The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

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.)

Overview

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."

Discussion

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.　

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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.

Discussion

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."

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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."

Commentary

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.

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Warren Buffett’s annual letter to Berkshire Hathaway shareholders has become a capitalist cult classic, eagerly awaited each year not only by Berkshire shareholders but also by a broader audience of readers keen to read Buffett’s observations about both his company and the larger business and economic environment. This year’s letter (here), issued after market close on February 29, 2008, does not disappoint, as it brims with commentary on a variety of matters, as well as about the performance of Berkshire itself. But to an unusual extent, this year’s letter may be as noteworthy for what it omits as for what it includes, as I discuss further below. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)

Buffett’s letter is of course a part of the Berkshire 2007 annual report, and the letter does contain quite a few interesting nuggets about Berkshire. Even though Buffett seemingly goes out of his way to detail his past investing errors (particularly emphasizing his failed Dexter Shoes investment as well as his failure to buy a Dallas TV station), the overall effect is to reinforce Buffett’s astonishing investing success. For example, after documenting his lapses at length, he almost parenthetically mentions the company’s 2007 sale of its 1.3% interest in PetroChina, acquired during 2002 and 2003 for $488 million, for which Berkshire received $4 billion – a staggering 820% gain in approximately five years.

On the other hand, Buffett’s letter also emphasizes that although Berkshire’s insurance businesses had another “excellent year” in 2007 (producing underwriting profit of $3.37 billion, on top of $3.8 billion in 2006), it is “a certainty that insurance industry profit margins, including ours, will fall significantly in 2008.” Buffett’s bases for this conclusion are that “prices are down and exposures inexorably rise.” If natural catastrophes occur, “results could be far worse.” Buffett warns Berkshire’s shareholders “to be prepared for lower insurance earnings during the next few years.”

Buffett also provides a detailed explanation of Berkshire’s growing derivatives exposure. The existence of these contracts in Berkshire’s portfolio may strike some as contradictory, as Buffett has for years railed against derivatives as, among other things, “financial weapons of mass destruction” (as he called them in his 2002 shareholders’ letter). He has bemoaned for years the losses Berkshire sustained in winding down Gen Re Securities derivatives operation (on which Buffett reported in his 2006 letter that Berkshire had sustained a cumulative pre-tax loss of $409 million).

Buffett nevertheless reports in this year’s letter that Berkshire had entered a total of 94 derivative contracts (up from 62 in 2006), apparently in the form of credit default swaps and futures put options on four stock indices. (The stock indices put represents a bet that these indices will close at far-forward dates at levels above where they stood when Berkshire entered the contracts.) While Buffett’s willingness to enter these contracts seems surprising given his long-standing and often-expressed hostility to derivatives generally, he emphasizes that with respect to each of the contracts, Berkshire is holding the cash – which means not only that Berkshire has no counterparty risk, but also that Berkshire has the opportunity to earn investment income in the interim. It is also important to contrast Berkshire’s current portfolio of 94 derivative contracts with the 23,318 contracts that were formerly held by Gen Re Securities. 

Buffett does warn that the mark-to-market accounting required on the derivative contracts “will sometimes cause large swings in reported earnings.” Buffett compares this exposure to Berkshire’s catastrophe insurance exposure and Berkshire’s long-standing willingness to “trade volatility in reported earnings in the short run for greater gains in net worth in the long run.” I have more to say below about Buffett’s comparison between the derivatives portfolio and Berkshire’s catastrophe reinsurance business.

Buffett’s commentaries about Berkshire’s performance are interesting, but Buffett’s letters are valued for far more than their observations on Berkshire’s own performance. Most readers scour Buffett’s letters for his discourse on larger topics, and his most recent letter has much to offer in that regard. In this year’s letter, Buffett returns to some of his familiar themes and also launches into some new topics.

The first familiar theme Buffett sounds relates to problems in the residential mortgage sector. Buffett commented on this topic in last year’s letter, where he decried “weakened lending practices” and mortgage loan structures that subjected borrowers to potentially escalating repayment obligations. In this year’s letter, Buffett has a “told-you-so” tone when he references the “staggering problems” that “major financial institutions” have recently experienced. He comments that “our country is experiencing widespread pain” because of the “erroneous belief” that “house price appreciation” would “cure all problems.” Buffett notes that

As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide does out – and what we are witnessing at some of our largest financial institutions is an ugly sight.

