Warren Buffett released his annual letter to shareholders (.pdf) this morning along with Berkshire Hathaway’s 2009 annual report (.pdf). Our full package of analysis on Berkshire Hathaway will be available soon as part the Berkshire Hathaway 2010 Briefing Book. For now, this article highlights several notable statements that were made in the shareholder letter regarding Berkshire’s results, management philosophy, and future plans. Mr. Buffett also includes his usual commentary on broader economic issues.
There were a few areas in the letter where Warren Buffett clearly states that Berkshire Hathaway is worth far more than book value. With Berkshire Hathaway A (BRK.A) shares closing on Friday at $119,800, the share price is certainly trading above year-end book value of $84,487, but this was not the case only a few months ago. A history of Berkshire’s price to book value ratio for the past decade will be included in the forthcoming briefing book. Berkshire’s price to book value ratio is still quite a bit lower than the average ratio of the past decade.
In aggregate, our businesses are worth considerably more than the values at which they are carried on our books. In our all-important insurance business, moreover, the difference is huge. Even so, Charlie and I believe that our book value – understated though it is – supplies the most useful tracking device for changes in intrinsic value.
Mr. Buffett made a comment specific to the insurance subsidiaries value vs. carrying value:
Our property-casualty (P/C) insurance business has been the engine behind Berkshire’s growth and will continue to be. It has worked wonders for us. We carry our P/C companies on our books at $15.5 billion more than their net tangible assets, an amount lodged in our “Goodwill” account. These companies, however, are worth far more than their carrying value – and the following look at the economic model of the P/C industry will tell you why.
The question of why Berkshire was willing to issue shares to pay for part of the Burlington Northern acquisition has been a topic of much speculation over the past few months. Here is what Mr. Buffett has to say on the topic:
In our BNSF acquisition, the selling shareholders quite properly evaluated our offer at $100 per share. The cost to us, however, was somewhat higher since 40% of the $100 was delivered in our shares, which Charlie and I believed to be worth more than their market value. Fortunately, we had long owned a substantial amount of BNSF stock that we purchased in the market for cash. All told, therefore, only about 30% of our cost overall was paid with Berkshire shares.
In the end, Charlie and I decided that the disadvantage of paying 30% of the price through stock was offset by the opportunity the acquisition gave us to deploy $22 billion of cash in a business we understood and liked for the long term. It has the additional virtue of being run by Matt Rose, whom we trust and admire. We also like the prospect of investing additional billions over the years at reasonable rates of return. But the final decision was a close one. If we had needed to use more stock to make the acquisition, it would in fact have made no sense. We would have then been giving up more than we were getting.
Industry Growth vs. Investment Returns
Many investors routinely make the error of identifying a major change in technology and society and automatically assuming that businesses operating in such sectors are good investments. We have seen this again and again over the decades with the most recently example involving the dot-com collapse. This excerpt from the letter addresses the issue:
Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding.
Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes.
Autonomy of Operating Subsidiaries
Berkshire’s model of delegating significant authority to operating subsidiary managers is not without risk. Here is what Mr. Buffett had to say on this topic in general terms, while still asserting that the Berkshire model is better than the bureaucratic alternative:
We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that both operating and capital decisions are occasionally made with which Charlie and I would have disagreed had we been consulted. Most of our managers, however, use the independence we grant them magnificently, rewarding our confidence by maintaining an owner oriented attitude that is invaluable and too seldom found in huge organizations. We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly – or not at all – because of a stifling bureaucracy.
Although NetJets is discussed in another part of the letter, one gets the sense that the policy of delegation may have not worked so well for Berkshire’s fractional aviation unit:
NetJets’ business operation, however, has been another story. In the eleven years that we have owned the company, it has recorded an aggregate pre-tax loss of $157 million. Moreover, the company’s debt has soared from $102 million at the time of purchase to $1.9 billion in April of last year. Without Berkshire’s guarantee of this debt, NetJets would have been out of business. It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.
Dave Sokol, the enormously talented builder and operator of MidAmerican Energy, became CEO of NetJets in August. His leadership has been transforming: Debt has already been reduced to $1.4 billion, and, after suffering a staggering loss of $711 million in 2009, the company is now solidly profitable.
Here are some brief notes on other topics, as well as some of Warren Buffett’s famous one-liners:
- Burlington Northern will be included in the “regulated utilities” segment that currently reports on MidAmerican’s operations. Many Berkshire observers had anticipated a separate “railroad” segment. While Berkshire’s history of providing significant disclosure is reassuring, it is somewhat of a concern that the largest acquisition in Berkshire’s history is not being given an entirely distinct segment through which future results can be measured. We will see how Burlington is presented in the Q1 2010 report which should come out in early May.
- In commenting on Berkshire’s tendency to significantly outperform during years when the S&P 500 is down: “Our defense has been better than our offense, and that’s likely to continue.”
- Insurance float is up to $62 billion at the end of 2009. “Derivatives Float” was $6.3 billion at year end.
- Home Services, MidAmerican’s retail brokerage unit, was profitable in 2009 and will be “much larger” in a decade.
- Clayton Homes is facing headwinds due to negative perceptions of manufactured housing that have resulted in mortgage rates that are far higher than site built homes. One gets the sense that Mr. Buffett is preparing to get into the political debate regarding this topic particularly as it relates to FHA loans.
- Two options to increase housing demand that the United States wisely decided to not pursue: “There were three ways to cure this overhang: (1) blow up a lot of houses, a tactic similar to the destruction of autos that occurred with the “cash-for-clunkers” program; (2) speed up household formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers or; (3) reduce new housing starts to a number far below the rate of household formations.”
- “Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?” Buffett quoting Munger on his views regarding small value destroying acquisitions vs. a large one.
- “P.S.: Come by rail” regarding travel planning for the annual meeting.
Disclosure: The author owns shares of Berkshire Hathaway and is the author of an upcoming e-book that will provide analysis and valuation details including data from Berkshire’s newly released 2009 annual report.