Lessons to be learned from Warren Buffet's most recent shareholder letter

Mark Cliff of Alphen Asset Management takes a look at Warren Buffet’s most recent letter to the Shareholders of Berkshire Hathaway Inc. and what lessons may be learned from the World’s Greatest Investor.

Warren Buffett, Chairman of the mighty Berkshire Hathaway Inc (“Berkshire”), has frequently been described as “The World’s Greatest Investor” due to the investment success he has attained whilst at the helm of Berkshire.

As the chairman of a company which is ranked amongst the top 20 companies in the world, as measured by market capitalization, with holdings across the planet, his insights into US and global markets are usually worth reading.

Each year, Buffett pens a letter to the shareholders of Berkshire and this year’s missive is written in the usual folksy and easy-to-read manner. Today we’ll take a look at some of the points Buffet raised in his latest letter dated 26 February 2010.

The Numbers

The net worth of the company grew in the 2009/2010 financial year by 19.8%, relative to 26.5% for the S&P500. Since 1965, however, Berkshire stock has shown an annual compounded gain of 20.3%, relative to the S&P’s annualized 9.3%. When this is translated into a total return, Berkshire’s 434,057% is quite significantly better than the S&P’s 5,430%. Fantastic returns in anyone’s language.

Guiding Principles

Buffet, in the first paragraphs of the letter, re-iterated the importance of investors, and prospective investors, in Berkshire to understand Berkshire’s operations, goals, limitations and culture. These are enumerated in the body of the annual report as the 13 owner-related business principles and include the following:

Significant ownership in the company by the directors – “We eat our own cooking”. A long-term economic goal of seeking to maximise Berkshire’s average annual rate of gain in “intrinsic business value” on a per-share basis. Using debt sparingly and, when the company does borrow, they attempt to structure their loans on a long-term fixed-rate basis.

Buffett describes “intrinsic value” as being “the discounted value of the cash that can be taken out of a business during its remaining life”.

By highlighting the principles by which the company is managed, Buffet (and long-time business partner Charlie Munger) ensure that investors’ expectations are properly managed and aligned.

Bigger is Not Better

Buffett highlights, in more than one place, his certainty that the rate of per-share progress will diminish in the future due to a greatly enlarged capital base. “As our net worth grows, it is more difficult to use retained earnings wisely”… “The big minus is that our performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain [his emphasis] to continue”. Berkshire is no longer nearly as nimble as it once was and this, Buffett highlights, will inevitably cramp the company’s ability to grow its intrinsic value).

Even the Greatest Makes Mistakes

Even Warren Buffett makes mistakes. During the year under review he admitted that he had “closed the book on a very expensive business fiasco” entirely of his own making. Acting on his own bright idea, Buffett felt that Berkshire could leverage off its insurance client base by marketing their own credit card. “We got business all right – but of the wrong type. Our pre-tax losses from credit card operations came to about $6.3million before I finally woke up. We then sold our $98 million portfolio of troubled receivables for 55¢ on the dollar, losing an additional $44 million”. Buffett highlighted that the managers of his insurance business “were never enthusiastic about my idea. They warned me that instead of getting the cream of [their] customers, we would get the - - - - - well, let’s call it the non-cream. I subtly indicated that I was older and wiser. I was just older”.

Owning Great Companies

Berkshire has four major operating sectors: Insurance (including holdings in companies like GEICO, General Re and BH Reinsurance); Regulated Utilities (including holdings in companies like MidAmerican Energy (which in turn owns Yorkshire Electricity and Northern Electric – the UK’s third largest distributor of electricity), MidAmerican Energy, Pacific Power and Rocky Mountain Power and Kern River and Northern Natural pipelines; Manufacturing, Service and Retail (including holdings in companies like Dairy Queen, Star Furniture, agricultural equipment manufacturer CTB and jewellery retailer Borsheims and Finance and Financial Products (with holdings in companies like Clayton Homes and Berkadia Commercial Mortgage.

In addition to these major operating sectors, Berkshire has significant common stock investments in well-known companies like American Express, Coca-Cola, ConocoPhillips, Johnson & Johnson, Kraft Foods, Proctor & Gamble, Tesco, Wal-Mart and Wells Fargo as well as Goldman Sachs, General Electric and Dow Chemical.

Reaching for the Bucket

Buffett is always on the lookout for special circumstances where opportunistic investments can be made within the criteria of a significant “margin of risk”. During 2009 Berkshire noted that “very unusual circumstances then existed in the corporate and municipal bond markets and that these securities were ridiculously cheap relative to U.S. Treasuries. When it’s raining gold, reach for a bucket, not a thimble.”

This theme of maximising opportunities is highlighted when looking at the amount of cash on hand in the company relative to the preceding two years and I think that the following paragraph highlights a significant investment principle to which we, at Alphen Asset Management, try to aspire:

“We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two”.

A lack of space precludes a fuller discussion of the Berkshire purchase of freight rail company Burlington Northern Santa Fe (BNSF) – a deal which included the issue of precious Berkshire shares in the purchase price.

This most recent report has appeared after a period of great volatility and uncertainty on markets in both the US, and globally. It is clear from the writings of The World’s Greatest Investor that whilst a smaller investment vehicle has the ability to significantly outperform a larger one, and notwithstanding the inevitable mistakes which will be made from time to time, by sticking to some logical and established business principles, Berkshire has used a time of chaos and fear to make significant acquisitions at valuations where the margin of safety has been sufficiently low to allow them to reach for the bucket and fill it.

Since 1965 this has been a winning formula for both Berkshire and investors generally. Investors who filled their buckets during the times of chaos and fear will have done well in the recent past. The challenge for Berkshire, and many investors going forward, will now continue to be a search for investments in companies which will continue to outperform the average company over time.