Dear all,
Every year at around this time I normally send my family, as well as some of my friends and colleagues the latest annual letter from Warren Buffett. Please find below the summary of the latest Annual Letter (2011) - fresh from the oven (out just under 2-3 hours ago).
Here are a summary of a few key points I found interesting this year:
- Berkshire Hathaway's per-share book value increased by 4.6% in 2011 (after-tax), compared to 2.1% in 2011 for S&P 500 (before-tax)
Some success stories include:
- 3 successor CEO candidates already identified by the Board; as well as two young investment managers being tested as future Chief Investment Officers
- Lubrizol acquisition last year. He mentioned how Lubrizol has increased, since 2004, pre-tax earnings from $147 million to $1,085 million in 2011.
- Each of Berkshire's five largest non-insurance companies - BNSF (railway), Iscar, Lubrizol, Marmon Group (diversified) and MidAmerican Energy) - delivered record operating earnings. In aggregate, they earned more than $9 billion pre-tax in 2011 (he forecasted next year in aggregate they should exceed $10 billion pre-tax earnings in 2012). Contrast that to seven years ago, when Berkshire only owned one of the five, MidAmerican, whose pre-tax earnings were $393 million.
- Insurance operations delivered record "float" - money that doesn't belong to Berkshire, but Buffett and co get to invest for Berkshire's benefit - which stood at a staggering $70 billion today (from $41 billion nine years ago). Moreover, these floats have produced 'negative cost of capital' because it has generated consecutive underwriting profits over the same nine years period, aggregating $17 billion.
- Significant investment in IBM (5.5%). Buffett praised IBM: "CEOs Lou Gerstner and Sam Palmisano did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their operational accomplishments were truly extraordinary .... But their financial management was equally brilliant ... Indeed, I can think of no major company that has had better financial management... The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively purchased its own stock."
Some not-successful stories include:
- $2 billion Buffett spent buying several bond issues of Energy Future Holdings a few years ago was a big mistake. The company's prospect in large measure was tied to the price of natural gas, which tanked shortly after this purchase. Buffett said, "I totally miscalculated the gain/loss probabilities when I purchased the bonds. In tennis parlance, this was a major unforced error by your chairman."
- Housing recovery in the US has not occurred since the Global Financial Crisis in 2008. In aggregate, Berkshire's five housing-related companies had pre-tax profit of $513 million in 2011, which is similar to 2010 but down from $1.8 billion in 2006. But he said, "Housing will come back - you can be sure of that" and with it, the current dire unemployment situation in the US will improve significantly.
- Buffett then spent time talking about the stock buy-back that Berkshire did and the rationale of this buy-back
- Last September, Berkshire announced it will buy-back its shares at a price of up to 110% of book value. They were only in the market for a few days "- buying $67 million of stock - before the price advanced beyond our limit."
- Buffett said: "Charlie and I favor [stock] repurchases when two conditions are met: first, a company has ample funds to take care of operational and liquidity needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated.... We have witnessed many bouts of repurchasing that failed our second test."
- He also said that if companies that he liked and is invested in, e.g., IBM, decides to repurchase its shares over the next five years, it is far better for IBM's share price to be lower over the next five years than higher, which he says is not really how most people think. He recommended readers to read Chapter 8 of Ben Graham's "Intelligent Investor" on how to think about market fluctuations.
- Buffett then looked at four major sectors of his operations; First: Insurance
- "Float" has increased from $39m in 1970 to $237m in 1980, to $1.6bn in 1990, to $27.9bn in 2000 and $70.6bn today. And they are currently generating underwriting profits!
- But Buffett warned: "Let me emphasize once again that cost-free float is not an outcome to be expected for the property-casualty [insurance] industry as a whole: We don't think there is much "Berkshire-quality" float existing in the insurance world. In most years, including 2011, the industry's premiums have been inadequate to cover claims plus expenses. Consequently, the industry's overall return on tangible equity has for many decades fallen far short of the average return realized by American industry, a sorry performance almost certain to continue. Berkshire's outstanding economics exist only because we have some terrific managers ...". The main Berkshire insurance divisions by float size are:
- Berkshire Hathaway Reinsurance Group run by Ajit Jain. From a standing start in 1985, Ajit has created an insurance business with float of $34 billion today (and significant underwriting profit).
