On Saturday, Berkshire Hathaway (BRK-A) released its 2008 annual report and shareholder letter. Not surprisingly given the economic and market downturn, Berkshire’s net worth, or book value, declined in aggregate by 9.6% to $70,530 per each class A share. It should be noted—as Chairman Warren Buffet did—that this is the largest decline in both the S&P 500 as well as Berkshire’s net worth in the conglomerate’s 44-year history.
The majority of Berkshire’s decline in net worth was due to the decline in the value of the conglomerate’s equity holdings, which given the size of the companies that Berkshire owns, it’s not surprising that with the S&P down substantially, so were the value of Berkshire’s equity holdings. But even with this headwind, Berkshire’s results were better than the S&P, to the tune of 27.4 percentage points better. Berkshire’s accounting net worth was also impacted by increased accounting liabilities—non-cash for the most part—on its derivatives exposure.
Derivatives Exposure
Berkshire’s derivative exposure has, in my opinion, caused some investors to view the firm a bit differently than they had previously. For years, Buffett referred to derivatives as “weapons of financial mass-destruction”, and he had indicated that he steered clear of them in both word and action. On the latter, he sold Berkshire’s position in Freddie Mac (FRE) in the early 2000’s, and wound down the conglomerate’s derivative book in General Re, which Berkshire had acquired in the late 1990’s. So, to learn that Berkshire has some new—and recently written—derivative contracts may be a bit un-nerving to some long-term shareholders.
I agree that the flip-flop on this stance has certainly impacted the perception of Berkshire in the marketplace. But, I think there are some important differences to note as well. One is that Berkshire has essentially no counterparty exposure in the contracts, which helps to isolate the firm from the interconnectedness that has plagued other large financial institutions in today’s vicious downward re-pricing of assets. The other significant difference is that Buffett said Berkshire would not engage in any contracts where it was required to post collateral. This is important because collateral postings in a time of financial stress can often be devastating to a company—think AIG (AIG). As a result, Berkshire should be further insulated from this type of risk, and probably, I would suspect, ultimately make money on its derivative positions in the coming years, despite the impact these contracts have had on Berkshire’s present day image.
Earnings
There was nothing really that surprising in Berkshire’s earnings report. Auto-insurer GEICO has continued to grow nicely despite the weak economy, and in fact has seen more rapid growth than I had expected, as many consumers have looked to reduce their auto insurance costs by using a low-cost player like GEICO. Berkshire’s reinsurance operations were also profitable this past year, thanks largely to the absence of natural—not financial—disasters in 2008. As a result, Berkshire benefited from another year of negative-cost on its float, which now approximates $58 billion.
Berkshire continued to grow its utilities earnings, which now are an even bigger and more important component of the conglomerate’s overall earnings stream. What’s more, Buffett indicated that he is seeking to further expand Berkshire’s utility footprint if additional deals become available at the right prices.
As for the other businesses Berkshire owns, the results were a bit of a mixed bag. Certainly the businesses that are tied to housing, construction, and the consumer suffered, particularly in the fourth quarter, with the current economic slowdown. Other higher-end businesses such as Net Jets also saw weakness in its earnings. On the other hand, McLane—a grocery distributor—actually saw a very modest increase in sales and a slight improvement in its operating margin. All in all, earnings were largely down, though, and consistent with the general economic weakness we are experiencing today.
Annual Letter Tidbits
To me at least, this year’s annual letter was a little bit different than some of the more recent letters. Part of this is likely because there is just a lot more to write about this past year than there have been in prior years. I basically see this year’s annual letter as divided into three distinct components: review of earnings, marketing for deals, and general economic/market commentary.
The first of these, earnings, as I’ve detailed above, was neither a great year, nor a terrible year for Berkshire, but in aggregate the conglomerate is being affected just like everyone else is by today’s economic weakness.
The second of these, marketing for deals, was significant, I thought. As usual, Buffett indicated that he was on the prowl for large and well run family businesses that are in need of either a long-term owner, or that are facing the challenge of needing to simplify their ownership structure. This is really no different from prior letters.
The more interesting elements of the marketing aspect of the letter were that Buffett was basically telling regulators that Berkshire via Mid-American is looking to expand and make acquisitions in the utilities sector. What’s more, he indicated that Mid-American has been a leader in wind power generation. With the current government emphasis on making capital outlays for alternative energy sources—such as wind—Buffett was potentially positioning Berkshire to capture some of this investment.
And finally, the letter also marketed Berkshire’s financial strength to municipalities and states seeking bond insurance for any new or existing debt issues. Berkshire entered into the bond insurance industry in early 2008 via Berkshire Hathaway Assurance Corp, and so far has provided protection on bonds that were already insured by legacy players. Berkshire is now likely to push harder into the primary market of bond insurance with its solid AAA rating.
The third element, and perhaps the most interesting to the average investor, was Buffett’s comments on the economy and the markets. To be sure, he indicated, these are in fact challenging times. But—and importantly—he said that we as a country have survived and prospered through much worse during the twentieth century, and that our system of unleashing human economic potential will also get us through this difficult spot and allow us to prosper again. He also defended the government’s actions to save some beleaguered financial institutions, as they had potentially become a threat to the overall financial system due to their size and interconnectedness.
Buffett also indicated that the world has gone from under to over pricing risk, and warned—as I’ve alluded to previously—about the potential for a bubble in the Treasury bond market. He also warned that the current government action, while necessary, would have side effects, one of which could be inflation.
The most interesting aspect of this discussion to me, though, was that he wrote “Beware the investment activity that produces applause; the great moves are usually greeted by yawns.” (1) Naturally, this means that to produce great investment returns, decisions shouldn’t be popular—we all know that. What it also means, however, is that investors should avoid trying to catch a falling knife, and look for areas of the markets that are generally ignored, where people don’t have enough interest to have an opinion one way or the other. I think of Berkshire’s investment in Anheuser-Busch a few years ago as a prime example of this, as nobody really had much to say about this investment, and Berkshire ended up almost doubling its money when Anheuser was acquired earlier this year. Perhaps Burlington Northern (BNI) is another stock like this.
If it is, or if it isn’t, 2008 was a year that while Berkshire’s reported results were down, the conglomerate put a lot of cash to work and a number of markers on the table, as asset prices cascaded down. Berkshire’s cash balance is down from over $40 billion to around $24 billion, and I believe that Buffett has been busy planting some great investment seeds for the future, at what appear to be varying depths.
You might also be interested to know that buffettologist.com was featured in a recent MarketWatch article which I’ve linked here, and also mentioned in an Associated Press article which I’ve linked here.
Justin
(1) http://www.berkshirehathaway.com/letters/2008ltr.pdf
The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business. This content is intended solely for the entertainment of the reader, and the author.
