While most investors measure themselves by long-term monetary returns, many of us place greater value in the craft and legwork of investing itself - researching businesses, digging into their operations and financials, predicting change, and attempting to discover unknown and undervalued companies in which a dollar can be purchased for 50 cents. To do this, we build a model/framework to evaluate companies and their stocks and hope to create a foundation for long-term success. However, we also need to maintain a level of flexibility and self-evaluation, constantly revising the tools we use and assumptions we make, allowing that framework to evolve. Fortunately, Warren Buffett provides one of the best free, comprehensive tool kits to build our model and help guide its evolution - his annual letters.
I wanted to briefly discuss some themes and my own takeaways from this year's release:
1) Berkshire per share book value increased by 18.4%, or $16.9B, to over $70K/share, the highest yearly gain by any US business that did not engage in a corporate merger. The lack of large insurance claims helped significantly, as its insurance subsidiaries kept most of the premiums paid versus distributing them to claimants.
2) Cash on the books increased to over $50B and will rise by another $7B because of an agreement to assume the liabilities of British syndicate Equitas , a successor to Lloyd's of London. Berkshire will pay up to $13.9B in claims over 50 years, and can invest the $7B in the meantime. BRK will surely make out like a bandit on the deal, and Buffett may welcome this week's (month's?) equity decline to potentially allocate that cash to equities.
3) Buffett thinks that GE's (GE) Jeff Immelt, Wells Fargo's (WFC) Dick Kovacevich, Amex's (AXP) Ken Chenault, and GEICO's Tony Nicely are remarkable. He also really likes Ajit Jain of BRK's National Indemnity insurance. He believes that most CEOs are overpaid and notes that no one calls him for help on their compensation committee. He's discussed this in the past and, unfortunately, not much has changed.
4) Why do you see so many GEICO ads on TV? He's allowed BRK's auto insurance subsidiary to increase its spending from $31M in 1995 to $631M in 2006. This likely means more depressed cavemen, upon which Disney may base a new show. But it works. Policies in-force increased 42% to 8.1M, earnings rose 7.6% to $1.3B, and the float (premiums not yet paid in claims that can be invested by BRK) reached $7.2B. Managed well, insurance remains one of the best businesses in the world, but GEICO may see some competition competition from Progressive (PGR), not coincidentally a long-standing holding of the Buffett/Graham-centric Sequoia Fund.
5) BRK acquired several firms in 2006, including TTI, a distributor of electronic components, and its biggest purchase in years, Israel-based Iscar, a cutting tool maker - $4B for an 80% stake. Iscar maintains a significant competitive moat, making products with little likelihood of obsolescence, no generic competition, and strong profitability, and operates its facilities in several countries. It can sell its products in multiple currencies, which acts as a natural hedge for BRK against any decline in the dollar precipitated by the US trade deficit. Buffett addressed two birds with one stone - profits and foreign exchange. He's also reduced his bet on foreign currencies and that the dollar would fall sharply in the short term, but he's kept his long-term declining dollar thesis. Based on his equity portfolio holdings (discussed below), he's likely shifted his bet from currencies themselves to purchasing the shares of strong companies that receive profits in non-dollar monies and whose shares are denominated in their native currency.
6) He's getting old, his colleagues are almost as old, and he needs someone younger to gradually assume the role of chief investor. The managers of his operating businesses (i.e., See's Candy, BRK's furniture store holdings, GEICO) need no such help, and they'll just keep sending their profits to Omaha. However, he wants to ensure that BRK's capital will be properly allocated in the future, with a high sensitivity to potential risk of loss of that capital. No specific timeline to fill the position, but a big job. I wouldn't want to be Berkshire's mailman...
7) Superior board members remain tough to find, and Buffett noted that he used four criteria to evaluate potential appointees - "owner-oriented, business-savvy, interested and truly independent." The last one's tough to meet. Many rely on yearly board fees as their main source of income and do not want to disrupt that cash flow by disagreeing with the CEO. However, Buffett thinks that BRK found a great new board member in Susan Decker, CFO and likely next CEO, of Yahoo (YHOO). I'm sure you're thinking - what does this say about YHOO's future and its leadership, something we've previously discussed? It's likely improving quickly, but the company needs to reestablish its 30% operating margin for the stock to rise significantly.
8) Buffett likes the regulated utility business but predicts the continuing decline of the newspaper industry, another topic that we've discussed. BRK earned over $800M from its energy production and distribution investments - 86.6% ownership of electricity generation/distribution in Great Britain, the Midwest and West Coast and natural gas transmission in the West - and earns 9% on its loans to these entities, an advantageous rate to both parties. Utility ownership remains a great mechanism to "stay rich" and reliably invest BRK's operating earnings and insurance float.
