Notes on Warren Buffett's 2011 Letter to Shareholders

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Feb 25, 2012
Berkshire Hathaway (BRK.B) is out with Warren Buffett’s latest letter to shareholders. It’s only been a couple hours since I read it. So I haven’t had much time to digest the contents – a full article on Berkshire’s intrinsic value will follow – but I did manage to write down some notes.

Here they are:

· From 1965 through 2011: Berkshire Hathaway’s book value per share grew 19.8% a year. This is basically Warren Buffett’s long-term record. Of course, he ran an investment partnership before this where he averaged 30% a year over about 10 years. If you factor this part of Warren Buffett’s career in, his returns are about 22% a year. Regardless, we are talking 20% to 22% a year compounded over a 56-year investment career. It is the length of the career that makes this so impressive. See my article on Walter Schloss’s 47-year investment career for a comparison. Between Warren Buffett, Walter Schloss, and Ben Graham you have something like 130 years of investing in common stocks – and yet you have very little overlap between them owning the same stocks at the same times. The careers of these 3 men are a treasure trove of truly long-term investing results. The concept of luck is pretty unimportant when we’re talking about 3 obviously intellectually connected men each picking hundreds of stocks over 3 to 5 decades. Learn everything you can about these men. What they really owned. And when they owned it. Their system works.

· Todd Combs and Ted Weschler “have the brains, judgment, and character to manage our whole portfolio when Charlie and I are no longer running Berkshire.” We’ll see more talk from Warren Buffett about Berkshire’s future portfolio managers. For now, they are each going to be running a smidge under $2 billion. It will be interesting to follow their picks. You’ll notice that most of the smaller positions GuruFocus tracks for Warren Buffett are actually positions bought for Berkshire Hathaway by Todd Combs or Ted Weschler. Buffett also mentions that both men will help in finding acquisitions. And that they are each getting 20% of their compensation based on the other guy’s performances – to increase idea sharing. Not a bad system.

· Lubrizol has grown pre-tax profits under James Hambrick from $147 million in 2004 to $1,085 million in 2011. That’s a 28% earnings growth rate over 8 years. Which is very impressive growth. I know a lot of that came from margin expansion. Margins were the key concern that Buffett discussed with Sokol about Lubrizol.

· Berkshire has already spent $493 million on 3 “bolt on” acquisitions of specialty chemical companies. That’s a lot to spend in a short time. Berkshire has made a lot of bolt on acquisitions that go under reported in the media. This may be part of the attraction of some very big companies in industries with favorable long-term prospects. With companies like Marmon, Iscar, Burlington Northern, MidAmerican, and Lubrizol – Buffett can probably buy a lot of smaller companies to add to what he already owns. It’s a good way to invest even more money into industries he believes in. MidAmerican can also invest in lots and lots of power projects as well. Buffett mentions investments in wind and solar – and the fact that MidAmerican retains all its earnings – later in his letter.

· Burlington Northern, Iscar, Lubrizol, Marmon, and MidAmerican all had record earnings in 2011. This reinforces for me how much of a growth at a reasonable price investor Warren Buffett is. He doesn’t buy companies that need to be turned around. Sure, these are recent acquisitions. But it’s not like every company in the world is reporting record earnings in 2011. Most of Buffett’s big recent acquisitions are. As an investor, I think Buffett’s 4 key criteria are: return on equity, growth, price, and staying power. Warren Buffett’s approach isn’t identical to any other great investors I can think of. He’s not quite like Ben Graham anymore. But he’s definitely not like Phil Fisher – who wasn’t concerned with price. And he’s not like Peter Lynch – who was eager to have growth even if it wasn’t at the absolute highest returns on equity. And Lynch was a lot less concerned with staying power. Some of Lynch’s consumer picks look kind of faddish compared to Buffett’s. Buffett does have some similarities with Phil Fisher though. Both men were always looking for a company that could be a perpetual growth machine. Warren Buffett isn’t looking for something that will grow at 20% for the next 5 years or 10 years and then never again after that. I think Wells Fargo (WFC, Financial) is probably the Warren Buffett investment archetype at this point. Although Berkshire hasn’t yet seen phenomenal returns in Wells Fargo stock – the cost and market value comparison is pretty tepid at this point – it’s clearly a company Buffett loves and a stock he believes is cheap right now. He even points out that Berkshire added another $1 billion to its Wells Fargo stake this year – something that has been under reported because Wells Fargo is a very old position for Buffett.

