On February 26, 2011, Berkshire Hathaway issued Chairman Warren Buffett’s much-anticipated annual letter to the company’s shareholders (here). Although aficionados of Buffett’s letters will not be disappointed, this year’s letter is largely focused on Berkshire’s performance and has fewer excursions into larger topics than in past years. (Full disclosure: I own BRK.B shares, although not as many as I wish I did.)
Perhaps even more than in prior years, the 2010 letter sets out a detailed analysis of Berkshire’s long-term performance, opening with a detailed review of Berkshire’s history compared to that of the S&P 500. (Interestingly enough, Berkshire failed to outperform the S&P 500 for the last two years in a row, the first time in Berkshire’s history that has happened.) Buffett then moved on to a review of Berkshire’s performance during 2010. Although Buffett addresses Berkshire’s investment performance, his devotes greater space to detailing the annual performance of Berkshire’s operating companies.
Because Berkshire often is perceived essentially as an insurance holding company, he takes considerable pains to highlight the relative performance of Berkshire’s noninsurance businesses, particularly Burlington Northern Santa Fe, for which Berkshire paid about $27 billion last February in the company’s largest ever acquisition. Buffett called the railroad’s performance "the highlight of 2010" and commented that it is working out "even better" than expected. The railroad generated operating earnings of $4.5 billion and net earnings of $2.5 billion.
With respect to the company’s insurance businesses, Buffett returns to several themes that will be familiar to those who have followed his letters over the years.
First, he emphasizes how elusive underwriting profitability has been for many insurers. Though Berkshire’s insurance businesses have, Buffett emphasizes, produced "an underwriting profit for eight consecutive years" and an underwriting gain of $17 billion during that period, underwriting profitability "is not an outcome to be expected of the P/C industry as a whole." (He compares, by way of example, Berkshire’s $17 billion of underwriting profit over the last 8 years to State Farm’s more than $20 billion underwriting loss during the same period.)
As a result, "the industry’s overall return on tangible equity has for many decades fallen far short of the average return realized by American industry, a sorry performance almost certain to continue."
The reason for the industry’s poor performance, Buffett comments, is that too many insurers forget one of the critical insurance disciplines, which is "the willingness to walk away if the appropriate premium can’t be obtained." The reasons for this recurring failure are that "the urgings of Wall Street, pressures from the agency force and brokers, or simply a refusal by a testosterone-driven CEO to accept shrinking volumes has led too many insurers to write business at inadequate prices."
Because so much of Buffett’s letter is a celebration of the company’s many success stories, it stands out when Buffett acknowledges a rare defeat. In this letter, Buffett acknowledges that from the perspective of its financial results, NetJets has been a "failure," and is Berkshire’s "only major business problem." Buffett does not acknowledge the many prior letters in which he had previously praised the company and its prior management. However, he does assert that under its new management, the company is turning around.
This Year’s Homily
Buffett’s letter would not be representative of type without an essay on broader topics. Though there is less of that in this year’s letter, Buffett still does manage to work in some commentary on the topic of "leverage," selecting as the text for his homily a letter his grandfather Earnest send to Buffett’s Uncle Fred in 1939.
Buffett notes that while debt usually can be refinanced, it sometimes happens that "maturities must actually be met by payment," for which "only cash will do the job." Credit, Buffett reflects, is "like oxygen" – that is, "when either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed."
The lesson of all this for Berkshire is illustrated in Earnest’s letter to Uncle Fred, in which Earnest gave Fred and his wife $1,000 to hold as a safety reserve. (Earnest’s letter, reproduced at page 23 of the shareholder’s letter, is interesting in many ways, not least because of the immense wealth that Earnest’s grandson went on to accumulate later on.)
Taking the necessity for a "reserve" as an operating imperative, Buffett explains that Berkshire will always hold at least $10 billion in cash and customarily keep at least $20 billion at hand so that the company can "withstand unprecedented insurance losses" and can "quickly seize acquisition or investment opportunities, even during times of financial turmoil."
By conserving cash and avoiding leverage, as well as by retaining and reinvesting earnings, Berkshire has grown its net worth from $48 million to $157 billion in four decades. Though being so cautious about leverage has penalized the company’s returns, it "lets us sleep at night." And perhaps more importantly, "during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while other scramble for survival." Indeed it was this very circumstance that "allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008."
Those Telling Asides
Readers familiar with Buffett’s past letters will know that among his letters’ most rewarding features are his occasional asides, where he pauses to make humorous or aphoristic observation. There are fewer purely humorous asides in this year’s letter, but there are the usual share of aphorisms and anecdotes, as noted below.
First, Buffett is long on America’s prospects. Though conceding that Berkshire’s businesses will expand abroad, "an overwhelming part of their future investments will be at home," explaining that "money will always flow toward opportunity, and there is an abundance of that in America." He adds that the country’s "human potential" is "far from exhausted," observing that "the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective." Buffett note that "as in 1776, 1861, 1932 and 194, America’s best days, according to Buffett, "lie ahead."
Second, in emphasizing the level of Berkshire’s directors’ stewardship commitment, Buffett stresses that "we do not provide them directors and officers liability insurance, a given at almost every other large public company. If they mess up with your money, they will lose their money as well." (Though Buffett highlights this approach to D&O insurance as a corporate strength, don’t expect this practice to catch on widely. No other company can offer an indemnification commitment as substantial as Berkshire’s. Nor could any insurer make an insurance commitment as financially substantial as Berkshire’s indemnification undertaking. Buffett’s views on D&O insurance reflect a unique set of circumstances.)
