Saturday, March 04, 2006

The Letter to Berkshire Hathaway Shareholders

All of us who aspire, pretend, claim, or actually are value managers await Warren’s letter to Berkshire Hathaway shareholders every year. This year, in my view, is one of the best.

For the first time, he presents not only the usual table of growth in book value (after-tax) versus the growth in the S&P 500 (pre-tax) where BRK’s results is average 21.5% versus the index of 10.3% since 1965, but also presents the results for the business as separated into the marketable securities (including cash) and the non insurance business’ earnings growth.

The marketable securities business has compounded since inception at a 28% rate, inclusive of the drag of cash! However, for the decade 1995-2005, the results seem more mortal at a compound rate of 13%. This contrasts with an S&P return of 9.46% over the decade. STILL OUTSTANDING despite all the naysayers who have been clearly mistaken in their belief that WEB had lost it.

Better yet, his disclosure clearly demonstrates the decided shift toward acquisition of businesses and the outstanding results that have been achieved.

The non-insurance business earnings stream on a pre-tax basis has compounded by 17.2% since 1965. However, it has grown by a sterling 30.2% in the last decade! Compare that with the S&P 500 operating earnings which have grown by a comparable 8.6% over that period.

As Buffett points out, there are now 68 distinct businesses with widely disparate operating and financial characteristics that are part of the holding company. Yet, the power of these earnings streams has not been realized by many critics, let alone, some of his investors.

“Intrinsic value estimates are by nature imprecise, and often seriously wrong” and “The more uncertain the future of the business, the higher the probability that this calculation will be off base.” These words ring so very true as we who actually attempt to value businesses, so often discover. Yet, there is great predictability and certainty about the future of Berkshire, given the tremendous franchises that this business represents.

I will have comments on the four divisions that WEB views as the logical breakdown of this company a little later.. But first, some general comments.

There is another warning about derivatives and the dangers that lurk there. Gen Re is now down to 741 contracts versus the 23,218 contracts that it had in place since acquisition. So far, the unwinding of these positions has cost BRK a total of $404 million, $104 last year alone. He warns of the maze of liabilities that continues to mushroom for the financial world. Gen Re should have been able to exit this sinkhole rather easily as a relatively small player. What danger exists in what I believe is the completely murky accounting of the large global derivatives players?

A few comments on competitive position and its importance.

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.”

But here comes the admonition: to focus on moat-widening!

“When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted.”

He reminds us that this has been the problem in the automotive and airline industries. Short term expedience has taken precedence over long-term needs.

A comment on equity valuation related to the portfolio:

Expect no miracles from our equity portfolio. Though we own major interests in a number of
strong, highly-profitable businesses, they are not selling at anything like bargain prices. As a group, they may double in value in ten years. The likelihood is that their per-share earnings, in aggregate, will grow 6-8% per year over the decade and that their stock prices will more or less match that growth. (Their managers, of course, think my expectations are too modest – and I hope they’re right.)”

Buffett also describes where the Dow Jones Index would need to be to match the performance of the last century. Too depressing to even think about!

Buffett finds justification in the compensation afforded value-creating CEO’s such as Jim Kilts at Gillette who turned around a capital mis-allocating enterprise smartly. However, too often, compensation committees reward executives ridiculously out of line from performance. He tells the following fable:

“Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period. Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred’s option will deliver him $63 million. Meanwhile, his shareholders will wonder what happened to the “alignment of interests” that was supposed to occur when Fred was issued options. A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces less extreme results but still can provide lush rewards for managers who achieve nothing.CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options. I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they somehow forget to tell shareholders that fixed-price options give them capital that is free.”

He also warns of the high frictional cost of equity management and the huge slippage that goes through the hands of hedge fund managers and private equity managers, who he has described in his example as ‘The Helpers.”

“A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the owners lose and pay dearly for the privilege of doing so.”

Finally, as to succession, Buffett again describes that there are three potential candidates who will replace him in death, or in addle or feeble–mindedness:

“Moreover, we have three managers at Berkshire who are reasonably young and fully capable of being CEO. Any of the three would be much better at certain management aspects of my job than I. On the minus side, none has my crossover experience that allows me to be comfortable making decisions in either the business arena or in investments. That problem will be solved by having another person in the organization handle marketable securities.”

“The other question that must be addressed is whether the Board will be prepared to make a change if that need should arise not from my death but rather from my decay, particularly if this decay is accompanied by my delusionally thinking that I am reaching new peaks of managerial brilliance.”

It is up to the Board to replace WEB should this occur;

“If I become a candidate for that message, however, our board will be doing me a favor by delivering it. Every share of Berkshire that I own is destined to go to philanthropies, and I want society to reap the maximum good from these gifts and bequests. It would be a tragedy if the philanthropic potential of my holdings was diminished because my associates shirked their responsibility to (tenderly, I hope) show me the door. But don’t worry about this. We have an outstanding group of directors, and they will always do what’s right for shareholders.”

Once again, an outstanding message from the greatest investor.


At 4:30 PM, Anonymous Anonymous said...

Thank you for that thoughtful timely analysis. It is a singular pleasure to read one these great letters as much for what it shares in WB's approach and way of thinking as for the content. It was striking to see WB breakdown the investments and operating business results, and to my mind, demonstrate very clearly the excellent value that BRK currently has. Curious if you might comment on the attractiveness of BRK given this information.
I enjoy your blog and posts.
Jacques Romano

At 4:34 PM, Anonymous Has Buffett Become the world's richest man? said...

Great Post Buffett is way too smart, and he works on Saturdays! No doubt there will never be another like Warren Buffett, I wonder if his successor(s) will be able to be able to live up to the Berkshire reputation. Maybe have all three of the top candiates share the task.


Post a Comment

<< Home

< ? Market Blogs £ >