There are two things I focus on when evaluating a stock: the underlying company -- both its current status and, more importantly, what its future holds -- and its valuation. Ideally, of course, the business is doing well and its future is exceptional, but for whatever reason, the market is mispricing the company, making it available at a very low price. This is a rare situation, but as I've said before, I believe this is the case with the Bore Port's largest holding (and my own), Berkshire Hathaway (NYSE: BRK.A). Warren Buffett's annual letter, which I urge you to read in its entirety, reinforced my bullishness on the stock (though it's not quite as compellingly priced as it was when I wrote "The Last Bull on Berkshire?" last month when the stock closed that day at $43,100 per share).
There's a great deal to write about, so I'm planning on writing at least four columns. In this column, I will comment on Buffett's capital allocation. Next, I will focus on MidAmerican Energy Holdings, the only major acquisition Buffett made during the year. Then, I will cover Buffett's report on three of Berkshire Hathaway's major businesses: General Re, GEICO, and Executive Jet. Finally, I will analyze what Buffett had to say about Berkshire Hathaway's valuation and share repurchases.
Capital Allocation -- Self-Evaluation
After as bad a year as Berkshire Hathaway's stock had, I think many CEOs would have come up with plenty of excuses. Buffett certainly would have had many, among them weak insurance markets for Gen Re and GEICO, simultaneous poor results from Coca-Cola (NYSE: KO) and Gillette (NYSE: G), and a market that increasingly rejected his investment philosophy, in particular his aversion to tech stocks. But to his credit, Buffett shouldered the responsibility. His primary job is to allocate capital, and he didn't think much of his performance:
"My grade [for capital allocation] for 1999 most assuredly is a D. What most hurt us during the year was the inferior performance of Berkshire's equity portfolio -- and responsibility for that portfolio, leaving aside the small piece of it run by Lou Simpson of GEICO, is entirely mine. Several of our largest investees badly lagged the market in 1999 because they've had disappointing operating results. We still like these businesses and are content to have major investments in them. But their stumbles damaged our performance last year, and it's no sure thing that they will quickly regain their stride."
While I respect Buffett's willingness to assume responsibility, I think he's being a bit too self-deprecating. Sure, three of Berkshire Hathaway's four largest holdings -- Coca-Cola, Gillette, and Freddie Mac (NYSE: FRE) -- fell in 1999 (13%, 14%, and 27%, respectively), but these stocks have all been spectacular investments over time. Even after their declines last year, Berkshire Hathaway had still made nearly 10 times its money on Coca-Cola and Freddie Mac and nearly seven times with Gillette. And don't forget that Berkshire Hathaway's second-largest holding, American Express (NYSE: AXP), was up 63% last year (and 472% since it was purchased). Overall, the investment portfolio was essentially flat for the year -- not much to boast about when the S&P was up 21%, but hardly worthy of a D.
The other major driver of Berkshire's underperformance in 1999 was the dismal showing of Gen Re, which I will discuss further in my next column. But that was a capital allocation decision Buffett made in 1998.
Capital Allocation -- 1999 Decisions
I think it's fairer to evaluate Buffett's capital allocation for 1999 based on what he did or didn't do during the year. His main sin, judging from the many articles I've read and e-mails I've received, is not buying Qualcomm (Nasdaq: QCOM) and the like last year. I think this criticism is mistaken, as I discussed in "Why Won't Buffett Invest in Tech Stocks." A related sin was that not only did Buffett fail to buy tech stocks last year, he didn't buy much of anything, choosing instead to amass an ever-increasing war chest of cash and bonds rather than pay what he considered to be very high prices for equities.
While the market has certainly punished Buffett and others like him that adhere to traditional notions of valuation, Buffett's war chest leaves him much better positioned than most other value investors, many of whom are suffering from redemptions. In contrast, Buffett will have an enormous amount of money ready to invest should prices ever become more favorable -- and any student of history will tell you that a significant correction is a virtual certainty. It's only a question of how severe it will be and when it will occur. (This doesn't mean I'm predicting a crash, nor do I advocate that long-term investors withdraw from the market, as discussed in my column last year, "Stay Fully Invested?")
In terms of actions he did take, Buffett sold at least half -- and I suspect all -- of Berkshire Hathaway's 51 million shares of Disney (NYSE: DIS). Despite the fact that my four-year-old daughter is listening to a Beauty and the Beast tape as I write this, I give Buffett an A for getting rid of this significantly indebted, low-return-on-capital company that has some of the most obscene executive compensation practices I've ever seen. Buffett also made a small acquisition of one of the finest furniture retailers in the country, Jordan's Furniture, which should be a nice fit with the other furniture retailers Berkshire Hathaway owns. Finally, for slightly more than $2 billion in cash, Buffett bought a 75% stake in Des Moines, Iowa-based MidAmerican Energy Holdings Co., which was valued at about $9 billion (including assumed debt). I believe this could become an enormously successful investment over time, which I will discuss next week.
Conclusion
The main sources of Berkshire Hathaway's underperformance in 1999 were rooted in capital allocation decisions made in prior years. For 1999 alone, based mainly on the strength of the MidAmerican Energy acquisition, I'd give Buffett a B for capital allocation.
-- Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected]. To read his previous guest columns in the Boring Port and other writings, click here.
