The much-anticipated annual letter to Berkshire Hathaway shareholders of its Chairman Warren Buffett has long been valued for its business insights and occasionally humorous tone. The 2009 version, which was released on Saturday February 27, 2010, and which can be accessed here, is no exception, though the expanding size of Berkshire’s business portfolio has reduced Buffett’s discussion of many company operations to just a few sentences and left relatively little space for his usual commentary.
Buffett does manage to work in some choice observations about the responsibilities of financial institutions’ senior officials for their companies’ collapses, and also about boards’ responsibilities in the M&A context.
For many readers, the 2009 version may be noteworthy for the things it does not discuss. For example, the 79-year old Buffett has nothing to say about leadership succession planning at the company (although the February 27, 2010 Wall Street Journal does fill the gap somewhat with an interesting article, here, about possible Buffett successor David Sokol, the Chairman of MidAmerican Energy)
Buffett also has nothing to say about recent events of keen interest to Berkshire’s shareholders, including the company’s addition to the S&P 500 and its loss of its triple-A financial rating (owing to the company’s deployment of cash for its largest-ever acquisition of Burlington Northern Santa Fe).
But despite the omissions, there is still much of interest in this year’s letter. Full disclosure: I hold BRK.B shares, although not nearly as many as I wish I did. (Actually, I do own more shares than I used to, due to the January 2010 50-for-1 split of the B shares.)
Buffett on Boards of Directors
For readers of this blog, the most interesting comments in this year’s letter are Buffett’s remarks about senior management of the financial institutions at the center of the global financial crisis. Buffett prefaces his comments by stating that he would never "delegate risk control," going on to contend that "in my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control."
Buffett not only suggests that corporate leaders should have full responsibility, but that there should be liability consequences for failure. Buffett says that if the CEO "fails" at risk control, "with the government thereupon required to step in with funds or guarantees," the "financial consequences for him and his board should be severe." Buffett notes that it has "not been shareholders who have botched the operations of some of our country’s largest financial institutions," yet they have had to "bear the burden" caused by the management errors. Despite shareholder losses, "the CEOs and directors of the failed companies … have largely been unscathed."
Buffett proposes that "the behavior of the CEOs and the directors needs to be changed," and they way to do that he suggests is to ensure that if "institutions and the country are harmed by their recklessness," then "they should pay a heavy price – one not reimbursable by the companies they’ve damaged or by insurance." Senior managers have long enjoyed "oversized financial carrots," now their employment arrangements should now include "meaningful sticks."
Buffett’s grumpy ruminations about board behavior don’t stop there; later in his letter, he returns to the boardroom context to discuss board functioning in the M&A context. He notes, based on his "more than fifty years of board membership," that directors often are "instructed" by "high-priced investment bankers (are there any other kind?)" on the value of a proposed acquisition target. But "never" has he heard investment bankers "or management!" discuss the "true value of what is being given" for the acquisition when company stock is being used to finance the acquisition.
Buffett proposes, as the only way to get "a rational and balanced discussion," that directors hire a "second advisor to make the case against the proposed acquisition," with the advisor’s fee "contingent on the deal not going through." He concludes with an observation about the way deal advisors typically function by the aphorism "Don’t ask the barber whether you need a haircut."
Buffett on Berkshire’s Investments
Overall, Buffett’s letter is upbeat, as might be expected in a year in which his company’s net worth rose $21.8 billion and income rose 61 percent to $8.06 billion. (This after the company reported in 2008 its worst results ever, due to the effects of the global financial crisis.)
Buffett is particularly chipper in talking about the performance of the company’s investments. He notes that the company has "put a lot of money to work during the chaos of the last two years," adding that its been an ideal period for investors" because "a climate of fear is their best friend."
The tale of Berkshire’s recent cash deployment is truly remarkable. The company entered 2008 with $44.3 billion in cash and cash equivalents, and during 2008 and 2009 the company retained an additional $17 billion in earnings. Nevertheless, by the end of 2009, the company’s cash pile was "down" to $30.6 billion (with $8 billion of that earmarked for the Burlington Northern acquisition) – implying a net cash outflow of $47.6 billion, or as much as $55.6 billion if the Burlington Northern obligation is taken into account.
