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Berkshire Hathaway
Annual Report Thoughts

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By TheSandman
March 17, 2003

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Although I read the annual report last Saturday, I have not had time to sit down and really read it until this morning. Here are some of my thoughts:

From 1995 to 1999 Mr. Buffett provided a "Guide to Intrinsic Value" Table in his shareholder letter. In the 1996 letter, WEB had this to say concerning the "Table":

"Last year, for the first time, we supplied you with a table that Charlie and I believe will help anyone trying to estimate Berkshire's intrinsic value."

I'm disappointed that this Table has not appeared in a shareholder letter since 1999. I don't know why it has not been included for the past few years. However, I do think that Mr. Buffett's 2002 shareholder letter provided all the information that we need to enable us to construct our own Table.

As you will recall, Column One lists Berkshire's ownership of investments.

2002 Numbers look like this:

Cash and cash equivalents = 10,294
Securities with fixed maturities = 38,096
Equity Securities = 28,363
Other investments = 4,044
Total for Column One = $80,797

Divide $80,797 by 1.535 million shares = $52,636 per share.

Column Two represents the earnings from Berkshire's operating businesses (before taxes and purchase-accounting adjustments but after all interest and corporate overhead expenses).

In the 2002 shareholders letter, Mr. Buffett gave us the numbers for Column Two. Berkshire's various non-insurance related operating companies currently produce $272 million (pre-tax) earnings per month. ($3,264 million per year.)

Divide $3,264 million by 1.535 million shares and you come up with $2,126 per share.

Column Totals = $54,762. At the Friday close prior to the annual report, Berkshire was trading for $64,800. A premium of $10,038 to the two column total.

Individual analysis will naturally arrive at various answers as to what multiple should be placed on Berkshire's operating companies.

Looking Forward
1. Mr. Buffett seems convinced that underwriting discipline has been restored at General Re. Apparently, Joe & Tad have corrected the problem. Mr. Buffett states: Gen Re's underwriting attitude has been dramatically altered: The entire organization now understands that we wish to write only properly-priced business, whatever the effect on volume. Joe and Tad judge themselves only by Gen Re's underwriting profitability. Size simply doesn't count. (Oh, how I hope they understand this.)

And, most importantly: In summary, I believe General Re is now well positioned to deliver huge amounts of no-cost float to Berkshire and that its sink-the-ship catastrophe risk has been eliminated. (Emphasis added is mine).

If Gen Re had reported no-cost float for 2002, this would have added $853 per share. For Warren to say Gen Re has potential for huge amounts of no-cost float.... well, that's very exciting.

I sure do hope that Gen Re has finally read the Berkshire playbook and that they now recognize the goal.

2. Warren has been able to find some opportunities to re-deploy some of Berkshire's war chest. The more I read about The Pampered Chef the more impressed I become.

Building a Company Warren Buffett Would Buy


What a great company, and great story. Warren seems to have made a great deal when acquiring The Pampered Chef (TPC). The Fortune article indicates that TPC has pretax profit margins above 25%. So, it looks like TPC is making ~$185 million per year pre tax, and Warren was able to acquire this company for ~$900 million. (current return of ~20.5%) I sure hope there are many, many more companies like The Pampered Chef that would like to call Berkshire their home.

It looks as if Shaw Industries was another great acquisition. Berkshire paid $2.4 billion for Shaw ($2 billion in year 2000 for 87.3% of Shaw. In January 2002, Berkshire acquired the remaining 12.7% of Shaw in exchange for 4,740 "A" shares.) For the full year 2002, Shaw's pre-tax earnings were $424 million. A pre-tax earnings yield of 17.7%.

3. Warren was able to identify $8.3 Billion of unique "junk" bonds & loans that were worthy of a Berkshire investment. I don't know what a reasonable return projection might be for this type investment. However, I did notice that Mr. Buffett invested $100 million in LVLT Junior subordinate convertible bonds.... while the LVLT Senior bonds were trading with a ~27% YTM. And, according to rumor, in 2001, Berkshire purchased ~$600 million (market value) LVLT senior debt in the ~$40 range (current yield of ~30%). Could be that the $100 million infusion was to assist LVLT in consolidating the telecom industry.... and achieve positive free cash flow.

I have no evidence to support the LVLT senior debt rumor. However, looking at the list of "Investments in Securities with Fixed Maturities" (pg. 38 of the annual report), Berkshire has ~$11 billion in corporate bonds and ~$1 billion in unrealized gains. And, when commenting on the "junk" bond investments, WEB does say that "approximately $2 billion were issued by telecommunications businesses" (pg. 59).

