Warren Buffett's Annual Letter

On Saturday, Warren Buffett released his annual letter to shareholders.  The major theme for the letter might be, "we are turning the corner."

Performance & results

Mr. Buffett would like investors to look at the per-share intrinsic value to determine the performance of the firm against the performance of the S&P 500 including dividends. 

The three key components of Berkshire intrinsic value incloudes the value of investments, value of earnings from other than investments or insurance underwriting, and the value of how retained earnings will be deployed back into the business.  The first two of these pillars of these are easy to calculate, while the final pillar is hard to calculate.  Regarding deploying capital:

This "what-will-they-do-with-the-money" factor must be always evaluated along with the "what-do-we-have-now" calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value...If a CEO can be expected to do his job well, the reinvestment prospects add to the company's current value; if the CEO talents or motives are suspect, today's value must be discounted.  The difference in outcome can be huge...

Mr. Buffett alluded to the fact that in the early days of his control of Berkshire, there was much more emphasis put on the investment side versus the development of earnings from non-insurance businesses.  This practice will most likely continue as Berkshire continues to grow in size, and amount of cash to invest continues to grow due to earnings from the portfolio of businesses, income from investments, and insurance float.  Furthermore, the size of Berkshire will reduce the ability to generate the large outperformance it did in the earlier years.  Regarding size:

...shows our 46-year against the S&P, a performance quited good in the earlier years and now only satisfactory.  The bountiful years, we want to emphasize, will never return.  The huge sums of capital we currently manage eliminate any chance of exceptional performance.  We will strive, however, for better-than-average results and feel it for you to hold us to that standard.

As Mr. Buffett alludes to in the letter, Berkshire's best days ended in the early 1980's.  In the market's golden period in the next seventeen years, Berkshire's absolute advantage narrowed.  In recent years, Berkshire's negative outperformance or lower outperformance came in years where the market did not properly reward the businesses Berkshire invests in.  Berkshire's outperformance comes in the years where the market is terrfied about market events and moves towards a "flight for safety."  In 2008 market turmoil, the per-share-book value of Berkshire went down -9.6% versus the -37.0% for the S&P 500 including dividends, or 27.4% of outperformance.  In 2009, when the equity started in recovery, the per-share-book value of Berkshire went up only 19.8% versus the 26.5% for the S&P 500 including dividends, or -6.7% of underperformance.  These results largely include the large, quality businesses that Berkshire invests in that have strong cash flow and balance sheets. 

Because of the size, Berkshire is looking to another big target like the acquisition of BNSF.  Regarding a big acquisition:

Charlie and I hope that the per-share earnings of our non-insurance businesses contines to increase at a decent rate.  But the job gets tougher as the numbers get larger.   We will need both good performance from our current businesses and more major acquisitions.  We're peprared.  Our elephant gun has been reloaded, and my trigger finger is itchy.

Corporate culture

Rather than get into an explanation about Berkshire's culture, I think the quotes below best illustrate Berkshire's culture:

Our trust is in people rather than process. A "hire well, manage little" code suits both them and me.

Berkshire's CEOs come in many forms.  Some have MBAs; others never finished college.  Some use budgets and are by-the-book types; others operate by the seat of their pants.  Our team resembles a baseball squad composed of all-stars having vastly different batting styles.  Changes in our line-up are seldom required.

Cultures self-propagate...bureaucratic procedures beget more bureacracy, and imperial corporate palaces induce imperious behavior...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 $303,363.

Successors

With the recent retirment of Lou Simpson, the next generation of leaders at Berkshire still remains in question.  It appears the next Berkshire CEO will have "x" amount of money to manage, and the firm may hire additional portfolio managers.  Mr. Buffett, along with Charlie Munger, intend to do the primary investing at Berkshire until neither one of them are in the role.  Regarding the criteria for successors:

...But past results, though important, do not suffice when prospective performance is being judged.  How the record has been acheived is crucial, as is the manager's understanding of - and sensitivity to - risk (which is no way should be measured by beta, the choice of too many academics).  In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed.  Finally, we wanted someone who would regard working for Berkshire as far more than a job.

Todd Combs was chosen as one of those successors.  Previously, Mr. Combs ran a hedge fund.  Regarding hedge funds:

...The hedge-fund world has witnessed some terrible behavior by general partners who have received huge payouts on the upside and who then, when bad results occurred, have walked away rich...investors who put money with such managers should be labeled patsies, not partners.

Most investment professionals have some sort of style that is theirs.  Regarding that style:

...fund consultants like to require style boxes such as "long-short", "macro," "international equities."  At Berskhire, our only style box is "smart."

