Warren Buffett’s annual letter to shareholders is awaited for its wisdom, foresight and wit.
01-Apr-2007 •Value Research
Warren Buffet is always in the news. And, for a variety of reasons, not the least being that he is the world's richest individual, after Microsoft Corporation Chairman Bill Gates. Last year, he won much acclaim and admiration for donating a huge portion of his wealth to the Bill and Melinda Gates Foundation. More recently, he drew flak for investing in PetroChina Co. amid claims that the company's parent supports Sudan's government, which the United States accuses of genocide.
Known as the Oracle of Omaha, Buffett transformed Berkshire from a failing textile company in 1965 to a billion dollar conglomerate by buying companies with strong management and businesses, and investing in stocks. Every March, the 76-year old legendary investor comes out with his annual report which is much awaited the world over.
This year, the Berkshire Hathaway Annual Report for 2006 was released on March 1, 2007 with the company reporting a gain of $16.9 billion in net worth during 2006. His humour is evident upfront when he goes on to claim that "a confession" about this gain is in order. "Our most important business, insurance, benefited from a large dose of luck: Mother Nature, bless her heart, went on vacation. After hammering us with hurricanes in 2004 and 2005 storms that caused us to lose a bundle on super-cat insurance " she just vanished. Last year, the red ink from this activity turned black very black". Having said that, he is extremely cautious about the insurance business in 2007.
“The big unknown is super-cat insurance. Were the terrible hurricane seasons of 2004-05 aberrations? Or were they our planet's first warning that the climate of the 21st Century will differ materially from what we've seen in the past? If the answer to the second question is yes, 2006 will soon be perceived as a misleading period of calm preceding a series of devastating storms. These could rock the insurance industry. It's knaive to think of Katrina as anything close to a worst-case event.
Neither Ajit Jain, who manages our super-cat operation, nor I know what lies ahead. We do know that it would be a huge mistake to bet that evolving atmospheric changes are benign in their implications for insurers."
Underlying his caution, however, is shrewd business acumen.
"Don't think, however, that we have lost our taste for risk. We remain prepared to lose $6 billion in a single event, if we have been paid appropriately for assuming that risk. We are not willing, though, to take on even very small exposures at prices that don't reflect our evaluation of loss probabilities. Appropriate prices don't guarantee profits in any given year, but inappropriate prices most certainly guarantee eventual losses. Rates have recently fallen because a flood of capital has entered the super-cat field. We have therefore sharply reduced our wind exposures. Our behavior here parallels that which we employ in financial markets: Be fearful when others are greedy, and be greedy when others are fearful."
Last year, the company conducted its first across-the-border acquisition. ISCAR, an Israeli company in the cutting-tool business across 61 countries, was owned by the Wertheimer family. In October 2005, Buffet received a letter from its chairman, Eitan Wertheimer, who felt that Berkshire Hathaway would be the ideal home for ISCAR. What's really interesting is an insight into what Buffet valued about this company. Here are a few excerpts.
"Overall, Eitan's letter made the quality of the company and the character of its management leap off the page. It also made me want to learn more." He went on to meet with the chairman, Jacob Harpaz, CEO and Danny Goldman, CFO, ISCAR.
“A few hours with them convinced me that if we were to make a deal, we would be teaming up with extraordinarily talented managers who could be trusted to run the business after a sale with all of the energy and dedication that they had exhibited previously.”
“ISCAR's products are small, consumable cutting tools that are used in conjunction with large and expensive machine tools. It's a business without magic except for that imparted by the people who run it. But Eitan, Jacob and their associates are true managerial magicians who constantly develop tools that make their customers' machines more productive. The result: ISCAR makes money because it enables its customers to make more money. There is no better recipe for continued success."
In July 2006, Berkshire purchased 80 per cent of ISCAR for $4 billion and the remaining 20 per cent stays with the Wertheimer family.
Undoubtedly, management is a crucial factor in his decisions. That is evident when he refers to his own selection of directors. Here we have represented portions of his views on this subject as he explains his selection of Susan Decker, CFO, Yahoo! who is now on his board of directors.
"In selecting a new director, we were guided by our long-standing criteria, which are that board members be owner-oriented, business-savvy, interested and truly independent. I say "truly" because many directors who are now deemed independent by various authorities and observers are far from that, relying heavily as they do on directors' fees to maintain their standard of living."
"Charlie and I believe our four criteria are essential if directors are to do their job which, by law, is to faithfully represent owners."
"Over the years I've been queried many times about potential directors and have yet to hear anyone ask, "Does he think like an intelligent owner?"
"At Berkshire, we are in the specialized activity of running a business well, and therefore we seek business judgment."
Buffet gives considerable mention to long-time friend Walter Schloss who turned 90 last year. In Buffet's own words, Schloss was an able and honest investment manager who ran an investment partnership from 1956 to 2002. He never took a dime unless his investors made money. His office contained one file cabinet in 1956; the number mushroomed to four by 2002. His only associate was his son Edwin, a graduate of the North Carolina School of the Arts. He did not have a secretary, clerk or bookkeeper.
"Walter and Edwin never came within a mile of inside information. Indeed, they used "outside" information only sparingly, generally selecting securities by certain simple statistical methods Walter learned while working for Ben Graham. When Walter and Edwin were asked in 1989 by ' Outstanding Investors Digest', "How would you summarize your approach?" Edwin replied, "We try to buy stocks cheap." So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.
Following a strategy that involved no real risk defined as permanent loss of capital Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500. It's particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type. A few big winners did not account for his success. It's safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.
I first publicly discussed Walter's remarkable record in 1984. At that time "efficient market theory" (EMT) was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at any moment is not demonstrably mispriced, which means that no investor can be expected to overperform the stock market averages using only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefully contradicted this dogma. And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching EMT made any attempt to study Walter's performance and what it meant for the school's cherished theory.
Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope. Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was "right" (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses that is, stocks were useless. Walter meanwhile went on overperforming, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it's helpful to have all of your potential competitors be taught that the earth is flat. Maybe it was a good thing for his investors that Walter didn't go to college." Buffet's wisdom, insight and wit make his annual letter to his shareholders a compelling read.
He also lists the common stock investments that had a market value of more than $700 million at the end of 2006. He deliberately excludes two securities with a market value of $1.9 billion because his firm continues to buy them. "I could, of course, tell you their names. But then I would have to kill you." For those of us who would rather live, we will just have to till he finally stops buying. Or, for the next annual letter.