Berkshire Hathaway — The Anti-Volatility Fortress

I’ve commented on Buffett’s Shareholder letter now for the past five years.  Those who know me well know that I admire Buffett and Berky, but not uncritically.   Also, I view Berky as primarily an insurance company, secondarily as an industrial conglomerate, and thirdly as an investment company.

Onto the letter:

From page 3:

You may recall a 2003 Silicon Valley bumper sticker that implored, “Please, God, Just One More Bubble.” Unfortunately, this wish was promptly granted, as just about all Americans came to believe that house prices would forever rise. That conviction made a borrower’s income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA – house price appreciation – would cure all problems. Today, our country is experiencing widespread pain because of that erroneous belief. As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out – and what we are witnessing at some of our largest financial institutions is an ugly sight.

Buffett starts out with the cause behind most of our current problems in financial companies.   There are too many houses chasing too few people, and inadequate underwriting of the financing, because of a misplaced trust in the rise of housing prices.

From page 4:

Though these tables may help you gain historical perspective and be useful in valuation, they are completely misleading in predicting future possibilities. Berkshire’s past record can’t be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future.  (emphasis his)

Buffett has been honest on this point for years.  As the business grows, it is unlikely to find opportunities as good in percentage terms as it did when it was smaller.  That’s normal, even for the best investors.

In our efforts, we will be aided enormously by the managers who have joined Berkshire. This is an unusual group in several ways. First, most of them have no financial need to work. Many sold us their businesses for large sums and run them because they love doing so, not because they need the money. Naturally they wish to be paid fairly, but money alone is not the reason they work hard and productively.

Buffett hits on what I think is one of the great secrets of good capitalism.  The best capitalists are not purely money-motivated, but are idealists, aiming for excellence as they serve others though their businesses.  In the best businesses that I have worked in, we did it because we loved what we did.  That’s a key for all good businesses, from the CEO down to the clerk.

From page 7:

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

This is the core of Buffett the businessman.  He understands the need to redirect free cash flow to the opportunities that offer the best returns.  He knows that certain businesses will never be more than niches, and like a good farmer would, harvests his specialty crop each year, but doesn’t plant much more the next year.

He goes on for two pages on how he distinguishes between businesses, considering their long-term competitive advantage, return on investment, and capital intensiveness.    It’s a good read, and very basic.  If it weren’t for the fact that many companies operate more for the good of management than shareholders, you might see this in operation more broadly.  (And you would see opportunities diminish for private equity as far as big deals go.  Private equity keeps public management teams on their toes, for the bigger deals.)

From pages 9-11, Buffett discusses his insurance businesses, and spends much less time on them than in prior years.  It is not as if there isn’t a good story to tell.  Are underwriting profits down?  Yes, but only by 10%.  The rest of the P&C insurance industry is struggling with the same problems, and is likely doing worse in aggregate.  I think that some major disasters will have to happen to re-energize earnings here.  Berky is an anti-volatility asset, and always does relatively better when the rest of the insurance industry is hurting.

On page 11, Buffett comments on his utility businesses.  Earnings are up in this line.  These are a natural fit for Berky, with their earnings yield considerably above Berky’s cost of float, and earnings that tend to do well when inflation is higher.  Expect Buffett to buy more here, but only during some significant pullback in utility stock prices.

From that page:

Somewhat incongruously, MidAmerican also owns the second largest real estate brokerage firm in the U.S., HomeServices of America. This company operates through 20 locally-branded firms with 18,800 agents. Last year was a slow year for residential sales, and 2008 will probably be slower. We will continue, however, to acquire quality brokerage operations when they are available at sensible prices.

From page 13:

Last year, Shaw, MiTek and Acme contracted for tuck-in acquisitions that will help future earnings. You can be sure they will be looking for more of these.

and

At Borsheims, sales increased 15.1%, helped by a 27% gain during Shareholder Weekend. Two years ago, Susan Jacques suggested that we remodel and expand the store. I was skeptical, but Susan was right.

 

From page 15:

Clayton, XTRA and CORT are all good businesses, very ably run by Kevin Clayton, Bill Franz and Paul Arnold. Each has made tuck-in acquisitions during Berkshire’s ownership. More will come.

Buffett understands that most good acquisitions are little ones that can be used to increase organic growth of the subsidiary.  Same thing for intelligent capital spending, as at Borsheim’s.  He may keep a tight hold on free cash flow, but he listens to his subsidiary CEOs, and usually gives them enough to invest to improve the businesses.

Also look at the countercyclical nature of Buffett’s acquisitions.  He is willing to buy real estate sales franchises in this environment, if they come at the right price.  Much as I am a bear on housing, this is the right strategy, if you have a strong enough balance sheet behind it.

On pages 12 and 14, net operating income improved in Manufacturing, Service, and Retailing Operations, and fell in Finance and Finance Products.  He doesn’t discuss it, but there was a loss in life and annuity.  Berky mainly does life settlements there, a business I regard as somewhat malodorous because it undermines the life insurance industry, by weakening the concept of insurable interest.  Also, leasing didn’t do that well, as Buffett points out.

On page 15, I don’t have a strong opinion on his stock positions… they are a little more expensive than I like to buy, but he has to deploy a lot more money than I do, and has a longer time horizon.  His focus on long term competitive advantage is exactly right for his position in the market.

On page 16, Buffett discusses his derivative book:

Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories. First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

 

We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet.

 

The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

 

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

 

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

 

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

 

Okay, so Buffett is long high yield credit, and seemingly receiving a pretty reward for it (the numbers seem too good, what is he doing?), and is long the US and other equity markets by writing long-dated European puts.  Sounds pretty good to me on both, though I’d love to see the details on the high yield, and on the equity index puts, Berky will be vulnerable in a depression scenario (it would be interesting to know the details there also).

 

Buffett is behaving like a long-tail P&C insurer, and he is willing to take on volatility if it offers better returns.  Berky is almost always willing to take on catastrophe risks, if they are more than adequately compensated.  If you are uncertain about this, ask the financial guarantors, they will tell you.

 

On page 17:

 

There’s been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here. Why should we complain when they choose stocks over bonds?

 

Indeed, what’s sauce for the goose is sauce for the gander.  Why should the rest of the world buy our depreciating bonds, when they can buy our companies, which in my opinion, often offer much better prospects?  As Buffett puts it later, we are force-feeding dollars to the rest of the world… the decline in value is to be expected.

 

Also on page 17:

 

At Berkshire we held only one direct currency position during 2007. That was in – hold your breath – the Brazilian real. Not long ago, swapping dollars for reals would have been unthinkable. After all, during the past century five versions of Brazilian currency have, in effect, turned into confetti. As has been true in many countries whose currencies have periodically withered and died, wealthy Brazilians sometimes stashed large sums in the U.S. to preserve their wealth.

 

Clever move, and emblematic of the shift happening in our world where resource- and cheap labor-driven nations grow rapidly, and build up trade surpluses against the developed world.  Their currencies have appreciated.

 

Also on page 17:

 

Our direct currency positions have yielded $2.3 billion of pre-tax profits over the past five years, and in addition we have profited by holding bonds of U.S. companies that are denominated in other currencies. For example, in 2001 and 2002 we purchased 310 million Amazon.com, Inc. 6 7/8 of 2010 at 57% of par. At the time, Amazon bonds were priced as “junk” credits, though they were anything but. (Yes, Virginia, you can occasionally find markets that are ridiculously inefficient – or at least you can find them anywhere except at the finance departments of some leading business schools.)

 

The Euro denomination of the Amazon bonds was a further, and important, attraction for us. The Euro was at 95¢ when we bought in 2002. Therefore, our cost in dollars came to only $169 million. Now the bonds sell at 102% of par and the Euro is worth $1.47. In 2005 and 2006 some of our bonds were called and we received $253 million for them. Our remaining bonds were valued at $162 million at yearend. Of our $246 million of realized and unrealized gain, about $118 million is attributable to the fall in the dollar. Currencies do matter.

 

Though Buffett got scared out of many of his foreign currency positions over the last few years, intellectually he was right about the direction of the US dollar, and made decent money off it.  The Amazon position was a home run in bond terms.  Bill Miller benefited from that one as well.  (I also endorse the comment on occasional inefficient markets.)

 

On page 18:

 

At Berkshire, we will attempt to further increase our stream of direct and indirect foreign earnings. Even if we are successful, however, our assets and earnings will always be concentrated in the U.S. Despite our country’s many imperfections and unrelenting problems of one sort or another, America’s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever-growing prosperity for its citizens.

 

This is one of America’s greatest sustainable competitive advantages.  We allow more flexibility and failure than anywhere else in the world.  We have a relatively open and free system of markets and government.  Woe betide us if we change this.

 

On pages 18-20, Buffett takes on employee stock option accounting and pension accounting.  He believes options should be expensed, and that companies should bring down their assumptions for investment earnings, because they are unrealistically high.  I agree on the latter, and on the former, I think full disclosure is good enough.  Accounting rules are important, but investors (like Buffett) look for long-term free cash flows, which are largely unaffected by accounting rules.

 

I don’t think the market is fooled in either case.  Companies with large stock option grants and high assumed earning on pension plans both tend to trade cheap.  Their earnings quality is light.

 

Finally, on page 20:

Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement – sometimes to those in their low 40s – and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.

 

Ummm… say it again, Warren.  I’ve been saying this for years.  Hey, throw in multiple employer trusts as well.

 

With that, I would offer two observations about this letter from Warren.  First, it is shorter, and contains less data on the businesses, particularly the insurance businesses, but then, it was a quiet year.  Second, he had less in the way of “soap box” issues this year.

 

In closing, Berky had a good year, and I have little to quibble with in this letter.  Another good job, Warren.