You might think that Christmas comes in December. Sure, for many people. But for folks who hold shares in Berkshire Hathaway
I've had a few days to digest the report, and my initial reaction to the letter Saturday morning has only intensified: Warren Buffett and Charlie Munger believe that we're hurtling head-on toward a potential financial catastrophe. Furthermore, Buffett is somewhat displeased at his inability to deploy some of Berkshire's $43 billion in cash, calling his own performance "lackluster."
While Buffett in no way attempts to overstate his proficiency at macroeconomic prognostications, he clearly believes that the most likely outlook for the U.S. economy is dollar deflation, perhaps severely so. Think about this: Berkshire Hathaway has decreased its position in U.S. government paper by more than 80% to $1.6 billion since the beginning of 2002, while its foreign bond holdings have increased several-fold to $7.1 billion.
Here's what I find most amazing, though: Not only is Berkshire preparing for a metaphorical storm, but its results got hit as well by not one, but five real megacatastrophes in 2004 (four hurricanes and the tsunami), and the company still turned in a 10.5% gain in book value, just shy of the 10.9% posted by the S&P 500.
And it's not as if Buffett stuck his neck out and took on more risk for Berkshire to achieve those results. He moved assets into foreign-currency-denominated instruments. He didn't invest in opportunities that he considered marginal, even though he clearly dislikes holding that much cash (or $22 billion in bonds). Can you imagine? For most people, battening down the hatches would mean burying money in the back yard, or buying the most conservative investments possible. Ditto Berkshire, and in spite of this, and in spite of an insurance headwind, the company's after-tax gain in book value still exceeded 10%, nearly matching that of the pre-tax return of the S&P 500. Buffett said that he hoped Berkshire would be able to deploy more capital in 2005 but was not "promising success."
This result, and Buffett's fairly desultory comments about his own performance, brought out the Greek Chorus of media doofuses chiming that (or at least asking rhetorically whether) Buffett had lost his touch. There is some cause to look at Berkshire's 2004 results and wonder "what if." But such commentators forget that this is the same guy whom they dragged through the mud in 1999 for not buying Cisco
Here are some notes that I took on the report, in no particular order:
- In 2002, Berkshire decided that it would run off most of subsidiary General Re's derivatives book. Starting with 23,000 contracts, it now has fewer than 3,000 to go. This is now a three-year process for instruments that are supposed to be fairly liquid but clearly in aggregate are not. Gen Re was a fairly small player in derivatives. What would happen if the big players like Fannie Mae
(NYSE:FNM)and JPMorganChase (NYSE:JPM)were suddenly forced to run off their derivative books? I'm sure they could do it at some price, but it wouldn't be a good one.
- There's a transaction buried in the comments that is vintage Buffett. On page 12, he discussed the purchase of a seasoned portfolio of interest-bearing receivables at manufactured home subsidiary Clayton, for which Berkshire borrowed somewhere in the range of $5 billion. The seller -- a bank that wanted to get out of the business -- was motivated. You'll never see Buffett more excited than when his counterparty in a transaction is essentially saying, "Get this booger off my hand."
(NYSE:KKD)stock shot up last week on rumors that Buffett was buying shares, or the whole company. My own opinion is that such rumors are absurd, started and spread by the unscrupulous. My reason for thinking that this particular one is absurd is that Buffett focuses so intently on management excellence. He'll buy distressed businesses, but not without management. I read the report looking for an example where Buffett bought a stand-alone business with no good management team in place. I came up with none.
- Buffett's comments about the U.S. becoming a "sharecropper's society" were sobering, but they were something he'd published previously in Fortune. I've seen comments that suggest that he was taking a potshot at the current administration's fiscal policy, and others stating that he was trying to bring about financial hardship by betting against the United States and then crowing about it. An unbiased reading of the letter shows both assertions to be absurd. Buffett clearly calls both political parties to account for their unwillingness to address U.S. trade imbalances. Further, Buffett notes that even though Berkshire has the highest amount of assets on foreign denominations in its history, it is still overwhelmingly levered toward the U.S. dollar.
- Buffett took a well-aimed swipe at the media's insistence on trumpeting "Buffett Buys X" whenever the company has an SEC filing. He noted that in many cases, it is GEICO's Lou Simpson making the trades, typically without any input from Buffett.
Things left unsaid
All of this said, I couldn't help noticing a few glaring omissions from the chairman's letter. First and foremost is that the insurance industry is currently going through its biggest scandal in years, one that started with wrongdoing at Marsh & McLennan
I would surmise that since there are ongoing investigations, Buffett felt it inappropriate to address the issue. (There is a 100% chance that someone will ask about it at the company's annual meeting in early May.) But no mention at all of the potential for industry-wide changes felt like the elephant in the room. I think an "I plan on discussing this with you when I am able to do so" comment would have helped shareholders.
Further, some more discussion on Gen Re was needed. The company clearly has struggled from some under-reserving problems that Buffett had not picked up on when Berkshire bought the company. It has been seven years since that transaction took place, and shareholders seem to be treated to an annual statement to the effect that management is restoring discipline to underwriting. Understanding that each year's worth of results is affected by decisions that may have been made many years before, is there reason to expect that the promise of Gen Re will be realized anytime soon? This may have been the place to address the finite insurance problem.
All in all, though, Berkshire turned in a good, but not great, year. Given the macroeconomic climate, and the insurance losses, and the fact that Berkshire has such a tremendous cash drag given the price environment, I'd say that results were very good. Those givens, though, were not theoreticals, they are real elements dragging down returns. If they persist, you can expect that next year shareholders will be treated to the same thing: a letter that laments an inability to deploy capital.
Ode to an old friend
One last thing. I note that our old friend Thomas Kostigen at MarketWatch decided that one extraordinarily embarrassing column castigating Buffett for not buying technology stocks or using "advanced trading techniques" was not enough. The money quote last time was nonsensical: "And his biggest claim to fame is: buy and hold, otherwise known as value investing." Kostigen returned to the well to say, "Look, I told you so. Buffett agrees with me. His results are terrible."
The metaphor of the rooster thinking his crowing causes the sun to rise isn't quite it. It's more like the rooster thinking he's responsible for inventing cold fusion.
Mr. Kostigen, Berkshire Hathaway has $43 billion in liquid assets. Your insinuation that Berkshire is being harmed by Buffett's not buying technology stocks or eschewing "customized securities" isn't right. It isn't even wrong. Note the trading gains over the past two years from what Charlie Munger calls "the oddball pastimes of Warren Buffett." Your "Sophisticated Investor" column doesn't display much sophistication -- just sheer, unadulterated nastiness. If I had to guess, I'd call it performance art.
- Bill Mann's "Buffett: World's Greatest Sandbagger"
- Zeke Ashton's "Value Investing's 10 Commandments"
- Rick Munarriz's "Warren Walks"
Interested in finding those pockets of value the market creates? Try a trial subscription to Inside Value, edited by Philip Durell. A30-day trialis free.