At some point (probably long ago, actually), people are going to quit believing Warren Buffett.
To wit, in the Berkshire Hathaway (NYSE: BRK.A ) annual letter (pdf file) to shareholders, Buffett stated that the company's "performance in the future will fall far short of what it has been in the past." This may seem like bad news. But the problem is, so far Buffett's proving to be a lousy prognosticator. He's been saying the exact same thing, every single year, since the early 1990s: "We've done great, don't expect more of the same."
The trouble is that Berkshire has continued to defy his predictions. Its 2003 earnings nearly doubled to $3531.32 per share ($117.71 per share of Class B stock) and its book value increased by 21% for the year. A hint about this: Operating earnings is only part of the story at Berkshire. Look at that number, love it (if you're a shareholder), and move on.
His annual underpromise reminds me of the pastor who cancels his subscription each year following Sports Illustrated's swimsuit issue. At some point, it just seems like performance art. With the right reverend, I imagine it is just that, but Buffett is as serious as can be. He now manages a company that has $44 billion of other people's money as well as $35 billion of its own, much of which sits in cash and treasuries. Deploying this amount of money is nigh upon impossible. And yet, in the last five years, Berkshire's earnings have increased an average of 28%. Nigh upon -- but not quite -- impossible.
So just like that reverend, who if he had been true to his word would have not seen the last 20 or so swimsuit issues, Buffett is clearly generating returns that he has said repeatedly he wouldn't be able to achieve.
We've seen plenty of commentaries rushed out over the weekend following the letter's midnight Saturday release. As usual, I find the majority of them to be superficial and addled -- such as the one that claims that Buffett is calling for higher corporate taxes or the one that claims he forecasts an above-average 2004 for Berkshire. I'm still looking through the original's 22 pages for any mention of the sort, and am not finding it. Not that I expected to.
For people interested in what Buffett actually said, I'd advise that you simply ignore the commentaries on it (this one included) and just read the letter for yourself. I do, though, have some impressions of the letter and of Berkshire's performance in 2003. Take them as you will.
The tax kerfuffle
At the Berkshire Hathaway 2003 annual meeting, Buffett noted that "the rule at Berkshire is that we praise by name and criticize by category." By and large, the letter to shareholders followed this policy, though I've never heard of a category called "Pamela Olson." Buffett had some special words for Olson, who is the assistant secretary for tax policy at the Treasury Department. In a speech last year, Olson accused Buffett of playing the corporate tax codes "like a fiddle" (Fool member bsmeal from the Fool discussion boards found the text of Olson's original speech, from June 2003).
Buffett notes that Berkshire paid more than $3.3 billion in taxes in 2003, which equaled 2.5% of all taxes paid by corporations, though Berkshire only accounts for 1% of the value of corporations. He suggested that Olson look not to Berkshire to voice her frustrations, but to Congress and the Bush administration and the myriad tax breaks and loopholes they've created for corporations.
Olson specifically mentioned Berkshire's retained earnings, so I'm not sure that she's talking about Berkshire's corporate taxes, but rather the taxes Buffett personally pays. Either way, it's a stupid comment. Buffett has said over and over that he would retain capital as long as he thought he could put it to work. Olson seems to be insinuating that Buffett's getting rich by virtue of not paying out dividends, creating taxable events for the company and individuals alike.
But no corporate officer ought to be running his or her enterprise for the benefit of the chief executive or for the benefit of the government. Buffett clearly understands the power of unrealized capital gains, a trait that few people, and fewer portfolio managers, seem to share. That's not "playing the tax code like a fiddle." It's managing capital for the benefit of its owners. Last time I checked, that constituency doesn't include the U.S. government. When you look at operating earnings increasing at 28% over the last five years, you know that Buffett's decision not to pay out dividends is, for the time being, defensible.
Fund companies hammered
Speaking of portfolio managers, Buffett absolutely savaged them and their boards, stating that investment companies have had the same "independent board" requirements that are considered now for corporate America.
