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
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
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
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
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
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.
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.
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