Visitors to the Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) website last Friday might have experienced a longer-than-usual wait time. The 2007 annual report was released that day, and like eager fans fighting over tickets to a nearly sold-out show, tens of thousands of investors rushed the site to read Warren Buffett's letter to shareholders.
Berkshire's annual report is important reading for any investor. Anyone interested in the nuts and bolts of Berkshire will want to tackle the entire 80 pages -- not bad for a $208 billion company.
Investors will want to focus on Buffett's 20-page letter -- the crown jewel of the report. In the 30-plus years Buffett has been writing these letters, they have become gospel to the investment community. Many investors will agree that if you read and understand The Intelligent Investor and Security Analysis, both by Ben Graham (Buffett's mentor), and Buffett's letters, then your understanding of investing is ahead of many others'.
The motley Buffett
Qualities that make Buffett's annual letters popular and effective (just as we strive to be here at the Fool) are that they are clearly written and sprinkled with Buffett's wry humor.
In this report, Buffett comments on the disastrous losses suffered by financial institutions including Citigroup (NYSE: C), Merrill Lynch (NYSE: MER), and others. He quotes John Stumpf, CEO of Wells Fargo (NYSE: WFC): "It is interesting that the [lending] industry has invented new ways to lose money when the old ways seemed to work just fine."
Lenders who were motivated by a belief that housing prices would always be at high tide came to believe also that consumer income levels and cash equity were not important factors. All was well until the tide went out. Then, said Buffett, was when you found out "who has been swimming naked ... and what we are witnessing at some of our largest financial institutions is an ugly sight."
The mighty Berkshire
Buffett's remarks on the lending industry come as no surprise. The housing bubble has wreaked havoc on everyone, including Berkshire's housing subsidiaries. Yet Buffett's skill was again on display in 2007:
Our gain in net worth during 2007 was $12.3 billion, which increased the per-share book value ... by 11%. Over the last 43 years ... book value has grown ... 21.1% compounded annually.
In a year when the S&P 500 was up 5.5%, in 2007 Berkshire's shares were up 27.6% -- more than twice the book value appreciation. Apparently Mr. Market had forgotten about Berkshire in the past and rushed in to buy shares in 2007. Investors of all stripes (growth, value, safety, or whatever you decide to call yourself) would do well to always keep this company on their radar screens.
Since 1965, Berkshire's book value has increased at an annual rate of 21.1% versus 10.3% for the S&P 500. This growth translates into a mind-boggling 400,863% overall gain for Buffett versus 6,840% for the index!
New and current investors may still have time to jump aboard this ship; but don't expect years of earnings like the past 42.
In an interview with Morningstar, Buffett disciple Mohnish Pabrai speculated that Berkshire could easily appreciate by 10%-15% a year going forward when bought at fair value, and he pegged fair value at around $150,000. Thus anytime you can buy Berkshire below fair value, your returns will go up. Of course, fair value can change quickly, but with Berkshire I wouldn't count on it moving too fast. And with Berkshire (this is the one time I can say this comfortably) there is virtually no downside risk -- it's like cash but better.
The two faces of Berkshire
The engine that drives Berkshire continues to be the insurance businesses that allow Buffett to skillfully allocate capital, and the company has two areas of value that make it as good as cash in the bank. These two "yardsticks" are what Buffett and Munger use to analyze Berkshire.
The first yardstick is its investments and cash equivalents. In 2007, insurance float came in at near $59 billion on the heels of two great years in the industry, which, according to Buffett, won't be repeated in 2008. What Buffett has been able to do with this float since 1965 is unmatched in the investment world.
For the entire 42 years, our compounded annual gain in per-share investments was 27.1% (emphasis mine). But the trend has been downward as we increasingly used our available funds to buy operating businesses.
As the available pool of funds has mushroomed, the available pool of home-run-type investments has shrunk. Between 1965-1979, the annual gain in investments was 42.8%! During 1993-2007, the comparable figure was 14.3%.
So I would not expect Buffett's investments in Burlington Northern (NYSE: BNI) and Kraft (NYSE: KFT) to produce 30% annual returns, but I wouldn't be surprised if, over a period of years, they outperform the historical market return of 10%. At the same time, Buffett may find an occasional PetroChina, which he bought 1.3% of in 2002 and 2003 for $488 million. In 2007 he sold out for $4 billion.
The other measure of Berkshire is the non-insurance side. It's exciting to see how this part of the company has performed relative to the investment side. As the annual gain in investments has declined, Buffett has put the excess capital into buying businesses. From 1965-1979, the annual gain in earnings in part of the company has appreciated by 11.1%. From 1993-2007, earnings appreciated 23.5%. Folks, this is the mark of a brilliant capital allocator.
Another era for Berkshire
Buffett thrives in these tumultuous markets. Since the end of 2007, he has been readily buying private companies -- think Marmon -- and investing billions in public ones. He's even set up a new company to insure municipal bonds.
If you haven't read his 2007 annual letter yet, do so. The general state of the market might be sour, but there are pockets of value out there ready to reward the patient investor.
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