Newsletter March 2, 2008
InvestorsFriend Inc. Newsletter March 2, 2008
Warren Buffett’s 2008 Letter to Shareholders – Selected Highlights
The book value per share of Berkshire Hathaway increased 11.0% in 2007. The average compounded increase since the start of 1965 was 21.1% per year. Remarkably this works out to a gain of 401,000% in those 43 years. Most investors would agree that such a record is quite motivating in terms of what can be accomplished through investing over a lifetime.
“It’s a certainty that insurance-industry profit margins, including ours will fall significantly in 2008.”
Buffett discussed the type of business he likes as follows:
Lets take a look at what kind of businesses turn us on. And while were at it, lets also discuss what we wish to avoid.
Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.
We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality arent available, though, we are also happy to simply buy small portions of great businesses by way of stock market purchases. Its better to have a part interest in the Hope Diamond than to own all of a rhinestone.
A truly great business must have an enduring moat that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business castle that is earning high returns. Therefore a formidable barrier such as a companys being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with Roman Candles, companies whose moats proved illusory and were soon crossed.
Our criterion of enduring causes us to rule out companies in industries prone to rapid and continuous change. Though capitalisms creative destruction is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.
But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your areas premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnerships moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you cant name its CEO.
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. Theres no rule that you have to invest money where youve earned it. Indeed, its often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, cant for any extended period reinvest a large portion of their earnings internally at high rates of return.
I was somewhat surprised to learn in the 2007 letter that Buffett personally manages 62 derivative contracts. In 2008 he reveals this is now 94 contracts. I was surprised because Buffett has described derivatives as being very dangerous. Often they are a bet with some counter-party on the direction that some financial item will move. For example parties bet which way interest rates or the stock market or oil prices will move.
This year Buffett provided details on the derivatives and they look pretty low risk. They all involved other parties handing Berkshire cash up front and then Berkshire has to pay out cash if certain events transpire. One group of derivatives provided Berkshire with cash up front of $4.5 billion and they only have to pay out if certain stock market indexes are lower at the expiry dates between 2019 and 2027 than those indexes were when the contracts were set. Presumably the pay-outs at that time could be large. But I suspect the payouts are capped. I understand Berkshire never takes on any unlimited liability there are always caps. And the chance of a major stock index being down over such a long period time is probably remote. Yes, I know that the Japanese index is still down from its peak way back around 1989 but you can bet that Buffett has not made this bet based on a stock index that was trading at some bubble peak. Meanwhile Buffett will invest the $4.5 billion for many years and in all probability will never have to pay out a dime on these contracts.
The second category of derivatives that Berkshire has require payouts if certain high-yield bonds default. Berkshire received $3.2 billion up-front cash and has paid out $472 million to cover defaults. Buffett expects to pay out more but the very maximum to be paid is another $4.7 billion. Buffet said that a pay-out of $4.7 billion was extremely unlikely to occur. So, in a worse case Berkshire might lose on these derivatives. But meanwhile he would have invested the cash to offset the losses. It sounds like he has taken on bets here that are likely to be quite profitable.
These derivatives really look more like insurance than a true derivative. These are far from the dangerous types of derivatives that many corporations have.
Car Insurance Business
Berkshire owns the car insurance company GEICO. This company sells direct to individual drivers. They have a cost advantage because of their size and the fact that they don’t have to pay fees to insurance brokers.
I found it very interesting that GEICO in November sold its first ever commercial auto policy. GEICO has been around since the 1930’s. Berkshire has controlled the the company for decades and has owned 100% of it since about 1990.
Most companies are eager to diversify to grow their business. GEICO must have considered many times getting into the commercial auto insurance business. And they may have considered getting into home insurance as well. And yet for all these decades GEICO stuck to only offering personal auto insurance.
I think this illustrates the thinking of Buffett and his discipline. GEICO had a competitive advantage in personal auto insurance. For whatever reasons Buffett must have judged that commercial auto was not as attractive and the company had the discipline to decline to enter that market. Until now, when presumably they have judged the time to be right for this move.
U.S. trade deficit and the U.S. dollar.
Buffett views the current trade imbalances as unsustainable and appears to believe that the U.S. dollar will continue to fall. But he has no active direct currency bets at this time accept a bet that the Brazilian Real will rise. He also notes that Berkshire’s investments in foreign companies and bonds will benefit from a falling dollar. (So these might be considered as an implicit bet against the U.S. dollar).
Long-term future stock market returns
Buffett indicates that the DOW in the 20th century rose an average compounded 5.3% per year (dividends provided substantial additional returns). He appears to indicate than an expectation of an average of 5.3% rise in market indexes this century is quite optimistic. This would require the DOW to rise to 2 million by the year 2100 which he implies is optimistic. He also notes that with dividend yield around 2%, an expectation for 10% annual returns (which many people do expect) requires 8% annual gains in the market indexes which would require the DOW to be at 24 million by the year 2100 which he seems to indicate is impossible.
For additional information on how Warren Buffett picks stocks and for a link to where you can read his letters, see our article.
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