I’ve commented on Buffett’s Shareholder letter now for the past five years. Those who know me well know that I admire Buffett and Berky, but not uncritically. Also, I view Berky as primarily an insurance company, secondarily as an industrial conglomerate, and thirdly as an investment company.
Onto the letter:
From page 3:
You may recall a 2003 Silicon Valley bumper sticker that implored, “Please, God, Just One More Bubble.” Unfortunately, this wish was promptly granted, as just about all Americans came to believe that house prices would forever rise. That conviction made a borrower’s income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA – house price appreciation – would cure all problems. Today, our country is experiencing widespread pain because of that erroneous belief. As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out – and what we are witnessing at some of our largest financial institutions is an ugly sight.
Buffett starts out with the cause behind most of our current problems in financial companies. There are too many houses chasing too few people, and inadequate underwriting of the financing, because of a misplaced trust in the rise of housing prices.
From page 4:
Though these tables may help you gain historical perspective and be useful in valuation, they are completely misleading in predicting future possibilities. Berkshire’s past record can’t be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future. (emphasis his)
Buffett has been honest on this point for years. As the business grows, it is unlikely to find opportunities as good in percentage terms as it did when it was smaller. That’s normal, even for the best investors.
In our efforts, we will be aided enormously by the managers who have joined Berkshire. This is an unusual group in several ways. First, most of them have no financial need to work. Many sold us their businesses for large sums and run them because they love doing so, not because they need the money. Naturally they wish to be paid fairly, but money alone is not the reason they work hard and productively.
Buffett hits on what I think is one of the great secrets of good capitalism. The best capitalists are not purely money-motivated, but are idealists, aiming for excellence as they serve others though their businesses. In the best businesses that I have worked in, we did it because we loved what we did. That’s a key for all good businesses, from the CEO down to the clerk.
From page 7:
Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.
This is the core of Buffett the businessman. He understands the need to redirect free cash flow to the opportunities that offer the best returns. He knows that certain businesses will never be more than niches, and like a good farmer would, harvests his specialty crop each year, but doesn’t plant much more the next year.
He goes on for two pages on how he distinguishes between businesses, considering their long-term competitive advantage, return on investment, and capital intensiveness. It’s a good read, and very basic. If it weren’t for the fact that many companies operate more for the good of management than shareholders, you might see this in operation more broadly. (And you would see opportunities diminish for private equity as far as big deals go. Private equity keeps public management teams on their toes, for the bigger deals.)
From pages 9-11, Buffett discusses his insurance businesses, and spends much less time on them than in prior years. It is not as if there isn’t a good story to tell. Are underwriting profits down? Yes, but only by 10%. The rest of the P&C insurance industry is struggling with the same problems, and is likely doing worse in aggregate. I think that some major disasters will have to happen to re-energize earnings here. Berky is an anti-volatility asset, and always does relatively better when the rest of the insurance industry is hurting.
On page 11, Buffett comments on his utility businesses. Earnings are up in this line. These are a natural fit for Berky, with their earnings yield considerably above Berky’s cost of float, and earnings that tend to do well when inflation is higher. Expect Buffett to buy more here, but only during some significant pullback in utility stock prices.
From that page:
Somewhat incongruously, MidAmerican also owns the second largest real estate brokerage firm in the U.S., HomeServices of America. This company operates through 20 locally-branded firms with 18,800 agents. Last year was a slow year for residential sales, and 2008 will probably be slower. We will continue, however, to acquire quality brokerage operations when they are available at sensible prices.
From page 13:
Last year, Shaw, MiTek and Acme contracted for tuck-in acquisitions that will help future earnings. You can be sure they will be looking for more of these.
and
At Borsheims, sales increased 15.1%, helped by a 27% gain during Shareholder Weekend. Two years ago, Susan Jacques suggested that we remodel and expand the store. I was skeptical, but Susan was right.
From page 15:
Clayton, XTRA and CORT are all good businesses, very ably run by Kevin Clayton, Bill Franz and Paul Arnold. Each has made tuck-in acquisitions during Berkshire’s ownership. More will come.
Buffett understands that most good acquisitions are little ones that can be used to increase organic growth of the subsidiary.