Another recurring theme Buffett revisits in this year’s letter is the U.S. trade deficit and its impact on the dollar’s valuation. In last year’s letter, while reporting on Berkshire’s direct foreign exchange gains, he bemoaned the U.S.’s transformation into a net debtor country as a result of which the country is now shipping “tribute” overseas in the form of an interest income burden that finances what he called U.S. “over-consumption.” Buffett returns to this topic in this year’s letter, specifically commenting on how these circumstances have led to the emergence of sovereign wealth funds:

There has been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot of foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here.  Why should we complain when they choose stocks over bonds?

In last year’s letter, Buffett did note that Berkshire had “come close to eliminating our direct foreign exchange position,” on which Berkshire had earned roughly $2.2 billion between 2002 and 2006 in investments in 14 different currencies. In this year’s letter, Buffett notes that in 2007 Berkshire had only one direct currency position, in the Brazilian real. Buffett also noted that Berkshire had invested in bonds denominated in currencies other than dollars, citing as a specific example euro-denominated Amazon.com bonds Berkshire purchased in 2002 for $162 million, that were redeemed in 2007 for $253 million (having paid 6 7/8 % interest in the interim).

Yet, Buffett emphasizes, Berkshire’s assets “will always be concentrated in the U.S.,” citing as justification “America’s rule of law, market-responsive economic system, and belief in meritocracy,” which Buffett contends, “are almost certain to produce ever-growing prosperity for its citizens.”

One standard feature of Buffett’s annual letter is a penultimate portion in which he skewers some particular foible of the financial scene. Last year, Buffett targeted the “2-and-20 crowd” of hedge fund “helpers” whose fees enrich themselves at their clients’ expense. This year, in a section of the letter captioned “Fanciful Figures – How Public Companies Juice Earning,” Buffett targets “the investment return assumption a company uses in calculating pension expense.”

Buffett notes that the 2006 average assumed pension return among the 363 S & P companies that have pensions is 8%. Buffett compares this assumed 8% return to the 5.3% average annual increase in the Dow Jones average during the 20^th century. In order for the Dow Jones average to continue to grow at just a continued 5.3% annual rate in the 21^st century, the Dow Jones average would have to close at 2,000,000 on December 31, 2099. And the companies that are projecting a 10% return “are implicitly forecasting a level of about 24,000,000 on the Dow by 2100.” Buffett characterizes the “helpers” who make these kinds of assumptions as “direct descendants of the Queen in Alice in Wonderland” who has “believed as many as six impossible things before breakfast.”

The reason for these high investment return assumptions, Buffett notes, “is no puzzle,” as they allow CEOS to “report higher earnings,” securing the knowledge that “the chickens won’t come home to roost until long after they retire.”

Having disparaged corporate pension fund accounting, Buffett then moves on to “public pension promises” for which “funding is woefully inadequate.” The “fuse on this time bomb is long,” but the promises that politicians find so easy to make “will be anything but easy to keep.”

Buffett’s annual letter is always entertaining and informative, and this year’s letter is no exception. But it strikes me that there are omissions from this year’s letter, some of which seem to me to be particularly conspicuous.

First, Buffett’s letter makes absolutely no reference to the recent “finite reinsurance” criminal trial that resulted in guilty verdicts against four former Gen Re officials (as well as one former AIG officer). Buffett’s silence on this matter is at one level understandable, as his name did arise in trial testimony, and as news reports suggest (here) that the criminal investigation is continuing. But given the fact that the former CEO and former CFO of Berkshire’s largest subsidiary were found guilty of criminal wrongdoing, Buffett’s lack of any reference to the verdicts (even to say that he could not comment) seems like a significant omission.

Buffett did implicitly draw a seeming contrast between prior Gen Re management (the ones on trial) and current Gen Re management; Buffett said that current management is doing “first-class business in a first-class way” despite “costly and time consuming legacy problems.” Buffett also commented that he learned to his regret that when he acquired Gen Re in 1998, it was no longer the “Tiffany of reinsurers” as it had been previously. Buffett made similar comments in the 2001 and 2002 Berkshire annual reports. (Full disclosure: I was for ten years an employee of a Gen Re operating subsidiary, and for that reason I feel obliged to forebear from any further commentary on these circumstances.)

