The annual letter to Berkshire Hathaway shareholders of Warren Buffett, the company’s Chairman, is anticipated every year as much (or arguably more) for its commentary on the financial world and the economy as it is for its discussion of the company’s performance. This year’s letter (here), released on February 25, 2012, does not disappoint. The letter contains numerous insights into the U.S. economy and the financial marketplace. Buffett’s letter also reflects his well-known penchant for homespun humor and telling anecdote, although in smaller rations than in years past.
In this year’s Buffett refers to some familiar themes. Several of the topics can charitably be described as “well-worn.” Also, as I noted in my review of last year’s letter, Berkshire itself has become so huge and diverse that simply summarizing its results nearly consumes the editorial potential of the shareholder letter medium. Though some of the topics may be shopworn, Buffett nevertheless manages to work in sufficient insight to make his letter well worth reading, even for those who don’t own Berkshire stock. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.) My summary of the letter’s main themes follows.
By any measure, Berkshire Hathaway is an astonishing construction. During 2011, the company had net income of $10.3 billion on revenues of $143 billion. Though the company’s earnings were down from 2010 (when the company earned $13 billion), the company’s book value, a measure of assets minus liabilities, rose during the year to $164.9 billion from $157.3 billion at the end of 2010. The 4.6 percent increase in book value outpaced the S&P 500’s 2.1 percent return. At year end the company had $37.3 billion cash on hand, despite several multi-billion dollar investments during the year.
For many years, Berkshire was fairly described as an insurance holding company with a very impressive investment portfolio. Those descriptive attributes remain accurate, but they are no longer sufficient. Berkshire is now an extraordinary collection of businesses, including not only the more than 70 businesses that operate directly under the Berkshire umbrella, but an additional 140 businesses within the Marmon unit (among many others). Buffett notes in his letter than there are eight Berkshire subsidiaries that would be in the Fortune 500 if they were stand-alone companies (“That leaves only 492 to go. My task is clear, and I’m on the prowl.”)
As a result of a number of acquisitions in recent years, Berkshire is also now a holding company of huge industrial operations. A large part of the letter is devoted to discussing the company’s five largest non-insurance operations (BNSF, Lubrizol, Marmon Group, Iscar and Mid American Energy), only one of which Berkshire has held for more than five years. In the aggregate these five companies had full-year pre-tax earnings of more than $9 billion. (Five years previously, the single one of these companies that Berkshire owned then, MidAmerica, had earnings of only $393 million).
The sheer magnitude of these large recent investments is underscored by Buffett’s recitation of the extent of BNSF’s essential operating assets; he notes that “we must, without fail, maintain and improve our over 23,000 miles of track along with 13,000 bridges, 80 tunnels, 6,900 locomotives and 78,600 freight cars.” By the same token, MidAmerica’s pipelines “transport 8% of the country’s natural gas,” and its investments in wind generation and solar projects amount to “far more than any other regulated electric utility in the country.”
With these and many other businesses, Berkshire is now an essential component of the U.S. economy, which makes Buffett’s comments about the economy (discussed below) that much more vital. Buffett does not exaggerate when he says “when you look at Berkshire, you are looking across corporate America.” No matter what else you may want to say about the company, it has become huge. It is so big that not even Buffett knows all of its businesses. In mentioning that at last year’s shareholder’s meeting, one of the businesses, Wells Larmont, sold 6,126 pairs of gloves, Buffett comments that the unit’s gloves were a product “whose very existence was news to me.” Similarly, I was interested to learn from reading the annual report that Berkshire now also owns Brooks, the running-shoe company.
Whether or not the whole thing has become more than a single person can comprehend much less handle seems a legitimate question, but Berkshire shareholders themselves are more interested in the question of what happens to the company when the 81 year-old Buffett is no longer in charge. The succession question took on a whole new layer of urgency after the March 2011 departure of former MidAmerica Chairman David Sokol, the previously presumptive front-runner as Buffett’s successor who left under a cloud due to his stock purchases ahead of Berkshire’s decision to acquire Lubrizol (about which for refer here).
Arguably for the first time, Buffet indicates in his latest shareholder letter that a successor has been selected, an individual about whom the company’s board has had “a great deal of exposure,” whose “managerial and human qualities they admire” and about whom they are enthusiastic. Buffett does not name this individual, but the smart money seems to be on Ajit Jain, the head of Berkshire’s reinsurance operations. Buffett also mentions that there are two back-up candidates as well.
