comes from a “collect-now, pay-later” model used by all insurers, and Buffett warned that the float may decline over time:

We may in time experience a decline in float. If so, the decline will be very gradual – at the outside no more than 3% in any year.

The shareholder letter also showed how many years the profits have rolled in from the P&C business:

Berkshire has now operated at an underwriting profit for 15 of the past 16 years, the exception being 2017, when our pre-tax loss was $3.2 billion. For the entire 16-year span, our pre-tax gain totaled $27 billion, of which $2 billion was recorded in 2018.

It still seems possible that the post-Buffett and post-Munger era of Berkshire Hathaway is likely to be a multi-person approach. Buffett does not name any single successor to head the Berkshire empire. Still, Buffett did address the 2018 move when Ajit Jain was put in charge of all insurance activities and Greg Abel was given authority over all other operations. The letter said:

These moves were overdue. Berkshire is now far better managed than when I alone was supervising operations. Ajit and Greg have rare talents, and Berkshire blood flows through their veins…

For 54 years, Charlie and I have loved our jobs. Daily, we do what we find interesting, working with people we like and trust. And now our new management structure has made our lives even more enjoyable.

With the whole ensemble – that is, with Ajit and Greg running operations, a great collection of businesses, a Niagara of cash-generation, a cadre of talented managers and a rock-solid culture – your company is in good shape for whatever the future brings.

For the record, with all the talk of investments, it would seem worthwhile for Buffett and his fellow managers at Berkshire Hathaway to invest in a web-hosting provider that can actually handle a flood of simultaneous traffic.

Whether shareholders will like what they have read may depend on how long term their views are. Berkshire Hathaway’s shares were actually down by about 1% so far in 2019, while the Dow Jones industrials and the S&P 500 had gains of 11%. Over the past year, that performance is effectively flat, compared with a 5% gain for the Dow and 3% for the S&P 500.

And to put these numbers in further context, the $302,000 close for Berkshire’s A-shares is against a 52-week range of $279,410 to $335,900. Its market cap as of Friday’s closing bell was $497 billion.

A full verbatim review of Buffett’s shareholder letter is also available.