Second, other than commenting on the mortgage lending industry’s lamentable shortcomings, Buffett provides no further commentary on the subprime crisis. Other insurers reporting their earnings in recent weeks have felt compelled to address both their potential insurance loss exposure to subprime-related liabilities and their companies’ investment portfolio vulnerability to subprime investment losses. On the one hand, Buffett’s credibility is such that if Berkshire had significant exposure in these areas, we would all expect him to have said something about it. On the other hand, given the prominence of these issues, it does not seem too much to have expected him to address these issues, and, again, his failure to comment on these topics seems like an omission.

Third, and related to the topic of subprime, Buffett’s letter makes no reference to Berkshire’s recent high profile entry into the municipal bond insurance business, in the wake of turmoil involving the traditional monoline insurers. While we may perhaps look forward to reading about this development in next year’s letter, this initiative did unfold in late 2007, and I would have expected some commentary about it in this year’s letter, especially given the high profile nature of the move.

But while Buffett did not mention Berkshire’s move into municipal bond insurance, his commentary on the problems public pension funds may face does put Berkshire’s move into providing municipalities with default guarantee protection in an interesting perspective. As Floyd Norris of the New York Times observes on his blog, Notions on High and Low Finance (here), “Why, you might wonder, would Mr. Buffett want to put Berkshire Hathaway into the business of insuring municipal bonds issued by such governments?”

One final apparent omission from Buffett’s letter is that he does not mention Berkshire’s recent acquisition of 3% interest in Swiss Re, or Berkshire’s agreement to assume 20% of Swiss Re’s property and casualty reinsurance business for the next five years. (Refer here for background on these transactions.) On the one hand, the Swiss Re transactions represent 2008 business, and so I suppose we should just be patient and wait until next year’s letter to see what Buffett says about the transactions. But the particular reason that Buffett arguably ought to have discussed the Swiss Re transactions, and in particular the timing of the Swiss Re transactions, is his commentary in this year’s letter about the likely future prospects of the insurance industry. I agree with Buffett that we should all “be prepared for lower insurance earnings over the next few years.” Given these prospects, the timing of the Swiss Re transactions cries out for further explanation.

A Final Observation: Perhaps others might be unwilling to find any relation between the two companies’ respective positions, but I find Berkshire’s increased derivatives exposure somewhat disconcerting in light of AIG’s recent $11.2 billion mark-to-market derivatives portfolio write-down. It may also fairly be argued that Berkshire’s volatility exposure is much smaller than is AIG’s. But after years of Buffett’s lectures about the evils of derivatives, Berkshire’s growing derivatives exposure seem incongruous.

Questions may also be raised about the appropriateness of the analogy Buffett draws between Berkshire’s volatility exposure as a catastrophe reinsurer and the potential volatility from Berkshire’s growing derivatives portfolio. The Wall Street Journal’s March 1, 2008 Breaking Views column (here) put its finger precisely on the problem in its commentary on AIG’s write-down, by pointing out that logical shortcoming of insurers’ putative qualifications to assess and accept risk from these financial instruments:

Insurers say they are experts at managing just this sort of high-severity, low-probability risk. They argue that insuring against floods, hurricanes, and earthquakes has given them peerless expertise in managing it.

But since there’s no market in acts of nature, insuring against them can’t lead to massive mark-to-market write-downs, as financial exposures can. And there’s a big difference between acts of nature, which can be modeled statistically, and the behavior of complex structured-finance instruments packed with assets that have little historical performance data, which frequently confounds statisticians.

The Journal column ends with the observation that “AIG isn’t alone in falling for this false analogy.” 

To be sure, Buffett did not claim that Berkshire’s expertise in underwriting catastrophe reinsurance qualified the company to underwrite derivatives, only that Berkshire’s willingness to accept the volatile results of catastrophe reinsurance was comparable to its willingness to accept volatile impacts from its derivatives portfolio, in exchange for the long run net worth benefits.

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