Feb 28, 2010 View Comments
Warren Buffett’s Berkshire Hathaway 2009 Shareholders Letter
I woke up at 7AM yesterday to have a chance to read Warren Buffett’s Berkshire Hathaway 2009 letter to shareholders (PDF). This year’s letter did not disappoint. I would like to highlight a few key ideas from the letter.
Intrinsic Value
At the beginning of each letter, you will see a table of how Berkshire Hathaway’s growth in book value fared versus the S&P 500′s. Now, as Buffett states below, book value does not precisely peg intrinsic value but it comes close:
The ideal standard for measuring our yearly progress would be the change in Berkshire’s per-share intrinsic value. Alas, that value cannot be calculated with anything close to precision, so we instead use a crude proxy for it: per-share book value. Relying on this yardstick has its shortcomings, which we discuss on pages 92 and 93. Additionally, book value at most companies understates intrinsic value, and that is certainly the case at Berkshire. 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. By this measurement, as the opening paragraph of this letter states, our book value since the start of fiscal 1965 has grown at a rate of 20.3% compounded annually.
Whitney Tilson takes a different approach for figuring out the company’s intrinsic value: you take the company’s per share investments and add them to pretax earnings per share with a multiple attached. This is closer to what Warren Buffett has recommended for pegging Berkshire’s intrinsic value, but it is also more difficult to determine. For most people, the book value approach should be sufficient enough.
Float
Most people don’t understand float, but it is probably the key factor in Berkshire Hathaway’s growth over the last 40 years. Let’s say you are a value investor and you manage to take control of a company. In general, your opportunities range from reinvesting in the business you have acquired, to looking at outside opportunities. These can be acquisitions of other businesses or simple investments in securities. Normally, such investments must be paid for using free cash flow or debt. But if you were to acquire an insurance company, you would have one more weapon in your arsenal, float:
Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float.
If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money – and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float…
Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest.
Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses. Our insurance CEOs deserve your thanks, having added many billions of dollars to Berkshire’s value. It’s a pleasure for me to tell you about these all-stars.
Bolded for emphasis. The $16M to $62B figure is absolutely amazing and speaks to the power of a disciplined insurance operation. Not to detract from the 2009 letter, but I think the following discussion on National Indemnity from the 2004 is quite insightful here. Indeed, in Buffett’s 2004 letter, he said that without the acquisition of National Indemnity, Berkshire would be nowhere close to its size today:
So, you may ask, how do Berkshire’s insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage? We’ve attacked that problem in several ways. Let’s look first at NICO’s strategy.
When we purchased the company – a specialist in commercial auto and general liability insurance – it did not appear to have any attributes that would overcome the industry’s chronic troubles. It was not well-known, had no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents, a method many people thought outdated. Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.
What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate. Take a look at the facing page. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.
Many insurance companies end up chasing premiums without adequate risk management and blow up. They never have the time to really endure and grow, the way that Berkshire has done with National Indemnity and its other operations. Now, back to the 2009 letter.
Buffett uses the rest of the insurance section of the letter to praise Ajit Jain’s activities at Berkshire Reinsurance and mentions that GEICO has gone from the country’s 6th largest auto insurer to the third largest in just 15 years. One of the best things about Buffett is he always owns up to his mistakes. It seems as if a foray into the credit card business did not work out so well for GEICO:
And now a painful confession: Last year your chairman closed the book on a very expensive business fiasco entirely of his own making.
For many years I had struggled to think of side products that we could offer our millions of loyal GEICO customers. Unfortunately, I finally succeeded, coming up with a brilliant insight that we should market our own credit card. I reasoned that GEICO policyholders were likely to be good credit risks and, assuming we offered an attractive card, would likely favor us with their business. We got business all right – but of the wrong type.
Our pre-tax losses from credit-card operations came to about $6.3 million before I finally woke up. We then sold our $98 million portfolio of troubled receivables for 55¢ on the dollar, losing an additional $44 million.
GEICO’s managers, it should be emphasized, were never enthusiastic about my idea. They warned me that instead of getting the cream of GEICO’s customers we would get the – – – – – well, let’s call it the non-cream. I subtly indicated that I was older and wiser.
I was just older.
That kind of honesty is unparalleled in shareholder letters, which usually read more like corporate propaganda than honest assessments of the business.
Burlington Northern Santa Fe
(Flickr: SP8254)
The regulated utilities section of the letter provides some insights on why the Buffett chose to acquire Burlington Northern. I think that for the most part, guys like Bruce Berkowitz were right in their assessment on Burlington Northern:
CONSUELO MACK: Let me ask you about the Burlington Northern acquisition, the largest acquisition that Berkshire Hathaway has ever made. The Wall Street Journal coverage of it saidWarren Buffett is turning Berkshire Hathaway into a big industrial operator and it’s no longer thenimble investment firm that it was once. What’s your view of what Warren is doing in buying thesebig industrial companies?
