My Baby, She Wrote Me A Letter – or – Tidbits from Buffett’s Letter to Shareholders

Warren Buffett’s annual Berkshire Hathaway shareholder letter is out.  As I peruse the letter, here’s what stands out to me:

Jumping right in:  on page 4, WB talks about the earnings of companies in which he owns significant equity stakes, and how these earnings are not reflected in Berkshire Hathaway’s earnings:

“Had we owned our present positions throughout last year, our dividends from the “Big Four” would have been $862 million. That’s all that would have been reported in Berkshire’s income statement. Our share of this quartet’s earnings, however, would have been far greater: $3.3 billion. Charlie and I believe that the $2.4 billion that goes unreported on our books creates at least that amount of value for Berkshire as it fuels earnings gains in future years.”

This is true – the earnings of IBM, WFC et all don’t show up in BRK’s income statement, but they are absolutely reflected in BRK’s book value, which WB likes to talk so much about.  The earnings of the underlying companies affect the underlying stock prices, which are incorporated into BRK’s book value.   Warren Buffett’s job is to buy bigger stakes if the market (as evidence by the stock price)  is undervaluing the earnings, and sell stakes if the market is overvaluing them -in his view, that is.   One problem some people have if they sit back and take a philosophical view of equity ownership is that we shareholders don’t actually GET those earnings.   We get the dividends, and the earnings flow through via a subjective market valuation – a multiple that we can’t control.

I’m not going to spend any more time talking about Buffett’s views on gold – I beat that topic to death already in a prior thread and comment section, but I do want to address one point:  critics of WB’s “gold is a greater fool theory” argument responded that stocks are also a greater fool theory.  This is precisely what they meant – equity holders don’t actually receive the earnings of the company – we rely on a greater fool theory of valuation in some sense.   This part of equity valuation is indeed a greater fool theory to some degree: -we have no idea if the market will value XYZ at 6 times, 8 times, 14 times or 50 times earnings.  However, the earnings are real and in the long run divergences between what management views as a “fair” valuation and what the market views as the valuation can be remedied via increased dividends, buybacks, cap-ex, leveraged re-caps, etc.

Moving on: Page 6:

“Charlie and I like to see gains in both areas, but our primary focus is on building operating earnings. Over time, the businesses we currently own should increase their aggregate earnings, and we hope also to purchase some large operations that will give us a further boost. We now have eight subsidiaries that would each be included in the Fortune 500 were they stand-alone companies. That leaves only 492 to go. My task is clear, and I’m on the prowl.”

Hide your kids, hide your wives – WB is ON THE PROWL!

Up next: WB talks about how when a company he owns is buying back stock, he wants the stock price to languish so that the company can buy back more shares.  Then he talks about insurance, the huge float that drives BRK’s cash machine, and the risk management of his various business heads.  Again, nothing new, but it’s worth understanding the philosophy behind BRK and its insurance businesses.  Buffett wants to use the premiums  – float – paid by policy holders.   If he can do that with a net zero underwriting cost, he has the use of free money.  As a kicker, the businesses have generated a combined underwriting profit for 9 years running, which is icing on the cake.

On General RE in particular (page 9):

“At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively evaluate the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained.

Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that their competitors are eagerly writing. That old line, “The other guy is doing it so we must as well,” spells trouble in any business, but in none more so than insurance. Indeed, a good underwriter needs an independent mindset akin to that of the senior citizen who received a call from his wife while driving home. “Albert, be careful,” she warned, “I just heard on the radio that there’s a car going the wrong way down the Interstate.” “Mabel, they don’t know the half of it,” replied Albert, “It’s not just one car, there are hundreds of them.”

Tad has observed all four of the insurance commandments, and it shows in his results. General Re’s huge float has been better than cost-free under his leadership, and we expect that, on average, it will continue to be. In the first few years after we acquired it, General Re was a major headache. Now it’s a treasure.”

On the housing bubble (Page 15, emphasis mine):

“As is well-known, the U.S. went off the rails in its home-ownership and mortgage-lending policies, and for these mistakes our economy is now paying a huge price. All of us participated in the destructive behavior – government, lenders, borrowers, the media, rating agencies, you name it. At the core of the folly was the almost universal belief that the value of houses was certain to increase over time and that any dips would be inconsequential. The acceptance of this premise justified almost any price and practice in housing transactions. Homeowners everywhere felt richer and rushed to “monetize” the increased value of their homes by refinancings. These massive cash infusions fueled a consumption binge throughout our economy. It all seemed great fun while it lasted. (A largely unnoted fact: Large numbers of people who have “lost” their house through foreclosure have actually realized a profit because they carried out refinancings earlier that gave them cash in excess of their cost. In these cases, the evicted homeowner was the winner, and the victim was the lender.)”

On derivatives (page 17):

“There is little new to report on our derivatives positions, which we have described in detail in past reports. (Annual reports since 1977 are available at www.berkshirehathaway.com.) One important industry change, however, must be noted: Though our existing  contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions. We shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength.”

Many people don’t realize that the big derivatives trade Buffett put on several years ago – a massive sale of S&P 500 puts – was a very rare trade.   The trade was right in line with Buffett’s insurance “float” philosophy:  someone paid him a huge upfront premium (the put premium) for insurance (the put itself) and Berkshire got to use that money for the entire term of the contract.   That part isn’t unusual – the kicker was that, due to the structure of the trade and BRK’s AAA rating, Buffett managed to make it so that he wouldn’t have to post collateral.   Even without industry rule changes, you might not have seen a trade like this again – because counterparties wouldn’t agree to the no-collateral terms.

Just in case the parallel between insurance premiums and derivatives sales wasn’t clear, the next paragraph explains it again:

“Our insurance-like derivatives contracts, whereby we pay if various issues included in high-yield bond indices default, are coming to a close. The contracts that most exposed us to losses have already expired, and the remainder will terminate soon. In 2011, we paid out $86 million on two losses, bringing our total payments to $2.6 billion. We are almost certain to realize a final “underwriting profit” on this portfolio because the premiums we received were $3.4 billion, and our future losses are apt to be minor. In addition, we will have averaged about $2 billion of float over the five-year life of these contracts. This successful result during a time of great credit stress underscores the importance of obtaining a premium that is commensurate with the risk.”

Again, the recipe is: 1) get paid money up front.  2) enjoy the productive use of that money to make more money.  3) try to price the product such that the price you are charging for protection adequately compensates you for the risks you are insuring.  4) repeat.

Buffett wants to challenge you to a newspaper toss (page 20):

{at the annual meeting}  “Soon after the 7 a.m. opening of the doors, we will have a new activity: The Newspaper Tossing Challenge.

Late last year, Berkshire purchased the Omaha World-Herald and, in my meeting with its shareholder-employees, I told of the folding and throwing skills I developed while delivering 500,000 papers as a teenager.

I immediately saw skepticism in the eyes of the audience. That was no surprise to me. After all, the reporters’ mantra is: “If your mother says she loves you, check it out.” So now I have to back up my claim. At the meeting, I will take on all comers in making 35-foot tosses of the World-Herald to a Clayton porch. Any challenger whose paper lands closer to the doorstep than mine will receive a dilly bar. I’ve asked Dairy Queen to supply several for the contest, though I doubt that any will be needed. We will have a large stack of papers. Grab one. Fold it (no rubber bands). Take your best shot. Make my day.”

Like Steve Wynn’s conference calls, Buffett’s letters are usually a good chance to get some free insight into one guy’s way of looking at the business world, regardless of the fact that you may not agree with everything he says or does.

-KD

disclosure: no positions in $BRK.A, $IBM, $KO, etc.

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