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Takeaways from the 2011 Berkshire Hathaway Shareholder Letter

February 29, 2012 | About:
You can read Warren Buffett’s latest letter to shareholders of Berkshire Hathaway here [PDF], but in the meantime, I’ve provided are my key takeaways below. Leave your key takeaways in the comments below!

On Succession

This is the big one everyone is talking about. Buffett has announced that his ultimate replacement as CEO has been chosen and approved of by the Board. Though this is newsworthy, I think the more important point here for most investors is the following:

The primary job of a Board of Directors is to see that the right people are running the business and to be sure that the next generation of leaders is identified and ready to take over tomorrow.
Takeaway: It is hard to underestimate the importance of the Board of Directors in holding management accountable and particularly in devising an adequate succession plan. For larger companies, this is usually not an issue (though, Hewlett-Packard (HPQ) does come to mind), but many value investors focus on relatively unfollowed small caps which are often family-led endeavours. Most family-run companies do a poor job of succession management, and the knee jerk reaction is to keep family members, however unqualified, in leadership positions. When making your investment decisions it is important to focus on whether the Board of Directors is adequately fulfilling its primary obligation of ensuring both that the right people are running the business (rather than say, nepotism) and whether this will continue to be the case when the current leaders retire or die.

It is worth noting that succession can also be a source of opportunity. If you recall, Conrad Industries’ (CNRD) 95 year old founder is still the co-Chairman of the Board. His children have successfully started their own businesses. The odds are low that the children, even if they wanted the company to be sold (similar companies have been sold in the last two years at significantly higher multiples than CNRD has traded at), would sell while their father is alive. It could be that his ultimate passing could be a catalyst for change at CNRD.

On Insurance

Buffett again outlines the key reasons why insurance can be such a great business for investors:

Our insurance operations continued their delivery of costless capital that funds a myriad of other opportunities. This business produces “float” – money that doesn’t belong to us, but that we get to invest for Berkshire’s benefit. And if we pay out less in losses and expenses than we receive in premiums, we additionally earn an underwriting profit, meaning the float costs us less than nothing. Though we are sure to have underwriting losses from time to time, we’ve now had nine consecutive years of underwriting profits, totaling about $17 billion. Over the same nine years our float increased from $41 billion to its current record of $70 billion. Insurance has been good to us.



Property-casualty (“P/C”) insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume.

If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit occurs, we enjoy the use of free money – and, better yet, get paid for holding it. Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous in most years that it causes the P/C industry as a whole to operate at a significant underwriting loss.

If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit occurs, we enjoy the use of free money – and, better yet, get paid for holding it. Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous in most years that it causes the P/C industry as a whole to operate at a significant underwriting loss.

At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively evaluate the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained.

Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that their competitors are eagerly writing. That old line, “The other guy is doing it so we must as well,” spells trouble in any business, but in none more so than insurance.
Takeaway: Insurance can be a fantastic, if difficult, business in which to operate and especially if the right value-focused manager is at the helm. The unique nature of its float is like catnip for long-term investors. For greater discussion of insurance, I suggest reading the annual letters of Prem Watsa of Fairfax Financial (found here).

On Investing and Risk

He reiterates his definition of investing and investment risk.

Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.
Takeaway: Value investors should have these concepts internalized.

On Share Repurchases

Buffett discusses the conditions under which share repurchases should take place, and the frequent abuse that he has witnessed in the market:

Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the 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. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.



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.
Takeaway: Share repurchases are neither intrinsically good nor intrinsically bad. The key is to consider management’s motivations and whether the repurchases are (and have been) completed at attractive prices in the past. Also, if you have invested in a company that you find to be cheap, and you are a long-term investor, then it is in your interest for that stock to remain cheap (and get cheaper) while the company continues to repurchase.

On the Housing Market

Buffett sees a recovery in the housing market as inevitable, with the timing decided by the supply of housing units and demand created from new households being formed. This will magnify the upswing of the recovery, just as the collapse of the housing market acted to magnify the collapse.

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).



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.
Takeaway: It is foolish to ignore the housing market, which acts as a double edged sword. It is also worth noting that the housing markets in Canada’s major cities are now significantly more bubbly than their counterparts in America were prior to the recession. Investors in Canada should not be ignoring this.

On the Lunacy of Gold

As you may recall, I do not believe it is rational to purchase gold as an investment. Buffett shares this view and presents a compelling argument in support:

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

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.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.
Takeaway: If you can read Buffett’s rationale and still think Gold is a good investment, I don’t think there’s much that I can do for you. It is a completely irrational place to allocate your capital.

Author Disclosure: None

About the author:

Frank Voisin
Frank is an entrepreneur who owned four restaurants by the time he was twenty. He sold his businesses and returned to school, completing a concurrent Law / MBA degree. At the same time, he successfully completed all three levels of the CFA exams. He now invests full time with a focus on value investing. Frank Voisin writes about value investing topics at http://www.frankvoisin.com.

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Comments

AlbertaSunwapta
AlbertaSunwapta - 2 years ago
The whole tiresome succession discussion and its ability to depress values is a wonderful gift to investors by the media and the market working upon each others' irrationality. Let's hope they raise the fears to a fevered pitch. :-)

On Canada's real estate, I agree that it feels "bubbly" and personally I can't bring myself to buy further property at anything close to these levels, however, that is against highly depressed US housing. I expect a very sharp recovery of US house prices to eventually hit - thus making Canadian prices seem far less bubbly. Add foreign investment and possibly vastly understated inflation and you really have to wonder what fair or replacement values are truly reasonable over the horizon of the next few years.

As for the prospects for BRK, I wish Buffett would address the issue, or law, of large numbers that he's frequently talked about over the years. My guess is that with the growth of China and increasingly India, that the law has undergone a reset.

A $200 billion market cap was a large company 10 years ago but is it today? In other words has Buffett (and his successors) been granted a huge opportunity to vastly outperform the S&P again and again. Look at Apple reaching $500 billion yet hardly having penetrated the Chinese market. Add to this the "relative" decline of the US dollar and market caps and thus prices seem to have a long way to go.

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