BRUCE BERKOWITZ: Berkshire has a tremendous amount of flow from the premiums received from long-term insurance policies. That flow has to be invested in very secure, sound financial instruments such as: electric utilities cost plus or a railroad business which has the stability unlikemany businesses. So here he’s taking money that’s actually got a zero cost to it and then investing itat a reasonable, not at an egregious yield, but at a reasonable investment yield. But when the cost iszero, the returns are phenomenal. He’s brilliant. Warren Buffett is being Warren Buffett in that he’smarried another great big business to Berkshire Hathaway that’s going to make a sizeable difference overtime
Buffett believes that BNSF should be looked at as a utility as well:
Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities. In both cases we provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require heavy investment that greatly exceeds depreciation allowances for decades to come. Both must also plan far ahead to satisfy demand that is expected to outstrip the needs of the past. Finally, both require wise regulators who will provide certainty about allowable returns so that we can confidently make the huge investments required to maintain, replace and expand the plant…
In the future, BNSF results will be included in this “regulated utility” section. Aside from the two businesses having similar underlying economic characteristics, both are logical users of substantial amounts of debt that is not guaranteed by Berkshire. Both will retain most of their earnings. Both will earn and invest large sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens – yes, tens – of billions of dollars of incremental equity capital.
Buffett does not say explicitly what he thinks the returns on invested capital will be for the railroad business but that it should increase over time. Burlington Northern should definitely have the kind of pricing power it needs to ward off the frictional forces of inflation, should regulators act properly.
NetJets
When David Sokol took the reigns at NetJets, I think people looked at the situation in two ways. 1. This would be a test for Sokol, to see if he has what it takes to be the CEO of Berkshire Hathaway. 2. Berkshire’s businesses aren’t infallible and may need guidance from time to time. Here is what Buffett said of the situation:
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…
The major problem for Berkshire last year was NetJets, an aviation operation that offers fractional ownership of jets. Over the years, it has been enormously successful in establishing itself as the premier company in its industry, with the value of its fleet far exceeding that of its three major competitors combined. Overall, our dominance in the field remains unchallenged.
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.
Most important, none of the changes wrought by Dave have in any way undercut the top-of-the-line standards for safety and service that Rich Santulli, NetJets’ previous CEO and the father of the fractional- ownership industry, insisted upon.
With the debt reduced to $1.4B and the company profitable, David Sokol looks as if he has passed the test. Sokol has gradually had the opportunity to get more face time with the media. We saw this with his activities at NetJets and the investment in BYD. I think he is poised to be the right operations guy at Berkshire, with Ajit Jain handling the insurance operations and the still unnamed CIO handling investments.
Financial Products and Derivatives
On occasion, Buffett has criticized the government’s lending policies with good reason. Berkshire is unable to get the kinds of lending rates that TARP recipients received in the past, which put the company at a decided disadvantage when it came to bidding on parts of companies such as AIG. But in this year’s letter, Buffett sheds light on another problem:
The residential mortgage market is shaped by government rules that are expressed by FHA, Freddie Mac and Fannie Mae. Their lending standards are all-powerful because the mortgages they insure can typically be securitized and turned into what, in effect, is an obligation of the U.S. government. Currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 51⁄4%. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels.
In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan. For the all-cash buyer, Clayton’s homes offer terrific value. If the buyer needs mortgage financing, however – and, of course, most buyers do – the difference in financing costs too often negates the attractive price of a factory-built home…
Our product is first-class, inexpensive and constantly being improved. Moreover, we will continue to use Berkshire’s credit to support Clayton’s mortgage program, convinced as we are of its soundness. Even so, Berkshire can’t borrow at a rate approaching that available to government agencies. This handicap will limit sales, hurting both Clayton and a multitude of worthy families who long for a low-cost home.
These kinds of double standards hurt buyers of Clayton’s homes, especially considering that Clayton’s buyers are not speculators. Most are simply people looking to buy a home and live in it. They aren’t the gluttonous home flippers that helped fuel the excess supply in the housing market.
One of the problems with the media and Warren Buffett is that they often try to over simplify what he says, boiling things down into sound bytes that don’t give the full picture. This is definitely the case with derivatives.
A number of commentators have criticized Buffett for investing in derivatives contracts after calling derivatives weapons of mass destruction. The thing is, Buffett was criticizing how most financial institutions were using derivatives. For the most part, companies like AIG were writing billions upon billions of dollars worth of CDS contracts using faulty math behind defaults. They were totally unrealistic. We see now that Greece tried to use contracts to fudge their budgetary accounting and make their deficits appear artificially lower. These kinds of uses of derivatives are pretty stupid and can cause the mass destruction that Buffett described. Actually, if you look at AIG and the state of Greece, you could argue that they have already caused that destruction.
The Berkshire approach to derivatives is different. For the most part, Buffett looks at these like he does insurance. He is trying to find mispricings where the risk is limited and the duration from now till when money must be exchanged is sufficiently long enough to earn enough from the float to limit any kind of damage that would occur if Berkshire is on the losing side of these contracts:
We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998. The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred – nor will it.
It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as MidAmerican, and the minor runoff contracts at General Re. If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.
Most people incorrectly assume that value investing means just investing in well run large cap stocks. It doesn’t. Value investing is buying a dollar for 50 cents. Where that dollar exists should not matter. A good investor should be willing to travel across asset classes in search of these bargains, and that is what great investors like Seth Klarman, Prem Watsa, and Warren Buffett have done in the past.
The entire letter is worth reading, especially for getting a more detailed insight into some of Berkshire Hathaway’s lesser known subsidiaries and overall performance for 2009.
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