Warren Buffett’s annual shareholder letter is an eagerly anticipated treat for the financial community, and as usual, the 81-year-old Oracle of Omaha did not disappoint. In his characteristically good-humored, plainspoken style, Buffett surveyed the 2011 performance of Berkshire Hathaway, the investing conglomerate he’s run for over 40 years, and offered some broader thoughts on the U.S. economy.
Overall, Buffett expressed the same fundamental optimism about the American economy that has undergirded Berkshire’s investments in some of the biggest names in business. Berkshire Hathaway holds over $100 billion in investments, including major positions in blue-chip icons like American Express (13% ownership stake), Coca-Cola (8.8%), Wells Fargo (7.6%) and IBM (5.5%). (Berkshire’s fourth-quarter earnings were down 30% from one year ago, largely due to a decrease in the value of the company’s derivative contracts.)
Buffett’s letter is a reminder of the renowned investor’s worldview: invest for the long term in undervalued assets, cultivate principled business managers who love what they do, and disregard flavor-of-the-month trends that create short-term gains for investors along the way to dangerous bubbles. Indeed, there is nary a word in Buffett’s letter about high-profile Internet IPOs like Facebook, which could be worth $100 billion after it goes public this spring. Buffett also explains how Berkshire’s insurance companies, including GEICO, provide the capital – in the form of individual premiums – that the company can invest. Buffett calls this the float – “money that doesn’t belong to us, but that we get to invest for Berkshire’s benefit.”
Here are some highlights from Buffett’s letter:
Succession: One of the biggest parlor games in business has been guessing who will replace Buffett. In this year’s letter, the 81-year-old assured shareholders that plans are in place for his successors to take over “tomorrow,” if necessary. Buffett is irreplaceable, of course, as Berskshire’s succession plan acknowledges: the Oracle’s duties will be divided between an investment manager, responsible for selecting where to allocate Berkshire’s money, and the CEO, responsible for making sure all the pieces of the Berkshire empire work together. On the investment side, Buffett has confirmed that Todd Combs and Ted Weschler, two little-known but highly touted hedge-fund managers, are in line to replace him. “Each will be handling a few billion dollars in 2012, but they have the brains, judgment and character to manage our entire portfolio when Charlie and I are no longer running Berkshire.”
On the management side, Buffett wrote that a candidate has been chosen, but he didn’t name the person: “Your Board is equally enthusiastic about my successor as CEO, an individual to whom they have had a great deal of exposure and whose managerial and human qualities they admire. (We have two superb back-up candidates as well.)” Speculation has centered on Ajit Jain, a longtime Buffett favorite who manages the multibillion-dollar Berkshire Hathaway Reinsurance Group.
Mistakes: Even the Oracle of Omaha isn’t perfect. In his letter, Buffett owned up to several recent missteps, including investing in a Texas natural gas utility called Energy Future Holdings. With natural gas prices continuing to be low, Berkshire has had to write down the investment’s value by $1.4 billion. “In tennis parlance, this was a major unforced error by your chairman,” Buffett wrote.
Buffett says he was too optimistic one year ago when he wrote that “a housing recovery will probably begin within a year or so.” In fact, housing prices and new-home starts remain depressed nationwide. This has had a negative effect on Berkshire’s housing-related businesses, including Clayton Homes, Acme Brick, Shaw (carpet), Johns Manville (insulation) and MiTek (building products). “In aggregate, our five housing-related companies had pre-tax profits of $513 million in 2011,” he wrote. “That’s similar to 2010 but down from $1.8 billion in 2006.” Still, Buffett remains confident that the housing market will return, even if it’s taking longer than he had originally predicted:
Housing will come back – you can be sure of that. Over time, the number of housing units necessarily matches the number of households (after allowing for a normal level of vacancies).
For a period of years prior to 2008, however, America added more housing units than households. Inevitably, we ended up with far too many units and the bubble popped with a violence that shook the entire economy. That created still another problem for housing: Early in a recession, household formations slow, and in 2009 the decrease was dramatic.
That devastating supply/demand equation is now reversed: Every day we are creating more households than housing units. People may postpone hitching up during uncertain times, but eventually hormones take over. And while “doubling-up” may be the initial reaction of some during a recession, living with in-laws can quickly lose its allure.
Stock buybacks: Here, Buffett explains the logic behind his $11 billion investment in IBM, which has announced a five-year plan to spend as much as $50 billion to repurchase its own shares. Specifically, Buffett explains why he wants IBM shares to “languish” over that period.
Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.
If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $11.2 billion more than if the “high-price” repurchase scenario had taken place.
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
Avoid gold: Here, Buffett explains why he prefers investing in “productive assets,” as opposed to currency-denominated assets, like bonds, and precious metals, specifically gold.
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.