- General Re run by Tad Montross - around $20 billion of float.
- GEICO run by Tony Nicely - "almost-impossible-to-replicate business model" - $11.1 billion float.
- Other insurance divisions - almost $6 billion float.
- Second: Regulated, Capital-Intensive Business
- Two very large businesses here:
- BNSF (railway) - Net earnings after tax around $3 billion (pre-tax $4.7 billion).
- MidAmerican Energy - Net earnings after tax to Berkshire around $1.2 billion.
- Buffett said: "In each instance..., Charlie and I believe current intrinsic value is far greater than book value."
- Two very large businesses here:
- Third: Manufacturing, Service and Retailing Operations
- Total pre-tax earnings of around $5 billion. Non-housing's component of this is $4.68 billion, which has increased steadily and significantly since 2009, denoting a strong recovery of US economy since 09 except for housing.
- The four housing-related companies had aggregate pre-tax earnings of $359 million in 2011.
- Buffett: "Though housing-related businesses remain in the emergency room, most other businesses have left the hospital with their health fully restored."
- Some superstar businesses and managers in this sector are:
- CTB (agricultural equipment operation) and its CEO, Vic Mancinelli. Buffett: "We purchased CTB in 2002 for $139 million. It has subsequently distributed $180 million to Berkshire, last year earned $124 million pre-tax and has $109 million in cash. Vic has made a number of bolt-on acquisitions over the years, including a meaningful one he has signed up after yearend."
- TTI, electric components distributor, increased its sales to a record $2.1 billion, up 12.4% from 2010. Earnings hit a record, up 127% from 2007, the year Berkshire bought the business.
- Iscar, 80% owned by Berkshire.
- McLane, a huge distribution company, had a pre-tax earnings record of $370 million.
- Netjets delivered pre-tax earnings of $227 million in 2011. Buffett: "A few years ago NetJets was my number one worry... Without Berkshire's support, NetJets would have gone broke. These problems are behind us.... No other fractional-ownership operator has remotely the size and breadth of the NetJets operation, and none ever will."
- Marmon, which Buffett bought from the Pritzker family in 2008, which owns 140 operating businesses in 11 distinct business sectors.
- See's Candies last year had record pre-tax earnings of $83 million, bringing its total to $1.65 billion since Berkshire bought it (around 1972). Contrast that to the purchase price the business of $25 million and 2011 end-of-year book value (net of cash) of less than zero!!
- Nebraska Furniture Mart (80% owned).
- Although overall Buffett praised this segment of the business ("overall this sector is a winner for us"), Buffett lamented the purchase of smaller companies in this sector. Buffett: "I have made my share of mistakes in buying small companies. Charlie [Munger] long ago told me, "If something's not worth doing at all, it's not worth doing well," and I should have listened harder." and "In any event, our large purchases have generally worked well - extraordinarily well in a few cases...".
- Fourth: Finance and Financial Products
- Berkshire's smallest sector; includes two rental companies, XTRA (trailers) and CORT (furniture), and Clayton Homes, the largest producer of manufactured homes in the US.
- Clayton has struggled since the GFC in 2008: Manufactured housing sales in the US were 51,606 in 2011 compared to 146,744 in 2005. Despite this, it has operated profitably. Buffett: "Clayton's earnings should improve materially when the nation's excess housing inventory is worked off."
- Buffett: "I believe the intrinsic value of the three businesses in this sector does not differ materially from book value."
- Other interesting comments:
- On how to define "terrific economics" of businesses Berkshire owns: "measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%."
- "Good" economics businesses "... produce good returns [earnings on unlevereaged net tangible assets] in the area of 12-20%."
- Lower than these are "very poor returns, a result of some serious mistakes I made in my job of capital allocation."
- Buffett also talked about the three investment possibilities: 1. in cash, currency and fixed interest, 2. in non-producing assets (including tulips and gold), and 3. in producing assets (businesses). He, of course, favour the third category. Buffett: "I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we've examined. More important, it will be by far the safest."
Until next year's annual report,
Regards
Tri
