On February 28, 2009, Berkshire Hathaway released (here) the annual letter of its Chairman Warren Buffett, to the company’s shareholders. Like prior editions, this year’s letter contains homey and often humorous aphorisms and thought-provoking observations both about Berkshire and about the business economy as a whole. But, consistent with the fact that 2008 was Berkshire’s worst year ever, this year’s letter is much denser than prior years’ and — along with Buffett’s usual tone of self-deprecation – reflects some occasional and uncharacteristic notes of defensiveness. There is at least one rather noteworthy omission from the letter as well. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)
The Letter’s Major Themes
The Global Economy: The letter opens with a sober appraisal of the "debilitating spiral" into which the global economy slipped during 2008. Buffett observes that these dire circumstances produced unprecedented governmental action, steps that were "essential" if the "financial system was to avoid total breakdown." But these "massive actions," while necessary, will "almost certainly bring on unwelcome aftereffects," including an "onslaught of inflation."
Buffett also expressed his concern that "the economy will be in shambles throughout 2009, and, for that matter, probably well beyond." However, in contrast to this gloomy shorter term view, Buffett’s long view is optimistic. He notes that "our country has faced far worse travails in the past," but that "without fail we’ve overcome them." Buffett asserts that "America’s best days lie ahead."
Berkshire’s Investment Performance: But even if the longer term view is bright, the immediate picture isn’t pretty. Berkshire’s 2008 results were its worst ever. On the other hand, the company’s results were considerably better than those of the S&P 500 companies. For example, Berkshire’s book value per share declined by 9.6% in 2008, while the S&P stock index fell 37% last year, including dividends.
The overall value of Berkshire’s investment portfolio fell 13.89%, form $90,343 per share to $77,793 per share. Nineteen of top 20 stakes in Berkshire’s U.S. stock portfolio declined last year.
Contributing to this investment decline were some "dumb things" Buffett did in managing Berkshire’s investments, including a "major mistake of commission" involving a major acquisition of ConocoPhillips stock when oil prices were near their peak. Buffett comments in the letter that "the terrible timing of my purchase has cost Berkshire several billion dollars." Buffett also noted his poor timing in spending $244 million to invest in two Irish banks that have since declined 89% in value.
Berkshire’s Derivatives Portfolio: Nearly a quarter of the shareholders’ letter is given over to Buffett’s defense of Berkshire’s derivatives portfolio. Greater detail regarding the portfolio was not only requested by regulators, but it was perhaps obligatory in any event, in part because of Buffett’s own long standing criticism of derivatives as "financial weapons of mass destruction," but also because of what the derivative investments did to Berkshire’s reported 2008 financial results.
The company’s share price has declined over 40% in the past year largely due to concerns about the company’s exposures to derivatives. The company’s fourth quarter net income fell 96 percent to $117 million from $2.95 billion in the prior year’s final quarter. The decline is primarily the result of mark to market losses on long-term derivative investments in Berkshire’s portfolio.
But while detailed disclosure of Berkshire’s derivative portfolio may have been mandatory, Buffett seems rather grumpy about it. Indeed, at virtually the same time Buffett lays out the company’s derivative investments, he mutters some rather disparaging remarks about the futility of increased "transparency" requirements for "describing and measuring the risk of a huge and complex portfolio of derivatives."
In case some readers might conclude that Berkshire itself has a huge and complex portfolio of derivatives (and, in my view, that is the only conclusion that anyone acquainted with the facts, even as presented by Buffett, reasonably could reach), Buffett strains to try to differentiate Berkshire’s portfolio. Not only were Berkshire’s derivative contracts "mispriced at inception," but also, by contrast to many similar arrangements, Berkshire "always holds the money." Moreover, only "a small percentage of our contracts call for posting of collateral," and even under last year’s chaotic conditions," Berkshire had to post less than 1% of its securities portfolio."
So, I guess the message is, don’t be alarmed by those massive, multi-billion dollar "mark to market" write-downs — everything is fine. My own view is that Buffett was much more persuasive before when he was decrying derivaties as "financial weapons of mass destruction."
The Subprime Debacle: Buffett’s letter also contains a separate homily about the experience of Berkshire’s mobile home subsidiary, Clayton Homes, whose recent performance is, in Buffett’s retelling, a sort of morality tale against which to compare the events that up to the subprime meltdown.
Though they are people of "modest incomes and far-from-great credit scores," Clayton’s mobile home buyers have much lower default and foreclosure rates that those of many similar residential borrowers because "they took a mortgage with the intention of paying it off, whatever the course of home prices." The mobile home buyers didn’t "count on making loan payments by refinancing" and they weren’t seduced by "teaser rates."
Buffett observes that foreclosures don’t happen because housing prices decline, but because borrowers "can’t pay the monthly payment they agreed to pay." The home purchased "ought to fit the income of the purchaser." And, Buffett adds, homeowners who have "made a meaningful down payment – derived from savings and not from other borrowing – seldom walk away from a primary residence."
