Critical Analysis of Buffett’s Annual Letter

I’ve written a lot about Buffett over the years.  I think this is the eighth shareholder letter that I have written about.  I have the unique perspective of being both an actuary and a value investor.  I get what Buffett is doing, though by no means am I his equal.  This is a commentary on his 2010 shareholder letter.

Buffett begins with the transformational merger of Burlington Northern.  I spoke well of this merger that many dissed in my piece, The Forever Fund.  Face it — where could you find such a big business that is inflation-protected, and with such a large moat?  No one could replicate BN at the price that Berky paid.  This acquisition reshaped Berky, making it far more of an industrial firm, albeit one financed with insurance float.

Measuring Performance

From page 2:

In Berkshire’s case, we long ago told you that our job is to increase per-share intrinsic value at a rate greater than the increase (including dividends) of the S&P 500. In some years we succeed; in others we fail. But, if we are unable over time to reach that goal, we have done nothing for our investors, who by themselves could have realized an equal or better result by owning an index fund.


The challenge, of course, is the calculation of intrinsic value. Present that task to Charlie and me separately, and you will get two different answers. Precision just isn’t possible.


To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value – book value – when measuring our performance. To be sure, some of our businesses are worth far more than their carrying value on our books. (Later in this report, we’ll present a case study.) But since that premium seldom swings wildly from year to year, book value can serve as a reasonable device for tracking how we are doing.

This is a wise way to measure performance, and many value-oriented insurance companies do this.  But Berky isn’t just an insurance company, and book value isn’t a perfect metric.  But change in book value plus dividends is a much better metric than earnings, so using that is a reasonable metric to evaluate Berky.  On that score Berky has done very well over the years, and I would argue that Buffett has done even better in his later years because it is increasingly difficult to deploy a large amount of money and still beat the averages.  Look at what I call “dollar alpha.”  The amount of outperformance is limited, but Buffett is absorbing a large portion of the alpha in the market.  (Of course aggregate alpha is zero, but if a large player continues to do well, that has a disproportionate effect on the rest of the market.)

Capital Management

Our flexibility in respect to capital allocation has accounted for much of our progress to date. We have been able to take money we earn from, say, See’s Candies or Business Wire (two of our best-run businesses, but also two offering limited reinvestment opportunities) and use it as part of the stake we needed to buy BNSF.

Buffett understands the difference between businesses that have reinvestment opportunities, and those that don’t.

Culture

Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.


To start with, the directors who represent you think and act like owners. They receive token compensation: no options, no restricted stock and, for that matter, virtually no cash. We do not provide them directors and officers liability insurance, a given at almost every other large public company. If they mess up with your money, they will lose their money as well. Leaving my holdings aside, directors and their families own Berkshire shares worth more than $3 billion. Our directors, therefore, monitor Berkshire’s actions and results with keen interest and an owner’s eye. You and I are lucky to have them as stewards.


This same owner-orientation prevails among our managers. In many cases, these are people who have sought out Berkshire as an acquirer for a business that they and their families have long owned. They came to us with an owner’s mindset, and we provide an environment that encourages them to retain it. Having managers who love their businesses is no small advantage.


Cultures self-propagate. Winston Churchill once said, “You shape your houses and then they shape you.” That wisdom applies to businesses as well. Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior. (As one wag put it, “You know you’re no longer CEO when you get in the back seat of your car and it doesn’t move.”) At Berkshire’s “World Headquarters” our annual rent is $270,212. Moreover, the home-office investment in furniture, art, Coke dispenser, lunch room, high-tech equipment – you name it – totals $301,363. As long as Charlie and I treat your money as if it were our own, Berkshire’s managers are likely to be careful with it as well.

Berky is one of the few companies where they have the interests of the outside passive minority shareholder at heart.  The company runs thin; excess expenses are small to nonexistent.

Insurance

He gives his usual praise of Ajit Jain who I have met.  A genuinely bright guy, and friendly as well.

With Gen Re, he emphasizes pricing discipline — the willingness to walk away, and not write business.  This is the core of good insurance management.  Never intentionally write business for an underwriting loss.

Manufacturing, Service and Retailing Operations

He talks abut the improvement at NetJets, which had been quite a dog for Berky.  David Sokol had quite an impact there.  But beyond that, Berky has a wide number of businesses that do very well.

He also discusses the black box that is Marmon, that Berky owns a majority of, and will own the whole thing by 2014 at latest.  It is also doing well.

Regulated, Capital-Intensive Businesses

BNSF and MidAmerican Energy fill out this segment.  Buffett is more than logical to put them together, because their enterprises are subject to their regulators, but enough distant from insurers that they get a different classification.  Why?

Like insurance, you don’t have perfect freedom to redirect earnings as you wish.  Some earnings must be reinvested into maintenance, and with discretion, into growth.

