No one writes a better investor letter than Warren Buffett. In his annual report to shareholders of Berkshire Hathaway, Buffett opens with a sentence few CEO’s would dare: “Our decrease in net worth during 2008 was $11.3 billion.”
If anyone misses the point, he quickly adds this was the worst performance in the company’s 44-year history and predicts, “the economy will be in shambles throughout 2009 – and for that matter, probably well beyond.”
Buffett, 78, is considered one of the shrewdest investor in America (and acknowledged to be the richest man in the world.) His letter to shareholders modestly avoids mentioning his company’s performance nonetheless outstripped most of Wall Street. This only makes his 20-page letter on what happened in America last year all the more compelling because Buffett is not one to sugarcoat it.
“Investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game.
“As the year progressed, a series of life threatening problems within many of the world’s great financial institutions was unveiled. This led to a dysfunctional credit market that in important respects soon turned non-functional. The watchword through the country became the creed I saw on restaurant walls when I was young: “In God we trust; all others pay cash.”
“By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulf the country. A freefall in business activity ensured, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.
“The debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.
“Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-bobbling requests. Weaning these entities from the pubic teat will be a political challenge. They won’t leave willingly.
“Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.”
Buffett is careful not be too downbeat. He reminds readers there have been other economic calamities over the last century – two world wars, a Great Depression, and a dozen or so other panics and recessions – and concludes with the bromide that “America’s best days lie ahead.”
But Berkshire Hathaway stockholders who watched the value of a single share drop from $148,000 in late 2007 to $74,000 at the beginning of this week don’t invest in bromides. They are putting their money on a man with a keen sense of where the market is going and a clear way of explaining it. A man who, for 40 of the last 44 years, has been right.
The Warren Buffett Way of Doing Business
Berkshire Hathaway is a diversified conglomerate based in Omaha, Nebraska. Its core business is providing insurance through GEICO and 50 other carriers, but it also operates 67 other businesses manufacturing everything from Ginsu knives and lollipops to carpets, paints, vacuum cleaners, jewelry and motor homes.
One arm of the enterprise operates utilities on the West Coast and Iowa, where astute observers will note Buffett invested $1.8 billion in wind power last year. Another takes major investment positions in large corporations like Coca Cola (9%), The Washington Post (18%), American Express (13%) and the Burlington Northern Santa Fe Railroad (18%).
Last year as the markets unraveled, Buffett scooped up another $14.5 billion of preferred stock in Wrigley, Goldman Sachs and General Electric. “Whether we’re talking socks or stocks, I like buying quality merchandise when it is marked down,” he writes.
But he also invested $7 billion in Conoco Phillips at the height of the oil boom – only to see the stock fall from $80 a share to $35.
“I did some dumb things in investments,” he writes. “I made one major mistake of commission and several lesser ones that also hurt . . . Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.”
This kind of candor permeates Buffett’s annual shareholder letter, and is one reason why it is so highly regarded. He gets away with it because, before getting into the details of various transactions, he articulates the business philosophy that guides his every move:
* Maintain a “Gibraltar-like financial position” with large cash reserves, modest debts and dozens of sources of income.
* Widen the “moats” around existing businesses to assure they have durable competitive advantages.
* Always look for new ways to acquire and develop varied income streams.
* Invest in people not spreadsheets.
Buffett’s letter to shareholders is replete with specific examples of the latter. When discussing subsidiaries, he invariably credits the key managers responsible for their success. When acquiring new companies, he says he seeks out family businesses where generations of owners have invested their lives and fortune in building the company reputation.
His nemesis in these acquisitions are private equity firms, “a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to the previously existing.”
“For them, acquisitions are ‘merchandise.’ Before the ink dries on their purchase contracts, these operators are contemplating ‘exit strategies,’” he writes.
Buffett and his partner Charlie Munger, on the other hand, win the bidding for family businesses because they become “the buyer of choice” by keeping their promises, avoiding leverage, giving autonomy to the managers and holding on through thick and thin – “though we prefer thick and thicker.”
“We have a decided advantage,” he writes, “when we encounter sellers who truly care about the future of their businesses.”
The Oracle of Omaha
Buffet is not just a sharp businessman; he also knows how to turn a phrase.
* On the prowess of the CEO of a farm equipment manufacturer they own: “He focuses on blocking and tackling, day by day doing the little things right and never getting off course.”
* “The cause of [the tax-exempt bond insurance] problems was captured long ago by Mae West: ‘I was Snow White, but I drifted.’”
* “Investors should be skeptical 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.”
* “Our feelings about [a company he acquired with a wide assortment of derivative contracts] mirrored a line in a country song: ‘I liked you better before I got to know you.’”
* Holders of derivative contracts, which Buffet has derided for the last five years, “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.”
* “The First Law of Corporate Survival for ambitious CEO’s who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mindboggling screw-ups that are required.”
Woodstock for Capitalists
Some 31,000 shareholders will attend the annual meeting of Berkshire Hathaway in Omaha this May 2. It will be a three-day event including a Friday night reception, a four-hour question and answer session on Saturday (“If you decide to leave during the day’s question period, please do so while Charlie is speaking”) and, at the end of the day, a vote on whether to let Buffett run the company for another year.
If all the shareholders except Buffett himself, his partner Charlie and friend Bill Gates vote against him, he will still win with over 70% of the votes. So the best reason to attend, Buffett says, is to shop in an adjoining 194,000-sqare-foot exhibit hall stuffed with company products. You can buy auto insurance at a discount, see the electric car they are manufacturing with a Chinese partner, or head out to the Omaha airport to look at private planes from their NetJets subsidiary.
“Come to Omaha by bus; leave in your new plane. And take along – with no fear of a strip search – the Ginsu knives that you’ve purchase at the exhibit of our Quikut subsidiary,” he says.
Spoken like a true capitalist.
CLICK HERE to read Buffett’s full 2008 letter to shareholders.