Buffett concludes with the observation that "putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective." However, keeping them in their homes "should be the ambition."
Tax- Exempt Bond Insurance: Buffett also takes considerable pains to describe Berkshire’s move into tax-exempt bond insurance, and how the financial troubles of the traditional monoline bond insurers allowed Berkshire an opportunity to reap outsized premiums for "second-to-pay" insurance (triggered if the primary monoline carrier defaults).
Though unabashedly gleeful in describing this opportunity and how it came about, Buffett also gravely notes that it is "far from a sure thing that this insurance ultimately will be profitable for us." He notes that while municipal debt historically has enjoyed an essentially default free record, the future could be far different, and indeed, the very presence of Berkshire insurance could itself trigger a higher rate of defaults. Buffett also notes that defaults could be correlated. In short, insuring tax exempts "has the look today of a dangerous business."
Some Interesting Sub-topics
In addition to the major themes, there are also of narrower message salted throughout the letter. Some of these, although barely mentioned, are among the letter’s more interesting details.
For example, I was interested to note that as a result of Berkshire’s unsuccessful bid to acquire Constellation Energy, Berkshire not only received a break-up fee of $175 million but also reaped an investment gain on the Constellation shares it did acquire of $ 917 million. I supposed Berkshire could hardly be described under these circumstances as a "disappointed bidder." (The details of the transaction are briefly summarized here.)
Buffett also tucks into the letter a brief commentary of how the swing of the risk-tolerance pendulum had resulted in the "U.S. Treasury bond bubble of late 2008," which could be regarded as "almost equally extraordinary" as the "Internet bubble of the late 1990s and the housing bubble of the early 2000s." Buffett predicts that clinging to cash equivalents or government bonds will almost certainly be "a terrible policy of continued too long," if for no other reason that inflation alone will "erode purchasing power."
There are also a couple of separate notes in the letter about Berkshire’s apparent growing commitment to green energy. In his description of Berkshire’s utilities businesses, Buffett describes the utilities businesses’ growing wind power output. And in his description of the upcoming Berkshire shareholders’ meeting, he notes that among the exhibits at the meeting will be a "new plug-in car developed by BYD, an amazing Chinese company in which we own a 10% interest."
While this year’s letter rewards careful reading just as much as prior years’ letters, and though this year’s letter arguably contains even more that customary detail, there are nonetheless some critical omissions.
First and foremost, the letter is silent about the criminal fraud convictions during the past year of the former CEO and former CFO of the Berkshire’s largest subsidiary, General Re, for misconduct committed while General Re was a part of the Berkshire group. For details regarding the convictions, refer here and here. (Full disclosure: for several years, I was employed by a General Re subsidiary.)
At one level, this omission may be understandable given questions some have asked about Buffett’s own possible involvement in the events at the heart of the prosecution. But given these criminal convictions, the letter’s happy talk about General RE’s 2008 annual results – including Buffett’s euphemistic reference to the fact that the subsidiary’s successor CEO also "stepped down" during the past year, without any reference to the reasons for the successor CEO’s other than purely voluntary departure – rings hollow, or at least lacking in context.
There is an ironic contrast between this rather obvious omission and the withering tone Buffett employs later in his letter to describe the June 15, 2003 OFHEO letter and report that "were delivered nine days after the CEO and CFO of Freddie had resigned in disgrace and the COO had been fired." Some might call it hypocritical on the one hand for Buffett to disparage OFHEO’s letter for its failure to mention the Freddie Mac officials’ departures while at the same time himself omitting even to acknowledge the criminal convictions of the two most senior officials of his company’s largest subsidiary.
In addition, while Buffett was characteristically direct in acknowledging the mistaken timing of his ConocoPhillips investment, I think it is worth noting that the ConocoPhillips and Irish Bank investments were far from the only recent Berkshire investments that may have been ill-timed.
Looking at Berkshire’s largest stock holdings, it appears that many of Berkshire’s most recent investments are faring poorly. In particular, the recent investments in Swiss Re (down 85% the past year), on which Buffett recently doubled down, raises certain questions.
For that matter, some of Buffett’s longer term investments have also declined beyond market wide averages, including in particular American Express (down 71% in the past year) and Moody’s (down 53% in the past year).
Of course, times are tough throughout the financial arena, and not even Berkshire is immune from the current overwhelming financial downdraft. Among many interesting points Buffett makes in his letter is his observation that 75% of the time during Berkshire’s 44-year history, the S&P 500 has recorded an annual gain, adding that he guesses "a roughly similar percentage of years will be positive in the next 44."
We can all, even those who may not own Berkshire shares, hope that Buffett is right about the prospects for future positive results.
A Final Note: My review of Alice Schroeder’s recent biography of Buffett, "The Snowball," can be found here.