Berkshire Hathaway releases annual report

 

Warren Buffett’s annual letter to Berkshire Hathaway shareholders has just been released. Unfortunately, he had his worst year ever as measured by the per-share change in book value. This was down 9.6% and was only his second down year ever (the first was 2001, for those keeping score.)

Berkshire is still looking strong, of course. Buffett has enough cash sitting in the bank to buy both Fortum and Sampo at current market prices, for instance. Operating earnings took a hit but not too seriously. Berkshire has such a diverse source of earnings that he came through relatively intact. 

Let’s take a look at his record as five-year rolling averages going back to the Buffett Partnership days of 1957 compared to the market. The “market” was the Dow Industrials up to 1965, after which the S&P 500 took over. Both have dividends reinvested.

Here we can see that not only has Buffett never had a down 5-year period he has never been beaten by the market over that stretch. But he has suffered since the turn of the millennium. His overall performance has been worse than his long-term average, and his superior gap over market returns has been less.

So has the Oracle of Omaha lost it? Hardly. He even warned us of this. In 1999 he wrote:  

“I expect that the gain in Berkshire’s intrinsic value over the next decade will modestly exceed the gain from owning the S&P… Please not that I spoke of hoping to beat the S&P ‘modestly.’ For Berkshire, truly large superiorities over that index are a thing of the past. They existed then because we could buy both businesses and stocks at far more attractive prices than we can now, and also because we then had a much smaller capital base, a situation that allowed us to consider a much wider range of investment opportunities than are available to us today.”

So he accurately predicted what would happen. To paraphrase Homer Simpson, I would like to dreamily say:

“Warren Buffett. Is there anything he doesn’t know?”

Buffett’s annual letters are greeted as a “state of the economy” type of event for much of the investment community, but there were few bombshells this year. He remains optimistic, as always, but warns that the problems will continue for some time: “We’re certain… that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond…”

He is also clearly worried about inflation in the future, spurred on by massive government and central bank intervention. We have lived with low inflation for a number of years now and have been helped in recent months by crashing commodity prices. But for how much longer will we be able to have the liquidity flood gates open but not see the rising waters? Buffett seems to think we may soon get our feet wet. 

Buffett also does a nice tightrope walk of damning some industry practices and explaining how he uses them. For instance, he justifiably castigates the lending practices in the housing industry and then explains how his Clayton Homes division does it better. He also damns derivatives and goes on to explain how he uses them.

This may seem odd, or perhaps hypocritical, but a closer examination shows Buffett knows what he is talking about. He was explaining poor lending practices in the manufactured housing industry for years and how Berkshire does it differently. He has also been calling derivatives “weapons of mass destruction” for a number of years and explaining how he is very careful and choosy regarding how he uses them. And his record bears him out. 

Of course, he had a few of his signature ‘Midwestern wisdom’ quotes:

“By yearend, investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game.”

 

“The watchword throughout the country became the creed I saw on restaurant walls when I was young: ‘In God we trust; all others pay cash.’” 

 

“Weaning… entities from the public treat will be a political challenge. They won’t leave willingly.”

 

“Berkshire is always a buyer of both businesses and securities, and the disarray in markets gave us a tailwind in our purchases. When investing, pessimism is your friend, euphoria the enemy.” 

 

“Long ago Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

 

“If merely looking up past financial data would tell you what the future holds, the Forbes 400 woud consist of librarians.” 

 

“Investors should be sceptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.”

 

“When forced to choose, I will not trade even a night’s sleep for a chance of extra profit.” 

 

“Approval… is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”

 

“Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyse our largest commercial banks and investment banks… A frightening web of mutual dependence develops among huge financial institutions… Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with.”