Buffett himself has made the question of who will succeed him separate from the question of who will manage Berkshire’s now $77 billion investment portfolio. To address this separate question, Buffett seems to be conducting on-the-job auditions. In the shareholder letter, Buffett describes the recent engagement of Todd Combs and Ted Wechsler as investment managers. Buffett reports that Combs has built a $1.75 billion portfolio and that Wechsler will soon built a similar portfolio. The tryout process from here is unclear, but Buffett does say with respect to these two investment managers that “Each will be handling a few billion dollars in 2012, but they have the brains, judgment and character to manage our entire portfolio when Charlie and I are no longer running Berkshire.”
These hints and indications about the long-term future of Berkshire management may not be enough to mollify the market’s general concerns about Buffett’s age; as the Wall Street Journal pointed out on Friday, one of the reasons the company’s share price has lagged in recent months compared to the larger market may be due to succession planning concerns. Berkshire has slumped 4 percent in New York in the last 12 months, compared with a gain of 4.6 percent for the Standard & Poor’s 500 Index.
The U.S. Economy
As he did in last year’s letter, Buffett takes great pains to emphasize his belief that “America’s best days lie ahead.” The Berkshire businesses are clearly acting on this belief. In 2011, the operating companies spent $8.2 billion on property, plant and equipment, 95% in the U.S., “a fact that may surprise those who believe our country lacks investment opportunities.” Even though there will be projects abroad, “the overwhelming majority of Berkshire’s capital commitments will be in America.”
However, In considering Buffett’s optimistic analysis of the U.S. economy, it is probably worth noting two “unforced errors” he acknowledges in the shareholder letter. First, he characterizes his $2 billion investment in Energy Future Holdings bonds, dependent as they were on natural gas prices rising substantially, as “a mistake – a big mistake.” He also acknowledges that his belief a year ago in a housing recovery within a year or so as “dead wrong.” If Buffett missed so badly on a couple of basic assumptions about such fundamental economic components as energy prices and housing construction, could he be wrong about the overall economy as well?
Buffett would argue (an in fact, does argue, in the letter) that he has only been off on the timing, not on the economic fundamentals. In the letter, he states that though the housing industry has been in a “veritable depression,” housing “will come back – you can be sure of that.” In making this argument, he asserts that while housing construction remains in the doldrums, the number of households increases, and every day we are creating more households than houses. He states that “demographics and our market system will restore the needed balance – probably before long. When that day comes, we will again build one million or more residential units annually. I believe pundits will be surprised at how far unemployment drops once that happens.”
In this year’s letter, Buffett replays an oft-repeated message when explains the importance of “float”—that is, the funds that an insurance company gets to hold between the time it collects premiums and the time that it pays claims. As in past years, Buffett emphasizes that when the insurance operations are profitable, the cost of float is less than zero, in effect paying the company for holding the funds while also allowing the company to earn investment returns as well.
However, as Buffett puts it, the “wish for all insurers to achieve this happy result creates intense competition, so vigorous in most years that it causes the P/C industry as a whole to operate at a significant underwriting loss.” Buffett (not for the first time) cites by way of example State Farm, “by far the country’s largest insurer and a well-manage company besides,” which has “incurred an underwriting loss in eight of the last eleven years.” As Buffett puts it, “there are a lot of ways to lose money in insurance, and the industry is resourceful in creating new ones.”
Buffett notes that the Berkshire companies have achieved underwriting profitability for nine consecutive years, in the interim producing underwriting profits of $17 billion. (He does not mention, however, that during the fourth quarter, the insurance operations had an underwriting loss of $107 million, due to catastrophe losses in the reinsurance operations.) He emphasizes that cost-free float “is not an outcome to be expected for the P/C industry as a whole.” In most years, including 2011, “the industry’s premiums have been inadequate to cover claims plus expenses.” For many years, the industry’s overall return on tangible equity for many decades has fallen far short of the average return realized by American industry, “a sorry performance almost certain to continue.”
The problem, as Buffett sees it, is that too few insurers are “willing to walk away if the appropriate premium can’t be obtained.” Many insurers, he notes, “simply can’t turn their back on business that their competitors are eagerly writing.”
With respect to the Berkshire insurance businesses, Buffett notes that if there were a $250 billion mega-catastrophe (“a loss about triple anything it has ever faced”) Berkshire “would likely record a moderate profit for the year because of its many streams of earnings.” At the same time, however, “all the other major insurers and reinsurers would be far in the red, and some would face insolvency.”
For many readers, the greatest value of Buffett’s letters is his occasional asides, where he comments on some aspect of the financial markets or global economy. Buffett’s message this year is that many investments often assumed to be safe (such as bonds or gold) are far less likely to produce investment returns than are investments in equities, which Buffett characterizes as the “safest” investment by far.