· Buffett expects these “fabulous five” will deliver aggregate earnings comfortably topping $10 billion in 2012. The “fabulous five” are: Burlington Northern, Iscar, Lubrizol, Marmon, and MidAmerican. He expects them to grow. And he’s obviously focused on Berkshire’s earnings per share growth rather than its investments per share growth at this point. Buffett makes this point in the annual report – page 99 – where he discusses intrinsic value. He says that for the first 25 years after he took over Berkshire Hathaway it focused on growing investment per share. Over the last 20 years, it has focused more on growing earnings per share. This is probably a result of: a) Berkshire’s size and b) Stock prices. Stock prices were a lot higher in the 1990s and 2000s than they were in the 1970s and 1980s. The combined influence of a bigger Berkshire and higher stock prices has made Warren Buffett’s job of growing Berkshire Hathaway’s intrinsic value per share much harder over the last 20 years.

· Berkshire Hathaway’s capital spending was $8.2 billion in 2011. 95% of the spending was done in the U.S. Capital spending in 2012 will be even higher. This just reinforces for me how much Berkshire has changed since the 1970s and 1980s. If you look at the companies Berkshire owned they were either insurance or asset light businesses with terrific – but small – niches. And his stock investments were in: insurance, media, advertising, and brands. Today – it’s totally different. Berkshire owns a lot of very tangible businesses. The idea that Warren Buffett would own a power company and a railroad – that would’ve seemed really odd in the 1970s and 1980s. Today, they are a huge part of Berkshire. This transformation seems to be a result of Berkshire’s size rather than any change in Buffett’s philosophy. I still think he like companies with valuable intangibles and little need for capital spending. He just has a hard time finding the right companies at the right price at the right scale for Berkshire. Maybe this is part of the modern day Berkshire that individual investors shouldn’t emulate. I don’t think Buffett is saying little investors should own railroads and utilities. But that’s the best path for soaking up Berkshire’s immense mounds of cash. The cash keeps coming into Omaha month after month. Buffett has to find a place to deploy billions of dollars at decent returns on capital. Regulated, capital-intensive businesses at least are predictable and protected from competition. The downside is their lack of tremendous upside potential.

· Berkshire had 9 straight years of underwriting profits. Underwriting profits have added almost $2 billion a year to Berkshire’s pre-tax profits ($17 billion over 9 years). Berkshire’s insurance operations have gotten much, much better over the years. One thing that the Berkshire Hathaway of 2012 has on the Berkshire Hathaway of the 1970s and 1980s is a much better insurance business. This has helped to offset some lower returns on equity at the owned businesses and some vastly inferior stock holdings. By vastly inferior – I mean Berkshire had to spend way more money to buy equal amounts of earning power in the stock market during the 1990s and 2000s than it did in the 1970s and 1980s. But back then, Berkshire’s insurance operations were much worse. Today, Buffett thinks Berkshire has the best large insurance business in the world. He never would’ve said that in the 1970s and 1980s. In fact, I remember him plainly saying that SAFECO was a better insurance business than anything Berkshire owned. That’s why he bought the stock. See Warren Buffett’s 1978 letter to shareholders for details.

· Buffett “expects the combined earnings of...(American Express, Coca-Cola, IBM, and Wells Fargo) – and their dividends as well – to increase in 2012 and, for that matter, almost every year for a long time to come. A decade from now, our current holdings of the four companies might well account for earnings of $7 billion, of which $2 billion in dividends would come to us.” Buffett thinks these companies can grow their earnings per share at 8% a year over the next 10 years. That sounds about right. Especially if they are buying back shares the way IBM is. As far as dividends, Buffett probably thinks Wells Fargo can increase its dividend faster than it increases earnings over the next 10 years. That’ll make it easy for the four stocks to provide $2 billion a year in dividends to Berkshire by 2022.