Leverage

Mr. Buffett speaks about how much he does not like Berkshire to use leverage.  To illustrate his point, Mr. Buffett includes a letter from his grandpa to his Uncle Fred.  The point of the letter was that there is peace of mind when people have cash they can put their hands on, it is important not to spend all a person makes, and do not sacrifice your business because of some one-time event.  Thus, "...liquidity is a condition for assured survival."  Furthemore:

At Berkshire, we have taken his $1,000 solution a bit further and will hold at least $10 billion of cash, excluding that held at our regulated utility and railroad businesses.  Because of that commitment, we customarily keep at least $20 billion on hand so that we can both withstand unprecedented insurance losses...and quickly seize acquisition or investment opportunities even during times of financial turmoil. 

Mr. Buffett maintains a relatively riskless strategy for investing short-term cash.  To his point:

We keep our cash largely in U.S. Treasury bills and avoid other short-term securities yielding a few mere basis points, a policy we adhered to long before the frailties of the commercial paper and money market funds became apparent in September 2008...At Berkshire, we don't rely on bank lines, and we don't enter into contracts that could require postings of collateral except for amounts that are tiny in relation to total liquid assets.

By being so cautious in respect to leverage, we penalize our returns by a minor amount.  Having loads of liquidity, though, lets us sleep well...we will be equipped both financially and emotionally to play offense while others scramble for survival.

On America

The most important them from the letter I think the biggest them that permeates Mr. Buffett's letter is his bullish attitude for the United States.  Now, a person in Mr. Buffett's position is in a different situation than an unemployed construction worker, but he is putting his money where his mouth is.

Mr. Buffett believes there is plent of of opporunity in the United States.  Regarding that opportunity:

Money will always flow toward opportunity, and there is an abundance of that in America.  Commentators today often talk about "great uncertainty."  But think back, for example, December 6, 1941, October 18, 1987 September 10, 2011.  No matter how serene today may be, tomorrow will always be uncertain.

Don't let that reality spook you.  Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America.  Yet our citizens now live an astonishing six times better than when I was born.  The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential - a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War - remains alive and effective....America's best days lie ahead.

The biggest news in 2010 for BNSF was the acquisition of BNSF railway.  Mr. Buffett is extremely optimistic about the acquisition and the earnings power of the business.  As a result, Berkshire is increasing CAPEX spending in BNSF railway, but most CAPEX spending for the portfolio of businesses will be in the United States.

Both of us are enthusiastic about BNSF's future because railroads have major cost and environmental advantages over trucking, their main competitor...When traffic travels by rail, society benefits.

Over time, the movement of goods in the United States will increase, and BNSF should get its full share of the gain.  The railroad will need to invest massively to bring about this growth, but no one is better situated than Berkshire to supply the funds required.  However slow our economy, or chaotic the markets, our checks will clear.

...we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment.  Of this amount, $5.4 billion - or 90% of the total - was spent in the United States.  Certainly our businsses will expand abroad in the future, but an overwhelming part of their future investments will be at home.  In 2011, we will set a new record for capital spending - $8 billion - and speand all of the $2 billion increase in the United States.

What does all of this mean?

There are several themes in this letter that relate to the average retail investor.  First, I would not bet against America.  Nor would I make a pure play on America.  Instead, I would continue to look at large U.S. based companies that have a good portion of their revenues generated outside of the United States and have sustainable dividend yields.  By looking at these companies with this type of sales mix, you will be exposed to an ever growing stream of non-US revenues, while seeing a recovery in sales from the United States.  Regarding the dividend point, we will be seeing some sort of inflation in the coming years.  These firms will be able to increase dividends the easiest, allowing investors to hedge inflation.  I would still look at select small-cap companies in areas that will benefit from a U.S. recovery.  Some sectors include rail, housing, and consumer discretionary.

Second, do not buy into trends.  It is important to develop your own style of investing, which may include investing in all different asset classes.  Rather than pack a particular asset class, develop an approach that is uniform to all asset classes.  Most people would associate Mr. Buffett as an equity investor.  In this year's letter, he speaks about bets he made using derivatives.  He used his approach to these instruments as well.

Third, be liquid and do not overly rely on leverage.  This can be applied several different ways to investing.  One way to interpret this is to invest in liquid companies meaning invest in companies that have strong cash flow and balance sheets.  As a result, these companies can internally provide the cash for operations, capital improvements, or be able to return cash to shareholders.  Another way to interpret this is it is ok to have cash drag on your portfolio.  I look at the cash allocation or cash drag problem like a football game.  As a value investor, it is important to follow a list of companies, determine their appropriate valuation, and when the time comes, buy the company.  Often times, these companies hit their appropriate valuation when a crisis hits. 

Warren Buffett's Annual Letter (click here)