The problem with bonds and other currency denominated investments is not just the tax drain on the investment returns, but the even more devastating effect of inflation. By way of illustration, Buffett notes that the value of the dollar has fallen “a staggering 86% in value since 1965.” As a result of inflation, currency-denominated investments “have destroyed the purchasing power of investors in many countries.” Even though bonds and other currency-denominated investments are often characterized as “safe,” they are in truth “among the most dangerous of assets” and “their risk is huge.” Interest rates “do not come close to offsetting the purchasing power risk.” In the current low interest rate environment “bonds should come with a warning label.”
As for gold, which is the current investment favorite in certain circles, Buffett suggests it has two significant shortcomings, which is that it is “neither of much use nor procreative.” Most of the gold’s industrial and jewelry uses are not quite enough to absorb ongoing production. Meanwhile, “if you own one ounce of gold for an eternity, you will own one ounce at the end.” Buffett imagines all of the gold assembled into one $9.6 trillion cube, and comparing it to a similarly valued cube composed of productive assets such all of the U.S. cropland and 16 Exxon Moblls. In a century, the second cube will have delivered trillions of dollars of value, with the ability to continue to produce value into the future, whereas the cube of gold “will still be unchanged in size and incapable of producing anything.”
Buffett contrasts these first two categories with investment in productive assets, such as businesses, farms or real estate. He notes that “ideally” these assets “should have the ability in inflationary times to deliver output that will retain its purchasing power.” Buffett sees a future in which the U.S. will “move more goods, consume more food, and require more living space than it does now.” Our country’s businesses “will continue to efficiently deliver goods and services wanted by our citizens.” So Berkshire’s goal will be to “increase its ownership in first class businesses.” Buffett contends that “over any extended period of time this category of investing will prove to be the runaway winner” among the three categories of investments, and, more importantly, “it will be by far the safest.”
Another investment area Buffett addresses is share buybacks. He discusses this question both because Berkshire itself for the first time implemented a share buyback program in 2011, and because during 2011 Berkshire invested $11 billion in IBM, which is in the midst of an aggressive buy back program. Buffett explained that the Berkshire’s buyback program is not intended to support the share price, but is merely a mechanism to take advantage of opportunities when the market has priced the shares below its intrinsic value.
In discussing IBM’s share buy back, Buffett explains that when Berkshire buys a stock In a company repurchasing its shares, Berkshire not only hopes that the company in which it has invested will continue to grow its earnings, but that its stock will underperform the market for a long time. Buffett notes that in the end the worth of Berkshire’s investment in IBM will be determined by IBM’s earnings, but an important secondary factor will be the share buy back program, as the lower the price at which the company buys its own shares, the more shares it will buy, and the larger will be Berkshire’s percentage ownership of the remaining shares (and therefore of IBM’s earnings). Buffett jokes that if the number of outstanding IBM shares is reduced to 63.9 million, “I will abandon my famed frugality and give Berkshire employees a paid holiday.” (Were the number of outstanding shares were reduced to 63.9 million, that would mean that Berkshire would own 100% of the outstanding shares.)
In commenting on the counterintuitive notion that an investor owning shares of a company that is net buyer of its own stock should hope for the company to be undervalued, he explains that “you are hurt when stocks rise. You benefit when stocks swoon.” Buffett explains that emotions too often complicate the matter. Most people he notes, including even those who will be net buyers in the future, “take comfort in seeing stock prices advance.” Buffett concedes that in his early days he too rejoiced when the market rose. But when he read Ben Graham’s book The Intelligent Investor, “low prices became my friend.”
Buffett is perhaps best known as a buy and hold investor, a person with a few simple investment principles that he follows rigorously. He cultivates and communicates an air of conservative consistency. The basic message from Buffett for years has been that with him, and with Berkshire, you know what are going to get. For that reason, a couple of developments during 2011 seem particularly noteworthy to me, both of which are things that I suspect many long-standing observers thought they would never see.
First, as noted above, Berkshire instituted a share buy back program, which although seemingly sound, also seems inconsistent with long-standing Buffett principles about putting cash to work.
The other development during 2011 that to me seems particularly noteworthy is that for the first time Berkshire has made a significant investment in a technology company. Much of Buffett’s current reputation as a visionary investor has much to do with his very public refusal to get caught up in the frenzy during the dot com era tech stock bubble. Buffett’s refusal to invest in tech companies because he doesn’t understand them has become such an iconic example of his simple but clear investment philosophy that Alice Schroeder began her recent biography of Buffett with a retelling of Buffett’s actions during that era. Of his decision to invest in IBM, Buffett says only that “it wasn’t until a Saturday in March last year that my thinking crystallized.”
