FOOL ON THE HILL
Buffett's Annual Letter

Warren Buffett released his annual letter to Berkshire Hathaway shareholders recently and it should be required reading for all investors. In it, Buffett critiques the tech stock bubble and comments on Berkshire's improving insurance operations and many acquisitions over the past year.

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By Whitney Tilson
March 13, 2001

Warren Buffett released his annual letter to Berkshire Hathaway (NYSE: BRK.A and BRK.B) shareholders last weekend and, as usual, it was a masterpiece. It is required reading for all investors. If you're not persuaded, think of it this way: If your financial fortunes were tied to your ability to hit a baseball and Ted Williams (the last man to hit .400) published his advice on hitting, would you read it? So stop reading this -- I'm a very poor substitute for Buffett -- and go straight to the source.

(Taking the baseball analogy one step further, if Ted Williams held a free hitting clinic once a year, would you go? So what are you waiting for? You can become a Berkshire shareholder for about $2,300 by buying a B share -- it's a great investment as well -- and then book your flight to the annual meeting in Omaha, which will be held this year on Saturday, April 28th. Listening to Buffett and Berkshire Hathaway Vice Chairman Charlie Munger answer questions about investing for the better part of a day is the best investment education you can get.)

Many other commentators have summarized the lessons Buffett teaches investors in the annual letter, so I won't repeat them here other than to draw your attention to his opinions on the tech stock bubble, including scathing critiques of "giddy participants," "shamelessly merchandising... promoters" and "bubble companies... designed more with an eye to making money off investors rather than for them." Buffett is obviously thinking it, but didn't say it, so I will: shame, shame, shame!

Buffett's thoughts aren't new, as many commentators have written post-mortems for the tech bubble, but Buffett's are the most eloquent I've read and, unlike many other commentators, he warned investors ahead of time.

I also urge you to read Buffett's writings about Aesop and his "immutable" investment axiom, "a bird in the hand is worth two in the bush." Even experienced investors can benefit from an occasional refresher course in Investing 101.

I'd like to use the rest of this column to cover the highlights of the letter and the annual report as they apply to shareholders (I'm one).

Insurance Operations
While Buffett was his usual cautious self -- he's a master at underpromising and overdelivering -- there was plenty of good news to report. Let's start with the insurance operations, which account for the bulk of Berkshire Hathaway's business, and which have performed poorly -- along with the entire sector -- over the past couple years. Berkshire's float grew a robust 10.3% in 2000, from $25.3 billion to an enormous $27.9 billion. (If you're not familiar with float, Buffett provides an excellent explanation in his letter.)

Buffett also noted that Berkshire signed a number of large reinsurance and "retroactive" insurance contracts in 2000. The former "penalizes our current earnings but gives us float we can use for many years to come. After the loss that we incur in the first year of the policy, there are no further costs attached to this business... When these policies are properly priced, we welcome the pain-today, gain-tomorrow effects they have." In contrast, a retroactive insurance contract "neither benefits nor penalizes our current earnings." However, the expected losses "will continue for many years, often stretching into decades. As an offset, though, we have the use of float -- lots of it."

The news on GEICO is mixed. It continues to grow rapidly and expand its market share, but the number of new policies fell as GEICO's incremental spending on advertising didn't pay off, due largely to price increases by GEICO and very aggressive pricing -- to the point of causing large losses -- by the nation's largest auto insurer, State Farm. Buffett concludes that "over time it [GEICO] will inevitably increase its market share significantly while simultaneously achieving excellent profits."

To summarize, while Berkshire's cost of float was an unusually high 6% for the year, 34% of its underwriting loss was due to one-time charges for reinsurance contracts. More importantly, Buffett predicted that "absent a mega-catastrophe, we expect our float cost to fall in 2001 -- perhaps substantially -- in large part because of corrections in pricing at General Re that should increasingly be felt as the year progresses. On a smaller scale, GEICO may experience the same improving trend."

That is music to my ears, as the weak insurance results have been a major factor depressing the stock price.

Acquisitions
Buffett's letter describes the eight acquisitions Berkshire has made over the past year or so. The cost was "about $8 billion, with 97% of that amount paid in cash and 3% in stock. The eight businesses we've acquired have aggregate sales of about $13 billion and employ 58,000 people. Still, we incurred no debt in making these purchases, and our shares outstanding have increased only 1/3 of 1%. Better yet, we remain awash in liquid assets and are both eager and ready for even larger acquisitions."

This, too, is music to my ears, especially because Buffett reports that "owners and/or managers increasingly wish to join their companies with Berkshire... Aside from the economic factors that benefited us [the economic slowdown and the market for junk bonds drying up], we now enjoy a major and growing advantage in making acquisitions in that we are often the buyer of choice for the seller."

These acquisitions contributed $600 million in revenue and $85 million in pre-tax operating profits in 2000.

Cash Flow
I wrote about Berkshire's soaring operating cash flow in August (the stock is up 21% since then), and the news just keeps getting better. Cash flow was $2.9 billion in 2000, up 34% from 1999. And in the fourth quarter alone, cash flow was $1.1 billion, its highest quarterly level ever (excluding a huge one-time gain in Q3 '99).

Berkshire Hathaway continues to be one of the great cash generating machines of all time. Combined with one of the greatest capital allocators ever, it is a potent combination. Suffice it to say that I sleep well at night with Berkshire as my largest holding.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway at the time of publication. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.