Where has the cash gone? Well, in addition to the massive Burlington Northern deal and other items, the company invested an absolutely astonishing $22.1 billion in non-traded securities of just five companies: Dow Chemical, General Electric, Goldman Sachs, Swiss Re and Wrigley. Under the heading "that’s why he’s Buffett and you’re not," it should be noted that these investments (which cost $22.1 billion) have a carrying value of $26 billion and also deliver an aggregate $2.1 billion annually in dividends and interest (or roughly 10% of cost annually, meaning the investments will pay for themselves in about 7.2 years).
Moreover, these massive purchases are far from the only investment successes on Buffett’s scorecard. Berkshire’s $232 million investment in 2008 in Chinese battery maker BYD Company is now worth $1.9 billion. Buffett also accumulated corporate and municipal bonds in 2009, which he called "ridiculously cheap." But, he wrote "I should have done far more. Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble."
Not all of Buffett’s financial moves have been funded out of cash; the company also sold some investments, including in particular its holdings in Conoco Phillips, Proctor & Gamble and Moody’s. Each of these investment sales is interesting in its own way.
In his 2008 letter, Buffett cited his mid-2008 purchase of ConocoPhillips as one the "dumb things" he had done during the year, referring specifically to the purchase as a "major mistake of commission" because he bought the shares at their peak. Berkshire’s P&G holdings were the result of P&G’s acquisition of Gillette, which had been a major Berkshire holding for many years prior to that. Buffett seemingly was less interested in holding the shares of the more diversified company.
The sale of the Moody’s shares is perhaps the most interesting move, as the company’s Moody’s position had been a prominent part of its portfolio for many years. Moody’s share price has plunged during the last couple of years as a result of controversies surrounding the company’s ratings of subprime-related investments. Buffett has plenty to say in his 2008 letter about the excesses that cause the subprime meltdown, but even then he omitted any mention of Moody’s. Perhaps his sale of the company’s shares, even if accomplished without comment or observation, is the most eloquent statement he could make. (As an aside, in April 2009, Moody’s downgraded Berkshire from its highest investment rating.)
Buffett on Berkshire’s Balance Sheet
Though Buffett says nothing about the company’s loss of its triple-A financial rating, he has a great deal to say (perhaps defensively?) about the company’s financial strength. He emphasizes that "we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity."
He goes on to comment, somewhat triumphantly, that "when the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity to the system, not a supplicant." adding that "at the very peak of the crisis we poured $15.5 billion into a business world that could otherwise look only to the federal government for help."
Buffett on Berkshire Shareholders
As I have previously noted (here) about Buffett’s essays to Berkshire shareholders, one of the not so subtle goals of his missives is to try to ensure that the company has the right kind of shareholder – that is, investors willing to take a long-term view and patient enough to await long-term results. Due to the Burlington Northern acquisition (and the split of the company’s B shares), Berkshire now has many new shareholders, and in his 2009 letter, Buffett is trying to school these new owners on what he hopes for from them
Buffett is very explicit that he wants to "build a compatible shareholder population." On that topic, Buffett sounds some themes that will be familiar to regular readers of Buffett’s letters. He warns his new shareholders that "investors who buy and sell on media analyst commentary are not for us." Rather, Buffett wants "partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand."
Buffett on Berkshire’s Businesses
Much of the balance of Buffett’s letter is given over to a review of the operating companies’ performances. With a few exceptions (such as his lengthy exegesis of the systemic challenges facing mobile-home manufacturer Clayton Homes), most of his company-specific reviews are quite brief. Indeed, many Berkshire businesses are not even motioned in the letter. As Berkshire has enveloped more and more companies, the kind of meaningful review Buffett claims to want to provide investors has been increasingly more challenging.
Readers of this blog undoubtedly will be interested in Buffett’s review of Berkshire’s massive insurance businesses, which continue to perform magnificently, collectively producing over $1.5 billion in 2009 calendar year underwriting profit despite prevailing soft market pricing conditions. This continued underwriting profitability, even if not shared equally by all of Berkshire’s insurance competitors, virtually ensures that the soft market conditions will continue until either pricing collapses to the point where profit is simply no longer possible or some external event intervenes to overwhelm industry profitability.