Buffett says little else to explain or describe his unexpected decision to invest in a major technology company, except to say that, like his investments in Coke in 1988 and railroad in 2006, his IBM investment “was late to the IBM party.” To be fair, though, his extensive discussion of IBM’s share buy backs provide some explanation for the investment, and perhaps even a little bit of a defense of his decision finally to invest in the company only after a long and significant gain in its share price. He seems to be suggesting that it was part of his plan all along to buy the shares when he expected the company to be undervalued in the marketplace for a while, because the share buy back program would make Berkshire’s shares more valuable.
Long-time Buffett devotees know that this is far from the first time that Buffett has managed to find exceptions to his own loudly proclaimed general investment principles. To cite just one noteworthy prior example, in his 2002 shareholder letter, Buffett denounced derivatives as “time bombs” and “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal,” yet only a short time later, during 2007, he entered massive derivative contracts that has affected the company’s financial results in every reporting period since. (Buffett takes great pains in his 2011 letter to detail how profitable these derivative positions have proven to be, thank you very much. He also notes that due to current marketplace requirements to post collateral, he won’t be making any further derivative investments any time soon.)
Buffett may have succeeded over time in portraying himself as the master of principled investing, but in recent years his actions have clearly shown that his principles may be, well, flexible. Observers may ask that if Buffett has yielded on these points, might Berkshire now consider paying a dividend?
My own view it that though Buffett may have proven flexible on some points, we are unlikely to see a Berkshire dividend on his watch. Over and over again in this year’s letter, he reiterates the critical importance of maintaining minimum liquidity of at least $20 billion, and he details the importance of retained earnings. For example, he emphasizes how MidAmerica’s ability to retain earnings has allowed the company to make industry-leading investments in alternative energy. He also stresses how the value of Berkshire’s investments is enhanced when the companies in which it has invested retain their earnings.
Buffett may have demonstrated a certain amount of unwonted investment flexibility in recent years, but I still doubt that the payment of a dividend is something he would ever consider. Indeed, given his ownership position, a dividend would be a highly unwelcome taxable event for Buffett personally, which is yet another even more important reason it won’t happen during Buffett’s lifetime.
There are some other significant matters about which Buffett is silent in his letter. Thus, even though he mentions the company’s 2011 purchase of Lubrizol multiple times, he does not mention the serious questions that arose at the time about David Sokol’s investment in Lubrizol shares prior to Berkshire’s decision to acquire the company. He also stays away from the high profile issues in which he has become publicly involved during the past year, including questions about taxation fairness. (In my view, it is just as well that he stayed away from the taxation issue and other politically sensitive topics.)
There may be a few omissions, and there are a few things, like the name of Buffett’s successor, that are alluded to but not revealed. But overall you can’t criticize Buffett for hiding things. Very few investment managers, or even people in general, are as forthright about their mistakes. Buffett not only discloses his investment mistakes, but he puts them right up front. Perhaps he is confident enough to highlight his mistakes because he is sure that the things he got right far outweigh the things he has gotten wrong.
Buffett has always had a remarkable record selecting investments. His more recent track record in selecting large industrial companies to acquire may be even more impressive. As Berkshire has become more of an industrial company, it has become an increasingly important part of the U.S. economy. It is deeply encouraging that Buffett remains bullish on the U.S. economy. It is even more encouraging that his optimism consists of more than mere words. His acquisitions and investments say even more than his words about his belief in the U.S. economy. For the sake both of Berkshire shareholders and everyone else in this country, we can only hope that Buffett is right.
The Coolest Soccer Team in Europe?: I have embedded below a video of the third of Uruguayan striker Edinson Cavani’s three goals in a January 9, 2011 Italian Serie A game between Cavani’s team, Napoli, and league rival Juventus, not only because the Italian announcer’s call of the goal sets some type of record for operatic exclamation, but also because the goal itself is flat out ridiculous. (I am not certain, but I think the announcer may have had some type of seizure while announcing the goal.) You have to watch the slow motion replay to even be able to see the “scorpion kick” Cavani uses to put the ball in the goal.
I feature this video here because it dramatically demonstrates what many have been saying more recently following Napoli’s unexpected 3-1 win last week over Chelsea, the talent-laden but inexplicably struggling English Premier League team, in UEFA Champions League round of 16 action. That is, as Brian Phillips puts it in a February 24, 2012 post on Grantland.com, you should root for Napoli now because they are “the coolest soccer team in Europe.” (Warning: the blog post contains humor some may find offensive.)