For those in the know, the investor letter from Stock Advisor and Inside Value favorite Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) is an annual treat for lovers of business and investing. It remains one of the most readable pieces of literature released by any company, and gives tremendous insight into not only Berkshire Hathaway itself, but the way that Warren Buffett and Charlie Munger -- arguably two of the greatest investment minds out there -- think about their field of expertise.
Of course, the letter is not just for the initiated, nor just for shareholders. Anyone can access the annual letter on Berkshire Hathaway's website. For that matter, you can access the annual Berkshire letter going back to 1977. And for those who don't feel like weeding through every letter online, George Washington University professor Lawrence Cunningham has done a great job of compiling salient commentary from the letters, in his book The Essays of Warren Buffett: Lessons for Corporate America.
The Berkshire businesses
Although the annual letter has taken on an even greater significance than talking about the results of Berkshire Hathaway itself, the primary purpose is, of course, to talk about the results of Berkshire Hathaway. Based on the measure deemed most important by Buffett -- gain in book value -- 2007 was a good year for Berkshire. Book value increased by $12.3 billion, or 11%, besting the 5.5% gain that the S&P 500 posted.
As laid out in the letter, Berkshire has two main areas of value -- its investments in stocks, bonds, and cash equivalents, and its operating businesses. Over the years, as Berkshire has grown to its current impressive size, the whole- or majority-owned operating businesses have had an increasingly important role in Berkshire's growth.
On that note, 2007 brought positive results from most of the company's operating businesses. Insurance, its largest area, had an impressive year, helped greatly by a lack of disasters that would cause major payouts. Buffett, however, did warn that the coming years likely won't be so kind. Competition has already heated up, driving premiums down, and sooner or later there will be major disasters for Berkshire to cover.
For anyone who has been following business news, the results for the rest of Berkshire's operating businesses probably aren't too surprising. Its manufactured housing and financing business, as well as its other housing-linked businesses, suffered during the year as the U.S. housing market continued to slump. The expectation, though, is that the businesses themselves are fine and will recover when the rest of the industry does. Berkshire's retail businesses likewise faced headwinds, but many of these -- notably See's Candies, Borsheims, and Nebraska Furniture Mart -- fought the tide and posted very positive results.
Berkshire
's investments
Buffett and Munger have always expressed a strong interest in owning truly great businesses, and if it's impractical to own the whole business, they are happy to own a portion of it. As Buffett states in this year's letter, "It's better to have a part interest in the Hope Diamond than to own all of a rhinestone."
Although the company's size has increasingly forced it to acquire entire businesses, Berkshire does still lean heavily on its marketable investment portfolio, which totals a massive $141 billion. ($75 billion of that is in common stocks.) Although Buffett is notoriously secretive about his investments, SEC regulations require that he reveal all positions over a certain size.
Berkshire's common stock holdings are the same market-traded stocks that individual investors hold, but you typically won't find Buffett equating the success or failure of one of these companies with the rise or fall of its stock price. In that vein, it's noted in this year's letter that three out of Berkshire's four largest holdings -- American Express, Coca-Cola (NYSE: KO), and Procter & Gamble (NYSE: PG) -- all saw double-digit per-share earnings increases in 2007. The other of the "big four," Wells Fargo (NYSE: WFC), had a small drop in earnings because of the problems surrounding the real estate bubble. In Buffett's estimation, though, this masked a slight increase in Wells Fargo's intrinsic value during the year.
Berkshire's one large sale of the year was to clear out its holdings of PetroChina. Berkshire had actually come under fire from many groups, based on the political view of the company, but the sell decision was ultimately based on PetroChina shares' climb to a price that well exceeded Buffett and Munger's estimated intrinsic value.
The Berkshire lesson
"Businesses -- The Great, the Good, and the Gruesome" is the title of one of the investing lessons that Buffett baked into his letter this year. The lesson deals with the dynamics of a business's "moat." A moat is any factor that protects a business earning higher-than-average returns from the onslaught of competition that would otherwise eat away at those returns. Buffett's love of moats can be seen clearly in Berkshire's investment portfolio, with companies like Coca-Cola, American Express, and Kraft Foods (NYSE: KFT) possessing significant sustainable advantages that are nearly impossible for competitors to overcome.
Using the example of See's Candies, Buffett further demonstrates how beneficial it can be to own a business that has enduring competitive advantages and doesn't require a tremendous amount of invested capital to produce outsized returns. He also points to the publicly traded examples of Microsoft (Nasdaq: MSFT) and Google (Nasdaq: GOOG) as similar examples of companies that have been able to grow and produce impressive results with a relative minimum of capital investment.
Not as impressive to Buffett, but still often worthy of investment, are companies that have a strong competitive position but require a significant amount of investment to earn their returns. He cites Berkshire company FlightSafety -- a flight training school -- as an example of this type of business. Berkshire's had to invest a significant amount back into the company to generate its continued earnings growth. Mr. Buffett referred to this as the "put-up-more-to-earn-more experience [that is] faced by most corporations."
The final business category is what Buffett calls the "gruesome" businesses. These are companies that require constant and significant investment and reward the investor with subpar returns. Where could such a lousy business exist? Look no further than the airlines. Buffett describes airlines' appetite for capital as "insatiable" and notes that the reward for all that capital investment has been a history of lousy -- and sometimes nonexistent -- earnings.
Tap-dancing to work
Buffett concludes the letter by noting how grateful he and Munger are to be doing what they're doing, and to be as successful as they are. "We have long had jobs that we love ... Every day is exciting to us; no wonder we tap-dance to work." If you ask me, this could be one of the greatest nuggets on investing success that could be pulled from Buffett's vast collection of investing nuggets. Investing success has been linked to a lot of things, many of them contradictory. All that aside though, if you find it truly exciting to open up a 10-K to learn about a business, it's going to be a lot easier to get the rest of the pieces to fall into place.
If you're thirsting for more, you can always head over to the Berkshire Hathaway website. You can also join Motley Fool advisor Philip Durrell at Inside Value, where he applies a very Buffett-like eye to the market in looking for attractive, undervalued stocks. Try the newsletter free for 30 days.
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