Third, with respect to our country’s shared goal of home ownership, Buffett observes that "all things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I rented and used the purchase money to buy stocks." (His two best investments were, he says, "wedding rings.") But the American dream can become "a nightmare if the buyer’s eyes are bigger than his wallet and if a lender – often protected by a government guarantee – facilitates his fancy." Our goal should not be to put families in the house of their dreams, "but rather to put them in a house they can afford."
Fourth, Buffett argues that net income is a "meaningless" number for Berkshire, because it is so susceptible to the timing of Berkshire’s realization of investment gains or losses. Buffett expresses "deep disgust" for the "game playing" some managers use to manipulate net income, "a practice that was rampant throughout corporate America in the 1990s and still persists, though it occurs less frequently and less blatantly than it used to."
Buffett urges Berkshire shareholders to "ignore our net income figure, suggesting that "operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing."
Finally, Buffett takes on the Black-Scholes valuation method, arguing that it "produces wildly inappropriate values when applied to long-dated options." Its appeal of course is that the method "produces a precise number." But that precision is illusory, as it suggests values that are more appropriately estimated can be pinpointed with accuracy.
Buffett concludes that the practice of teaching Black-Scholes as "revealed truth" needs reexamination, particularly since "you can be highly successful as an investor without having the slightest ability to value an option." What you need to know is "how to value a business."
Buffett’s latest annual letter sounds many familiar themes. Indeed many of this year’s points of emphasis have appeared (in some cases, many times) in prior letters. I doubt there is a single Berkshire shareholder unfamiliar with the stories of Buffett’s initial investments in GEICO and the Berkshire Hathaway textile firm, which Buffett recounts again in this year’s letter. At times, the 2010 letter reads like a collection of Buffett classics.
Of course, what makes him Buffett is the extent to which he has across the years honored his conservative investment principles, as a result of which it is entirely appropriate that Buffett has once again rehearsed the lessons of his lifetime of investing.
But the annual letter is so anticipated because of the insights Buffett has expressed over the years about the economy, about the financial marketplace, and even about life. On that score, this year’s letter is a little disappointing. His criticism of the Black-Scholes method, for example, is modest compared, for example to his attack in his 2002 letter on derivative securities as "weapons of financial mass destruction" or his withering criticism in his 2006 letter of "the 2-and-20 crowd" of hedge fund managers.
One problem Buffett now has is that his company is getting so huge and diverse. Just summarizing the past year’s results of Berkshire’s increasingly numerous operating businesses is a much more space-consuming task than just a few years ago. (I was stuck by the number of apparently sizeable companies Buffett mentions in his letter that I have never even heard of, even though I have been a Berkshire shareholder for years and have followed the company closely. There are even more Berkshire companies, also quite sizeable, that Buffett never mentions.)
Indeed, one of the striking aspects of Buffett’s letter is the extent to which Berkshire’s various businesses have become integral components of American commerce. It is not just the diversity of companies Berkshire encompasses, it is the significance of the companies to the entire economy – for example, BNSF moves more freight than any other railroad, and Mid-America is the largest electrical supplier in three states.
In the end, Buffett can perhaps be excused if he comes off as a little repetitive. He has not only made himself and Berkshire’s shareholders wealthy, but he has also built an extraordinary company that survived the economic crisis, profited from the downturn, and emerged stronger than ever. His track record, underscored in the table in his letter comparing Berkshire’s and the S&P 500’s performance over five year intervals since the mid-60s, is striking.
If Buffett’s latest letter lacks the entertainment value of some prior letters, for Berkshire shareholders the letter more than makes up for that with the level of the company’s performance. Berkshire’s 2010 earnings of $13 billion were up 61% from the year before. At year end, the company had $38 billion in cash. Its businesses are generating about $1 billion a month in cash.
Yet Buffett, in typical fashion, emphasized that given the company’s size, it is unlikely to reproduce prior results. "The bountiful years, we want to emphasize, will never return. The huge sums of capital we currently manage eliminate any chance of exceptional performance."
Buffett’s confidence in the future of America is reassuring. But the reference to the future inevitably leads to consideration of Berkshire’s own future, in light of Buffett’s age (80). Without acknowledging the issue directly, Buffett addresses the concern both in his lengthy discussion of the managers of various Berkshire businesses – particularly David Sokol, who is engineering the NetJets turnaround while managing Mid-American – and in his discussion of the thought process behind the selection of Todd Combs as an investment manager for Berkshire.
Berkshire, Buffett seems to be suggesting, will remain in good hands. Berkshire’s shareholders can hope that for the company as well as for our country, the future is bright.
Water Works In his interesting essay "How Skyscrapers Can Save the City" in the March 2011 issue of The Atlantic (here), Edward Glaeser observes that "One curse of the developing world is that governments take on too much and fail at their main responsibilities. A country that cannot provide clean water for its citizens should not be in the business of regulating film dialogue." It is also true that most governments that successfully provide clean water to all of their citizens don’t try to regulate film dialog. The provision of clean water could be the ultimate test of governmental efficacy as well as the key to political freedom.