If I understand correctly, LVLT senior debt was ~$50 at the start of 2002, and ended the year at ~$65. Therefore, the rumored $600 million position in LVLT senior debt could have contributed ~$180+ million to Berkshire's ~$1 billion unrealized gains. So, you decide.

4. Berkshire's marketable securities seem to be more reasonably valued than during the bubble days. I would think we could match/beat major indices going forward.

It seems that Gillette has fallen out of favor: Gillette Gives Berkshire Right to Sell 3% of Outstanding Shares 3/14/03.

However, as of today, I would have to think that some of Warren's favorites (KO, for example) are getting close to the strike zone.

5. Warren talks about sitting on the sideline.... waiting for his turn at bat. Unless, however, we see a very high probability of at least 10% pre-tax returns (which translate to 6�-7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.

This reminds me of one of my favorite Charlie Munger quotes: "It's not given to human beings to have such talent that they can just know everything all the time. But it is given to human beings who work hard at it � who look and sift the world for a mispriced bet � that they can occasionally find one. And the wise ones bet keenly when the world offers that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple." (Outstanding Investor Digest May 5, 1995.)

Well, while poor Warren was waiting "quietly" on the sidelines, it seems that he was able to identify a few opportunities. He found enough mispriced bets that he was able to invest $15.6 billion during the year (Thanks rclosch. http://loschmanagement.com/). I assume these investments met the requirement of a "very high probability of at least 10% pre-tax returns". The Pampered Chef, Shaw Industries, and the LVLT rumor seem to have exceeded the 10% hurdle by a wide margin.

In the past 3 years Berkshire has acquired a total of 14 companies. Getting these companies settled into the Berkshire family and annualizing their returns should be fun / rewarding. The ace in the hole will be getting Gen Re on track. To date, Gen Re's underwriting losses have been a ball & chain for Berkshire. However, according to Warren, this problem has been corrected. Alice Schroeder says that Gen Re appears to be writing at about a 98-99% combined ratio on current business (ex cats). As I mentioned, if Gen Re had reported no-cost float for 2002, this would have added $853 per share. Obviously, "huge" amounts of no-cost float would be a welcome addition.

6. Berkshire's Elephant : MidAmerican just might be the elephant that we are all waiting for. MidAmerican "delivers our largest stream of non-insurance earnings. It could well grow to be huge."

Berkshire's Investments in MidAmerican Energy Holdings Company
= $3,651
Berkshire's Pre-Tax Earnings for MidAmerican Energy (80.2% owned)
= $613 Pre-tax earnings yield = 16.8%

"Berkshire stands ready to inject massive amounts of money into MEHC".

Commenting on the MidAmerican acquisition (10/25/99), WEB said: "This investment is right in our sweet spot. If I only had two draft picks out of American business, Walter Scott and David Sokol are the ones I would choose for this industry."

According to David Sokol, the 150 or so energy companies in the U.S. will be whittled down to about 20. And of those 150, Sokol said MidAmerican -- with the virtually unlimited financial resources of Berkshire Hathaway -- will buy "as many as we can. The deal-making days are just beginning." (Sorry � I couldn't find a link for this quote)

"Wall Street bankers say they bump into Buffett's advisers often these days whenever a utility asset is being auctioned."
"Anybody who can write a check quickly is always going to be favored in this environment". ( Buffett Keen to Snap Up Cheap Utilities)

GEICO: The competition raised their prices. As a result, GEICO was able to improve their policy retention and improve their closure ratio on new policies. This trend is expected to continue through 2003. Voluntary policies in force jumped significantly in Q4.

Side Note: Those whacked-out Gecko/GEICO ads make me cringe. How could they possibly be effective in bringing in new business? If that silly Gecko makes a Berkshire shareholder groan.... then, what effect does it have on the target audience?

That's enough for now. I have to run. After having read the annual report this morning, I can see why Warren said 2002 was a banner year for Berkshire. For the first time since the Gen Re acquisition, it looks like we are finally ready to fire on all cylinders. Warren has Berkshire extremely well positioned to capitalize on opportunities as they present themselves. Hopefully there will be many more "Pampered Chef" type companies that would like to call Berkshire home.

Good Luck,
Sandman

This post was written without much time for review. Any comments/corrections are encouraged.


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