· Berkshire wrote down $1.4 billion of its investment in the bonds of a Texas electric utility that is dependent on natural gas prices. WarrenBuffett is a terrible investor when it comes to commodities. I’ve had a hard time finding any situation where his investment in a commodity company worked out better than similar investments he was making – and could’ve presumably added more to – at the same time. At best, Berkshire’s commodity related investments have done about as well as its non-commodity related investments made at the same time. At worse, they’ve failed miserably. This one looks like it falls into the latter category. Of course, there was one very big exception to Berkshire’s sorry history of investing in commodity stocks – PetroChina. That was a smashing success. Buffett’s other oil investments – like ConocoPhillips (COP, Financial) – not so much. Even if you go back to the 1970s and 1980s when Buffett was probably looking at commodity companies as helpful in his fight against inflation – he still wasn’t getting more for his commodity company investments than from his media company investments. It just seems like this is an area Warren Buffett should stay away from. If the thesis depends on the price of oil, coal, silver, aluminum, etc. – it isn’t a Warren Buffett investment. At least it’s not a Warren Buffett investment that’ll live up to the name. But he keeps making these mistakes. It’s something to think about. If your record is pretty spotty in one sector – maybe that’s a sector you should stay away from. There’s a reason I’m very reluctant to buy retail stocks – I tend to lose money on them. It wouldn’t be a bad idea for Buffett to apply the same logic to his commodity related investments.

· Berkshire’s housing related companies earned $1.8 billion in 2006 and only $513 million in 2011. Warren Buffett is not an economist. And economists are not investors. Just as he should stay away from commodity investments – he should stay away from investments that depend on his knowledge of some economically sensitive sector. If he can’t predict oil prices – why does he think he can predict house prices? This is one Buffett got very, very wrong. A value investor like Buffett – and someone who is so attuned to the public’s waves of fear and greed – should’ve been better aware of the housing bubble. He seemed to subscribe to the ridiculous notion that house prices – nationally – could never decline a whole heck of a lot at once. They did. Buffett got this one wrong. And it cost Berkshire a lot of money. Some of Berkshire’s biggest losses – like its investment in two Irish banks – were directly tied to Buffett’s not realizing there was a huge housing bubble. Buffett’s housing related mistakes and commodity related mistakes reinforce the idea that predictability is key. You need to understand where a company gets its money from. Buffett understands Coca-Cola. He never understood Bank of Ireland or Energy Future Holdings. The dumbest mistakes Buffett has made have been mistakes that looked good by the numbers. Should Buffett have seen the housing bubble? Actually, I think he did see the bubble. He knew it was a bubble. He just didn’t think hard enough – and internalize – the need to distrust the kinds of number (like earnings) he was used to trusting for any company tied to housing. The same is true for commodities. These are places Warren Buffett is better off not investing. They are simply outside of his circle of competence. They need to go into the “too hard” pile. This is a good lesson for all of us. We all think we know more about more industries than we really do. Of course, when we commit the sin of investing in something we know nothing about – it’s a much greater crime. Buffett at least has the excuse of having to act on an immense scale. He needs to buy billions of dollars of stocks or bonds in some company. We don’t. We can certainly afford to ignore housing or energy or retailers or airlines or whatever we know nothing about. There are thousands of stocks for us to choose from. For Buffet there’s – at best – a couple hundred.

· “Housing remains in a depression of its own”.Here, Warren Buffett is just reminding us how wrong he was on housing. He was wrong when he bought housing related companies. He was wrong when he bought insolvent Irish banks. And he was wrong when he predicted the economy would bounce back – and unemployment plummet – faster than the pundits thought. Why? Because he thought housing would bounce back. Because he thought we couldn’t go on growing our population so much faster than our housing stock. That was a failure of imagination – on the upside and the downside. Families got really small in the boom and they’ll grow really big in the bust. Of course, Buffett is right. Eventually, housing will return. New construction will return. But this is a good reminder of how successful Warren Buffett has been as an investor while simultaneously being totally unsuccessful in predicting anything about houses, commodities, etc. It’s a message of hope. You too can be incredibly dumb about a lot of things. As long as you are smart about a few things. And you bet on those things.

In this year’s letter – Warren Buffett also talked about Berkshire’s intrinsic value more than he normally does. It’s clear he thinks the stock is undervalued. I’ll talk more about this in an article laying out my thoughts on Berkshire Hathaway’s intrinsic value.

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