However, while its ownership of the Buffalo News remains profitable and maintains a successful internet presence, Buffett expects its earnings to fall and that "uneconomic buyers" - wealthy community members that seek the prestige of newspaper ownership regardless of profitability - will likely fill the gap left by faltering public companies. For more, see former GE CEO Jack Welch's and Eli Broad/David Geffen's pursuit of the Boston Globe and LA Times, respectively. A couple of very smart investors, including Arial Capital Mgmt, Gardner Russo, and Private Capital Mgmt (Legg Mason), continue to hold newspaper equities, but this industry may be another one that should be labeled "too tough" to predict.
9) Derivatives (entities such as options, forwards, futures, or swaps, that derive their value from an underlying asset, interest rate, or currency) are OK if one can accurately value them and if they possess no counterparty risk - meaning, avoid situations in which the institution on other side of the trade could lose too much money and default on its payment obligations. Buffett formerly referred to derivatives as "weapons of financial destruction," and BRK's General Re reinsurance subsidiary lost hundreds of millions attempting to unwind thousands of complex derivative agreements. As the last Gen Re contracts close, he has selectively reentered the derivative markets to make BRK money. Shareholders will benefit but shouldn't try it at home.
10) Buffett wouldn't disclose two large stock holdings he continues to buy, but he made several changes to BRK's equity portfolio. Several new companies appear, notably some overseas-based firms including POSCO (PKX), the South Korean steel manufacturer, and Tesco, a UK-based retailer. Shares of both firms again are likely denominated in their native currencies in order to capture both corporate earnings and foreign exchange-based gains. Fortune's Carol Loomis also posted a good summary of BRK's portfolio changes. Some additional takeaways include Buffett's continued interest in banks, apparently unfazed by the ongoing implosion of the sub-prime mortgage market - increasing his WFC stake, adding shares of US Bancorp (USB), and maintaining his position in M&T (MTB). He still owns a sizable chunk of Anheuser-Busch (BUD), PetroChina (PTR), Procter and Gamble (PG), ConocoPhillips (COP) and Johnson & Johnson (JNJ). We've previously discussed his recent USG (USG) purchase, as BRK currently owns 19% of the company.
As BRK has grown and its core shareholder base becomes richer yet older, Buffett has shifted his focus to preservation of wealth and "staying rich." He may have always focused on risk and capital loss, but, as Buffett notes, BRK's size limits its potential investments to "elephants," large companies that can absorb the capital that BRK wants to allocate and can make a material difference in its overall investment return. Buffett may find companies that could much more than double or triple in value, but remain so small (less than $1-3B in market cap) that BRK would need to purchase the entire firm to fully allocate its cash. Combined with his fears of a dollar decline, he would rather invest in the most durable large firms, including overseas markets, that limit his potential for losses in absolute terms than stretch to find new investments. Thus, anyone mimicking his portfolio should likewise reduce their expectation for future gains. Also, because of the later timing of BRK's holdings' disclosure, their equity holdings likely will have already increased substantially in value and may no longer remain undervalued. POSCO would be the best example, as the shares more than doubled prior to Thursday's disclosure. Overall, you'll steadily perform well, but the days of doubling or tripling the S&P's return are in the past.
Individual investors should focus on developing an investing framework, shaped in part by Buffett's writings and ideas, that allows them to discover investments outside of BRK's range but that capitalize on the flexibility that the non-BRK , individual investor retains. Durable competitive advantage, a strong balance sheet, high return on invested capital, superior management, and trading at less than intrinsic value remain the core tenants of his investing strategy.
Other than USG, with a smaller market cap of $4B, I would review Brown-Forman (BFB), maker of Jack Daniels and recently mentioned in Barron's, and Diageo (DEO), two global spirits makers with large competitive moats, excellent cash flow, and international growth opportunities. DEO may be close to fairly valued, but BFB trades near a 52-week low because of a disappointing earnings report and its recent purchase of Mexican tequila-maker Herradura. I do not expect it to remain at these levels for long. Of his current holdings, I would consider COP, a cheap stock trading at 7X earnings with a 20% ownership of Russia's Lukoil and a large refinery business, and JNJ, the diversified medical products firm which has rapidly become much less expensive in this week's market decline. Investors can also participate in POSCO's rise through Marty Whitman's Third Avenue Value fund [TAVFX], and for those hoping to participate in future appreciate of BRK shares, the Fairholme Fund [FAIRX] currently allocates more than 16% of its portfolio to the company.
Most importantly, Buffett's greatest contribution remains his recently announced philanthropic effort. Continually augmented by his ongoing success at BRK, those shares will ultimately be used to benefit the global community. While we all may search for that handful of stocks to help us achieve Buffett-like returns over the rest of the decade, I'm also sure that the passion that many of us have for the craft and continuing education of the investor await the insight and ideas that Buffett's next letter holds. If Buffett encourages us to not only become the best investors but to allocate that wealth to help others, his letters will surely become even more meaningful.
BRK.A vs. BRK.B 1-yr chart: