Notes on Berkshire Hathaway Shareholder Letter from 2007
Brief Summary of the Year:
Despite harrowing things going on in the economy this year, Berkshire profited largely from another year nearly free of super catastrophes (for which they insure against.) Buffett calls out some imperfections in the US economy like grotesque financial practices and a pension program that is unlikely to perform as promised. Of course, he goes on merrily regarding many great decisions in value-rich organizations that out perform the economy in huge ways. As always, the wrap up and invite to the party is lovely and enticing.
Notes For the Year:
Our gain in net worth during 2007 was $12.3 billion, which increased the per-sharebook value of both our Class A and Class B stock by 11%. Over the last 43 years (that is, since present management took over) book value has grown from $19 to $78,008, a rate of 21.1% compounded annually.* – Warren Buffett
Warren Buffett is dependable. You can count on him starting off each of these letters with the exact same thing. Results.
Overall, our 76 operating businesses did well last year. The few that had problemswere primarily those linked to housing, among them our brick, carpet and real estate brokerage operations. Their setbacks are minor and temporary. Our competitive position in these businesses remains strong, and we have first class CEOs who run them right, in good times or bad. – Warren Buffett
Straight to the point about CEOs and management being a soul of excellent companies.
Today, our country is experiencing widespread pain because of that erroneous belief. As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out – and what we are witnessing at some of our largest financial institutions is an ugly sight. – Warren Buffett
Wow, swimming naked when the tide goes out…
We also were very lucky in 2007, the second year in a row free of major insured catastrophes. – Warren Buffett
Again Buffett acknowledges his managerial team for a job well done and again (as in 2007) they escape super catastrophes which they insure against.
This must have helped them in 2007 to avoid some of the economic turmoil of the year. They had another great year of insuring against evils that never came to be.
That party is over. It’s a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. Prices are down, and exposures inexorably rise. Even if the U.S. has its third consecutive catastrophe-light year, industry profit margins will probably shrink by four percentage points or so. If the winds roar or the earth trembles, results could be far worse. So be prepared for lower insurance earnings during the next few years. – Warren Buffett
Berkshire’s past record can’t be duplicated or even approached. Our base of assetsand earnings is now far too large for us to make outsized gains in the future. – Warren Buffett
Again, Buffett (as in 2006 & 1995) is reminding people that they will have challenges making so much money in the future because their simply too large to allocate capital in the same areas.
In our efforts, we will be aided enormously by the managers who have joined Berk- shire. This is an unusual group in several ways. First, most of them have no financial need to work. Many sold us their businesses for large sums and run them because they love doing so, not because they need the money. – Warren Buffett
Of course, Warren is speaking about the CEOs of the companies they purchase. They are very wealthy people who continue to run the businesses despite the fact that they could go live on a yatch for the rest of their lives.
Lesson: When looking for a company to invest in, invest in the one that is run by a team who are there for the love of the game, not for the money.
Conversely, our CEO’s scorecards for success are not whether they obtain my job but instead are the long-term performances of their businesses. Their decisions flow from a here-today, here-forever mindset. I think our rare and hard-to- replicate managerial structure gives Berkshire a real advantage. – WarrenBuffett
The love for the long term performance of the business is what Warren looks for in the managerial team. This is the soul factor of great dedicated management teams.
Here, we made little progress in 2007 until very late in the year. Then, on Christmas day, Charlie and I finally earned our pay checks by contracting for the largest cash purchase in Berkshire’s history. The seeds of this transaction were planted in 1954. – Warren Buffett
They didn’t make any deals until Christmas. Again the theme, “We don’t make lots of calls, but when we do it’s big.”
Anyways, this deal has been brewing since 1954!
We will soon purchase 60% of Marmon and will acquire virtually all of the balance within six years. – Warren Buffett
Latest acquisition Marmon Group.
During the past year, many large deals have been renegotiated or killed entirely. With the Pritzkers, as with Berkshire, a deal is a deal. – Warren Buffett
A deal is a deal. Many large deals were killed because of complications, the one that went through was the one that was based on a handshake and a look at the financial statements. “No advisors, no nit-picking.”
Another common theme in these letters, simplicity, honor and common sense when making business deals.
Byron Trott of Goldman Sachs – whose praises I sang in the 2003 report – facilitated the Marmon transaction. Byron is the rare investment banker who puts himself in his client’s shoes. Charlie and I trust him completely. – Warren Buffett
Goldman Sachs’s Byron Trott facilitated the deal for Berkshire Hathaway and Marmon. It’s interesting that they outsource for facilitators in deals like this. Of course, it makes perfect sense too.
Charlie and I look for companies that have a) a business we understand; b) favor- able long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we arealso happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own allof a rhinestone.
A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitorswill repeatedly assault any business “castle” that is earning high returns. There-fore a formidable barrier such as company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
Our criterion of “enduring” causes us to rule out companies in industries prone torapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enter- prise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses. But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the MayoClinic to endure, even though you can’t name its CEO. – Warren Buffett
Most straight forward way to understand how Warren Buffett and Charlie Mungers pick companies.
Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.) – Warren Buffett
This is is a humorous wrap up to a very important lesson regarding how long term business decisions begin to branch into many beautiful things while moving forward. The lesson, take profits and reinvest them into other attractive businesses… of course, the most attractive businesses will be making too much money to reinvest 100% of the money into them.
When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our pur- chase, depreciation charges have totalled $923 million. But capital expenditures have totalled $1.635 billion, most of that for simulators to catch the new air- plane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) – Warren Buffett
Remarkable. Another business Berkshire Hathaway is involved in.
Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsightedcapitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down. – Warren Buffett
Warren Buffett Hates Airlines.
To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns. – Warren Buffett
Again, all very obvious but it’s interesting to hear and take in these lessons. The key to a powerful asset is that you keep getting paid by it. Duh, right?
To date, Dexter is the worst deal that I’ve made. But I’ll make more mistakes in the future – you can bet on that. A line from Bobby Bare’s country song explains what too often happens with acquisitions: “I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.” – Warren Buffett
Remarkably open about his mistakes. In the paragraph above he discusses how this mistake cost $433 million. It was a mistake he made in 1993!
This self depreciating confession is clearly framed in a way that establishes him as honest and willing to let the ugly side show. You know, he’s still sitting on billions of gains for the month so the investors reading this are unlikely to be upset with him about a measly $433 million right?
Now they get into accounting. Check out the tables:
They started off making little, but they carried millions in float. This is an interesting aspect… just because you’re making little profit, how do you account for the value of carrying so much money? Is this expensive or are they profiting from the activity?
So they learned a lot. Now they’re making millions on it and jeez, holding billions of dollars in float! Again, is this a great thing to have so much money that isn’t yours in the bank? I mean, as long as you don’t touch it, it’s no big deal right?
When Berkshire acquired control in 1995, that share was 2.5%. Not coincidentally, annual ad expenditures by GEICO have increased from $31 million to $751 million during the same period. – Warren Buffett
Buffett seems to be in love with GEICO.
Berkshire has an 87.4% (diluted) interest in MidAmerican Energy – Warren Buffett
What does diluted stock mean? It means that shares have been issued since purchase which change the fundamental positions and effect things like voting rights, ownership percentage and the value of individual shares.
We agreed to purchase 35,464,337 shares of MidAmerican at $35.05 per share in 1999, a year in which its per-share earnings were $2.59. Why the odd figure of $35.05? I originally decided the business was worth $35.00 per share to Berkshire.Now, I’m a “one-price” guy (remember See’s?) and for several days the investment bankers representing MidAmerican had no luck in getting me to increase Berkshire’soffer. But, finally, they caught me in a moment of weakness, and I caved, telling them I would go to $35.05. With that, I explained, they could tell their client they had wrung the last nickel out of me. At the time, it hurt. – Warren Buffett
How to wring a nickel out of Warren Buffett.
So I wanted to know exactly what I’m looking at when reading a balance sheet so I figured it would be great to get a revamping of skills. If you’d like to play along, I suggest going through this Khan Academy exercise. It’s free.
Also another diversion yet useful in exploring this subject, check out The World’s Billionaires.
Susan came to Borsheims 25 years ago as a $4-an-hour saleswoman. Though she lackeda managerial background, I did not hesitate to make her CEO in 1994. She’s smart, she loves the business, and she loves her associates. That beats having an MBA degree any time. – Warren Buffett
Warren Buffett on the importance and value of an MBA.
(An aside: Charlie and I are not big fans of resumes. Instead, we focus on brains,passion and integrity. Another of our great managers is Cathy Baron Tamraz, who has significantly increased Business Wire’s earnings since we purchased it early in 2006. She is an owner’s dream. It is positively dangerous to stand between Cathy and a business prospect. Cathy, it should be noted, began her career as a cab driver.) – Warren Buffett
Again, resumes are no good. Focus on brains (or hard work in understanding a specific subject), passion and integrity. Brains, Passion & Integrity.
For many decades, Iscar moved tungsten to Israel, where brains turned it into something far more valuable. Late in 2007, Iscar opened a large plant in Dalian, China. In effect, we’ve now moved the brains to the tungsten. Major opportunities for growth await Iscar. It’s management team, led by Eitan Wertheimer, Jacob Harpaz, and Danny Goldman, is certain to make the most of them. – Warren Buffett
The Tungsten used to move to Israel where it was made into tools by brainy types. Now the brainy types have moved to China where the tools are made by brainy types. Funny way to say, we exported manufacturing to Dalian, China.
The NetJets brand – with its promise of safety, service and security – grows stronger every year. – Warren Buffett
NetJet is still doing well.
Clayton’s loan portfolio is financed by Berkshire. For this funding, we charge Clayton one percentage point over Berkshire’s borrowing cost – a fee that amountedto $85 million last year. Clayton’s 2007 pre-tax earnings of $526 million are after its paying this fee. The flip side of this transaction is that Berkshire recorded $85 million as income, which is included in “other” in the following table. – Warren Buffett
Clayton Homes, the largest U.S. manufacturer and marketer of homes is owned by Berkshire Hathaway and they loan money to the company as well. So they are a investment client and when they win, Berkshire gets the gains in income too! What an advantageous set up.
P&G and Coke began business in 1837 and 1886 respectively. Start-ups are not our game. – Warren Buffett
Hey Warren Buffett? Are you looking for a startup company to invest in?
The second test, more subjective, is whether their “moats” – a metaphor for the superiorities they possess that make life difficult for their competitors – have widened during the year. All of the “big four” scored positively on that test. – Warren Buffett
Again with the “Moat” theme. Warren likes businesses that are insulated from competition in one way or another. Notice Wal-Mart, Kraft, Johnson & Johnson, Coca-Cola, Anheuser-Busch Company, American Express. Of course, it’s going to be hard to create a company that goes head to head and captures large amounts of brand equity.
We made one large sale last year. In 2002 and 2003 Berkshire bought 1.3% of PetroChina for $488 million, a price that valued the entire business at about $37 billion. Charlie and I then felt that the company was worth about $100 billion. By2007, two factors had materially increased its value: the price of oil had climbedsignificantly, and PetroChina’s management had done a great job in building oil and gas reserves. In the second half of last year, the market value of the companyrose to $275 billion, about what we thought it was worth compared to other giant oil companies. So we sold our holdings for $4 billion. A footnote: We paid the IRStax of $1.2 billion on our PetroChina gain. This sum paid all costs of the U.S. government – defence, social security, you name it – for about four hours. – Warren Buffett
On selling their PetroChina holdings for $4 billion. Wow.
The sale culminated in $1.2 billion which pays for the US government for 4 hours. Wow.
Buffett has increased his derivatives contracts that he manages from 62 to 94. He splits them into 2 categories.