What Matters Least at Berky

The public investments, large as they are, are a small part of what makes Berky run.  People pore over the investments that Berky makes, but the guts of Berky are not investing, but managing a conglomerate of businesses funded by cash flow from insurance.

Todd Combs

While at a prior employer, I came to know Todd Combs, and we traded a bunch of ideas in the insurance space.  He was a bright guy.  I have little doubt that he will do well for Berky.  I remain available for any additional mandate that Berky might  require.  (I giggle as I write this, because though I have done well, why should Warren want a shmoe like me?)  That said, I am willing to manage any assets of Berky at my bottom rate of 0.1%/year.

Derivatives

Buffett describes how he has use derivatives to his advantage.  Amid the criticisms, he has made money there as the stock markets of the world have recovered.

Life and Debt

Buffett explains how avoidance of debt is wise. And after that:

We agree with investment writer Ray DeVoe’s observation, “More money has been lost reaching for yield than at the point of a gun.”

True, utterly true.  And much as I like Buffett and Ray DeVoe, I would like my readers to internalize that there is no such thing as yield.  Yield is the decision of the company, but what you should  ask is what is the increase in value of the company.  Look for investments that increase your net worth the most.

6 Comments

  • Greg says:

    David, while Buffett has done an admiral job over the years, it would do both him and the public a service to give a more balanced assessment of his performance (even Buffett tries to do this in his letters to shareholders).

    In addition to all the usual (an deserved) praise Buffett gets — An objective assessment would have to mention quite a few caveats:

    (1) If not for Buffett’s political connections (his father was a Congressman), Buffett’s investment in Salomon Bros would likely have been wiped out by the Treasury fixing scandal that ended Gutfreund’s Wall St career.

    (2) Political connections again, Buffett bought into a huge legal can of worms with his Gen Re purchase – Gen Re had many off balance sheet products designed to conceal losses at AIG. Mere mortals without connections to the political elite have seen their business shut down for less.

    (3) While decrying derivatives as “weapons of financial mass destruction”, Buffett makes much of his money from selling derivatives – including his massive stock index put bets that he *personally* underwrote. If derivatives are really so awful as Buffett suggested, why does he continue to use them?

    (4) Most of Buffett’s early equity investments could be characterized as vulture investing – American Express chief on the list, but far from the only one.

    (5) Buffett talks a big game about culture and ethics, but then he buys $10 billion of Goldman Sach’s preferred? At prices that are never offered to the general public?

    For the who know’s how many-th time, one of Buffett’s holdings is caught red handed at the heart of a major financial disaster. And once again, the good ol’ boy network saves his rear end; Buffett’s holding, this time Goldman, is protected where most other companies would have faced ruinous criminal litigation.

    (6) Buffett’s preferred investments in Goldman Sachs and GE both were saved by enormous taxpayer bailouts. Wells Fargo, concentrated in the bankrupt state of California, got all sorts of taxpayer handouts – from TARP loans to free subsidies from an absurdly steep yield curve.

    To compare Buffett’s performance to others without adjusting for his political connections is an absurd comparison. Let’s subtract maybe $100 billion in losses for all the cases Buffett’s investments were let off the hook. Let’s back out the massive taxpayer subsidies…. He doesn’t look so good if his investments had been treated the same as those without his political connections.

    And while this is not an “investment” comment per se – it should be noted that while Buffett is saying the filthy dirt covered masses should all pay higher taxes to support future BRK bailouts … Buffett is giving his fortune to the Bill Gates Foundation. I don’t trust people who don’t heed their own advice.

  • znmeb says:

    I have a huge problem with the widely-circulated quotation from this report:

    “Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.”

    First of all, he left out 1963. But yes, America’s best days lie ahead – for our children. But that will be *after* the war that started on September 11, 2001 has been brought to a successful conclusion, our troops come home and the world is again in some relatively peaceful military and economic state. And it simply can’t happen without collaboration of the rich economies to invest in the poor ones without destroying the planet.

  • Doug says:

    David:

    You keep talking about how you have done well. Could you give us some numbers? When I do RFPs, they want to know things like 3, 5, and 10-year IR, Sharp, and Treynor Ratios. They want to know how I am benchmarked, and why. If I go outside of the universe to beat the universe, is that fair? If your value discipline requires concentrated bets, what is your risk management rubric?

    • Doug,

      I am having my track record attested. When it is attested, I will reveal it. That should be within the next month.

      Otherwise I run afoul of Seeking Alpha’s rules and likely those of the regulators.

      • Doug says:

        David:

        Since I don’t use the internet for posting performance, I’m not privy to the Seeking Alpha rules. But surely a qualitative comment such as “A 5-yr Sharp Ratio well above the S&P 500″ or “A 10-yr Information Ratio in the ~1 area,” would be covered under Safe Harbor rules. Qualitative language usually is. It’s when you get to two decimal places that you have to specify that you’re PPS-Compliant and use the Modified Dietz method.

        By the way, who is doing your performance calculations?

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