Some may find Buffett’s harsh words about CEOs and corporate boards alarming. His suggestion that company officials should be held liable for the harm they have caused, without benefit of indemnity or insurance, will strike fear into the hearts of company officials everywhere. It is particularly noteworthy that his prescription for individual liability is not limited just to CEOs but expressly extends also to members of the company boards.
However, a careful reading of suggests that these remarks may represent less of a threat to corporate officialdom that might appear at first blush. For example, it is clear that his remarks refer to officials at companies whose woes have required a government bailout. His suggestion of direct personal liability without benefit of indemnity or insurance is made with reference to misconduct that causes harm both to "institutions and the country." So, before anybody hits the panic button, Buffett is not necessarily suggesting that indemnification and insurance are never appropriate for corporate officials, but perhaps only when the officials’ misconduct has necessitated a government bailout.
But just the same, Buffett’s comments that corporate officials (including, apparently members of boards of directors) should not have recourse to insurance undoubtedly will make some board members uneasy – not to mention how uncomfortable it makes those of us who make our living in the D&O insurance industry.
Buffett’s plan for building a shareholder base built on owners who buy into Berkshire’s long term philosophy is commendable. However, as Berkshire has grown, this aspiration may be less realistic. Buffett may want partners invested "in a business they themselves understand" but the reality is that Berkshire may have grown beyond the point where the typical investor can fully appreciate and understand its business.
The fact is that much of this year’s letter seems a mile wide and an inch deep – indeed, at one point, he simply lists the names of companies, without any further gloss or detail.
Buffett’s description of the results of Berkshire’s insurance businesses is a good illustration of the challenge facing Berkshire’s new shareholders. Buffett is lavish in his praise of Ajit Jain and his thirty person operation. Indeed, Buffett adds the humorous aside that if he, Berkshire Vice Chair Charlie Munger and Ajit were in a sinking boat, "and you can save one of us, swim to Ajit."
But as for what Ajit’s 30 person team does to produce hundreds of millions of dollars of profit, shareholders are left with cryptic comments like this statement: "During 2009, he negotiated a life insurance contract that could produce $50 billion in premium for us over the next 50 or so years." Seems kind of important, but as for what kind of risks or uncertainties it involves, Buffett has little to say, because he has already moved on to the next topic.
The next topic, in fact, is another Berkshire insurance business, Gen Re, which prior to the Burlington Northern acquisition was Buffett’s largest ever acquisition and Berkshire’s largest operating division. Buffett spares only 125 words for Gen Re, 48 of which are actually about Gen Re’s European subsidiary Cologne Re.
Buffett also has relatively little to say about Berkshire’s derivatives exposures, other than to defend these complex transactions that cause Berkshire’s reported results to swing by billions from quarter to quarter. I hope that those of us who can recall that Buffett himself called derivative contracts "weapons of financial mass destruction" can be forgiven for feeling less than entirely comfortable with Buffett’s hasty sketch of Berkshire’s derivatives exposure.
Buffett says that "Charlie and I avoid businesses whose futures we can’t evaluate." Some of Buffett’s shareholders may wonder how in the world they are supposed to evaluate the future of a company that is entering massive, complex multi-decade financial commitments but whose leadership will be in place for only a few more years. Despite all of Buffett’s earnest attempts to educate Berkshire’s owners, current and prospective investors may simply have to take it on faith – which certainly does shine a harsh spotlight on that unanswered leadership succession issue.
But for all of that, the annual letter is not a disappointment. It continues to be worth waiting for. Buffett did manage to work in the zingers about corporate responsibility. And he even slipped in some of his signature humor. My personal favorite in this year’s letter is his remark, made as a demonstration of Prussian mathematician Jacobi’s inversion principles, that if you "sing a country song in reverse … you will quickly recover your car, house and wife." He ends his letter, with its extensive discussion of the Burlington Northern acquisition, with a postscript suggesting that visitors attending the May shareholders meeting should "come by rail."