Warren Buffet’s annual letter to Berkshire Hathaway shareholders rings of the Harry Truman quote, “I never did give anybody hell. I just told the truth and they thought it was hell.” Buffet also follows Truman’s counsel that “a pessimist is one who makes difficulties of his opportunities and an optimist is one who makes opportunities of his difficulties.” In practice, Buffet has excelled at that definition of optimism for decades — even in the face of a 62 percent drop in net income for his company. In this year’s letter he continues to embrace optimism while telling truths that singe their subjects.
Berkshire Hathaway publishes its compounded annual gain in value at the beginning of its annual report. The numbers tell a remarkable story: BRK has produced a compounded annual gain of 362,319 percent since inception (that’s about 10 times the return on the S&P in the same time frame, and approximately 20 percent in annual growth). While some might choose to rest on past laurels, Buffet opened with the hard news: The company’s net worth dropped by $11.5 billion, reducing per-share value of two classes of stock by almost 10 percent.
Describing the government as distributing “economic medicine that was previously meted out by the cupful … dispensed by the barrel,” Buffet went on to warn of the likelihood of inflation, but also described government actions as necessary to avoid cataclysmic economic consequences. He acknowledged that 2009 was likely to be a difficult year for BKH, as well as the American economy. But he embraced his optimistic nature and commented that “America’s best days lie ahead.”
Among the challenges of the year, Buffet reported a few pieces of upbeat news. Berkshires’ manufacturing, service and retail businesses posted encouraging earnings, and its two most important businesses — insurance and utilities — proved counter-cyclical to the rest of the economy. He took particular delight in reporting that the company’s $58.5 billion of insurance “float” money made Berkshire money — it was paid $2.8 billion to hold its float.
The loss in market value to Berkshire’s investments provided Buffet a chance to cite the teaching of his mentor that “Price is what you pay; value is what you get.” The Berkshire chairman isn’t bothered by loss of a market decline as long as he has funds available to buy. “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down,” Buffet said.
Buffet cited four long-held tenets to buying businesses: keep promises, avoid leveraging up acquired businesses, grant autonomy to management, and hold the purchased companies for a length of time. His goal is to be the buyer of choice for businesses available for purchase and criticized private equity firms for piling debt on their purchases, thus reducing equity.
One of Berkshire Hathaway’s businesses is Clayton Homes, the largest manufactured home business in the industry. Buffet noted that Clayton made slightly more than one-third of all manufactured homes, and he expects that market share to grow in 2009. He acknowledged some “atrocious” industry sales practices involving “borrowers who shouldn’t have borrowed being financed by financiers who shouldn’t have lent.” According to Buffet, his subsidiary can report that no purchaser of its mortgages lost a dime of principal or interest at the same time when industry losses were staggering. Buffet identified Clayton’s borrowers as individuals who took out mortgages they intended to pay back regardless of the direction of home prices. Summoning Nebraskan practicality, Buffet advised a minimum of a 10 percent down-payment and mortgages that fit the income of the home buyer.
“Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition.”
When discussing his tax-exempt bond insurance start-up, Buffet sounded more than a single warning. He considers the business’s potential profitability to be uncertain for a reason he’s never seen discussed anywhere else.
Buffet described New York City’s retreat from the brink of financial collapse in 1975, when virtually all of its bonds, all uninsured, were held by the city’s wealthier residents, banks and institutions. The lack of insurance on those bonds motivated their holders to help the city resolve its fiscal problems, which included a range of concessions and collaboration from varied constituencies. Buffet asked if those same bonds had been insured by Berkshire, would the various solutions have surfaced? He compared insuring tax-exempt bonds to insuring natural catastrophes: “In both cases, a string of loss-free years can be followed by a devastating experience that wipes out all earlier profits.”
“Beware of geeks bearing formulas” is one of Buffet’s most memorable warnings in this year’s letter. The reference is to the use of “back-tested” models that look at experience over a limited period of time, a plunge into logical fallacy for those who adopted the models. “In short, universe ‘past’ and universe ‘current’ had very different characteristics.”
Buffet concludes with a lengthy explanation of his firm’s involvement in 251 derivatives contracts, discussing the dangers of derivatives, their increasing impact on leverage and risk, their lack of transparency, and their part in allowing Fannie Mae and Freddie Mack to mis-state earnings for years. Buffet said the contracts Berkshire purchased were dramatically mis-priced; they allow Berkshire always to hold the money, thus assuming no counterparty risk. Leave it to Buffet to figure out a way to take much of the risk out of derivatives.
He’s consistently eschewed complexity in these letters, and he closes with a similar stance. “CEO’s who have concocted their own valuations for esoteric financial instruments have seldom erred on the side of conservativism.” Time has proved Buffet right more often than not, and if this year’s letter is reflective of those trends, the remainder of 2009 will continue to be a challenge. But the prediction that America’s best days lie ahead, together with Berkshire’s bond insurance business and venture into derivatives, place Buffet high on the optimism scale.
Julie M. Ridenour is director of business development for Norris, Perné & French LLP.