He noted quite acidly that many of the fund company boards did nothing to punish fund managers who turned in year upon year of dismal performance, and now that rampant malfeasance at fund companies has been uncovered, we're still not seeing many instances of boards throwing out the management companies. One, in fact, has put itself up for sale and, pending completion, the same managers who raked in millions of gains by deceiving their shareholders will receive millions more in transaction bonuses. (The only company that I know of that matches this description is Strong.)
He also sent stingers at corporations for the dizzying levels of executive compensation, and pointed out General Electric's (NYSE: GE ) new compensation policy as one that should be followed by others rather than "admired." And finally, Buffett spoke out about the frauds at Freddie Mac (NYSE: FRE ) , calling them "shenanigans of mind-blowing size and audacity." Where do you think Buffett stands on the bonuses granted to Greg Parseghian, who signed off on these accounting gimmicks?
Operating on all cylinders
Berkshire's operating segments, for the most part, turned in some spectacular results. Buffett said for the first time that General Re, its massive reinsurance subsidiary that it acquired in 1998, "is fixed." He said in this case that he made a mistake in considering Gen Re's underreserving, noting that this has caused Berkshire to pay "very substantial" taxes too early. The combined ratio that Berkshire Hathaway's own megacat insurance arm, run by Ajit Jain, turned in this year was phenomenal -- $1.4 billion in operating profits on $4.4 billion in business. Consider that the average insurance company loses money on its underwriting, and this performance becomes astounding.
And as I noted in an Aug. 2003 article, Buffett's ability to "trade" is phenomenal. Earlier this year, he disclosed that he had -- for the first time -- taken a currency position speculating in the drop of the U.S. dollar. Berkshire's earnings on this trade in 2003 exceeded $800 million. He also manages a trading account where he generated a gain of $379 million from opportunistic investments in fixed-income strategies. These aren't the only places where Buffett deploys capital, but between the two he accounted for $1.17 billion in earnings by himself. Once again, he suggests that we shouldn't expect these results in the future. We'll just see about that.
Areas where Berkshire performed less well were in its leasing businesses (XTRA containers and Cort furniture) and in its fractional jet business, all of which have suffered from the economic downturn.
I could continue going through the operating segments, but it's probably more worth your while to read the letter yourself. The presentation is clear, the segmentation logical, and where Buffett thinks comments are necessary -- positive or negative -- he makes them. The acquisitions of Clayton Homes and McLane food services -- the latter from Wal-Mart (NYSE: WMT ) -- are fascinating, and show why such companies are likely to be much more profitable as part of the Berkshire family than they were before. He notes that the year 2003 was not a distorting year from an earnings perspective, which tells me that Buffett thinks that it was a representative showing.
Most importantly, Buffett shows in black-and-white why he is among the most admired business leaders in America. He doesn't spend these words to take credit for the Berkshire juggernaut. He praises his managers and employees by name, and celebrates the fact that each of them does his or her own job better than he could. He also gives his shareholders a great deal of credit -- assuming that they understand that companies, especially insurance and financial ones, have results that are lumpy by nature.
Should Berkshire's stock price drop suddenly, you won't hear a word about it from Buffett. He assumes that the company's shareholders are smart enough to make that determination for themselves. This, in a time of "short sellers stole my lunch money" bellyaching, remains refreshing.
I'm certain that Buffett will eventually be proven correct about the enormous amount of capital he has to deploy. Berkshire cannot continue growing apace, so an extrapolation from the past is foolhardy. But there should be no doubt -- Berkshire Hathaway and its wizard of a chairman aren't pulling up the reins just yet.
With all that cash coming in, should Berkshire pay a dividend? Motley Fool Income Investor analyst Mathew Emmert thinks so. Talk about it on the Berkshire Hathaway discussion board, or take a free trial to Income Investor.
Saint Joseph's. No. 1-ranked Saint Joseph's. Righteous. Bill Mann owns shares in Berkshire Hathaway. The Motley Fool has a disclosure policy.