Important aspects of the derivative contracts market. 1. No Counterparty Risk as they hold the money. 2. Differing accounting rules for derivatives contracts so they are only effecting the balance sheets if they are sold or written down.
You will recall that in our catastrophe insurance business, we are always ready totrade increased volatility in reported earnings in the short run for greater gainsin net worth in the long run. That is our philosophy in derivatives as well. – Warren Buffett
Trade volatility for value and net worth? Of course.
The U.S. dollar weakened further in 2007 against major currencies, and it’s no mystery why: Americans like buying products made elsewhere more than the rest of the world likes buying products made in the U.S. Inevitably, that causes America to ship about $2 billion of IOUs and assets daily to the rest of the world. And over time, that puts pressure on the dollar. – Warren Buffett
Warren Buffett on the value of the dollar when Americans are buying more than producing.
They invested in the Brazilian Real.
But any Brazilian who followed this apparently prudent course would have lost halfhis net worth over the past five years. Here’s the year-by-year record (indexed) of the real versus the dollar from the end of 2002 to year end 2007: 100; 122; 133; 152; 166; 199. Every year the real went up and the dollar fell. Moreover, duringmuch of this period the Brazilian government was actually holding down the value of the real and supporting our currency by buying dollars in the market. – Warren Buffett
A few questions here:
1. Why does the Real double in value against the dollar from 2002 to 2007?
2. Why was the Brazilian Government holding the value down by buying dollars? (competition? to drive up exports? a policy to keep food prices down?)
3. How does Buffett know that the Brazilian government is buying US dollars? Is this publicly available information?
For example, in 2001 and 2002 we purchased €310 million Amazon.com, Inc. 6 7/8 of 2010 at 57% of par. At the time, Amazon bonds were priced as “junk” credits, though they were anything but. (Yes, Virginia, you can occasionally find markets that are ridiculously inefficient – or at least you can find them anywhere except at the finance departments of some leading business schools.) – Warren Buffett
Imagine buying Amazon in 2001/2002 for almost nothing because the stocks value was considered junk. Pierre Odimar would be your partner now!
Getting back to the succession bit. Now they are up to 3 successors whereas last year he only had one. Guess the Fredrick W. Cook and Company didn’t screw up the industry too much.
During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. – Warren Buffett
The Dow shows an annual gain of 5.3% (not 7% like I generally thought… perhaps the S&P 500 returns 7%?)
Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Pass-ive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so mustthe remaining group – the active investors. But this group will incur high trans- action, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win. – Warren Buffett
Again the Gotrock family and the helpers are not going to help. It’s better to do nothing (e.g. invest and hold for the long term in value rich companies) than hire financial advisors and other “helper” types.
Buffett anticipates that pension plans won’t play out the way they are promised. He doesn’t say social security directly, and maybe he isn’t discussing social security… but that’s what I gleam while reading this. Of course, he’s probably talking about 401ks and Roth IRA’s as well. Also, government positions and their pension plans.
I’ve never been a believer that my Social Security debits from past pay checks will ever be realized so this doesn’t come as too much of a surprise… but with Warren Buffett alluding to a point that may support this, I’ll doubtlessly be looking elsewhere.
A fellow was on an important business trip in Europe when his sister called to tell him that their dad had died. Her brother explained that he couldn’t get back but said to spare nothing on the funeral, whose cost he would cover. When he returned, his sister told him that the service had been beautiful and presented him with bills totalling $8,000. He paid up, but a month later received a bill from the mortuary for $10. He paid that, too – and still another $10 charge he received a month later. When a third $10 invoice was sent to him the following month, the perplexed man called his sister to ask what was going on. “Oh,” she replied, “I forgot to tell you. We buried Dad in a rented suit.” – Warren Buffett
Rented suit – The term has a new meaning now. Despite the grotesque nature of the allegory, it’s a valuable thing to avoid in business. Yet, a great deal if you’re the suit rental company.
Further Reading:
- Alan Greenspan’s comments on November 19, 2004 to the Federal Open Market Committee’s minutes of June 29, 2004
- Ben Bernanke’s statement on September 11, 2007