Berkshire Hathaway’s worst year, Buffet Speaks, Likes Long Term

Published on March 1, 2009

Berkshire Hathaway’s worst year, Buffet Speaks, Likes Long Term

March 1, 2009

Berkshire Hathaway (BRK.A) had its worst year on record, Chairman Warren Buffet told shareholders Saturday that the economy would remain in “shambles” during 2009 and beyond. His 22 page annual letter is full of wisdom nuggets. Also you may wanna read the annual report. Though I am capturing key points per my understanding, I shall encourage my readers to read the full letter as it offers valuable insights.

Berkshire Hathaway profits dropped 96%. The per-share book value of both Class A and Class B shares of Berkshire fell 9.6%. For beginners, Berkshire Hathaway has produced a compounded annual gain in value of 362,319% since it’s founding in 1964, about 10 times what you would have gotten investing in the S&P 500, compounded at 20.3% per annum. This includes recent bad results.

Let’s begin with some context of the economy-

  • “By the fourth quarter,” says Mr. Buffett, “the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.”
  • Government action was needed – ‘Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.
  • What’s needed – “Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects, Inflation is likely to be one such effect, Buffett said. “Moreover, major industries have become dependent on federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly. However, said Buffett, the U.S. government did need to take “strong and immediate action” to avoid a “total breakdown” of the economy.
  • Accepts the mistakes-“During 2008 I did some dumb things in investments,” he said. One such error, he said, was the purchase of a large amount of Conoco Phillips Inc. (COP) stock when oil and gas prices were nearing peak levels. “I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year,” he said. “I still believe the odds are good that oil sells far higher in the future than the current $40-to-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.” Buffett also said his acquisition of shares in two Irish banks have turned out badly — with losses of more than 89%.
  • Housing market, History repeats: “The 1997-2000 fiasco should have served as a canary-in-the-coal-mine warning for the far-larger conventional housing market. But investors, government and rating agencies learned exactly nothing from the manufactured-home debacle. Instead, in an eerie rerun of that disaster, the same mistakes were repeated with conventional homes in the 2004-07 period: Lenders happily made loans that borrowers couldn’t repay out of their incomes, and borrowers just as happily signed up to meet those payments. Both parties counted on “house-price appreciation” to make this otherwise impossible arrangement work. It was Scarlett O’Hara all over again: “I’ll think about it tomorrow.” The consequences of this behavior are now reverberating through every corner of our economy.”
  • Mortgage-backed securities: “Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford. In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact. Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.”
  • Market Declines – Indeed, we enjoy such price declines if we have funds available to increase our positions. … Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
  • Outlook for 2009 and BeyondWe’re certain, for example, that the economy will be in shambles throughout 2009 — and, for that matter, probably well beyond — but that conclusion does not tell us whether the stock market will rise or fall,” Buffett wrote. He pointed out that the U.S. has overcome much worse obstacles in the past. “Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.”
  • Recent Deals on GS, GE, etc– “On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter & Gamble and ConocoPhillips). However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits”
  • Subprime mortgage crisis– Buffett said lenders and buyers have to get back to a basic equation. “The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.
  • Derivatives market in which he concludes: “Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome, I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mind boggling screw-ups that are required.”
  • Buffett gives us specific examples of derivatives and hedges Berkshire uses to balance their risk and notes: “We have told you before that our derivative contracts, subject as they are to mark-to-market accounting, will produce wild swings in the earnings we report. The ups and downs neither cheer nor bother Charlie and me. Indeed, the “downs” can be helpful in that they give us an opportunity to expand a position on favorable terms. I hope this explanation of our dealings will lead you to think similarly. Again, this sums up our current investing philosophy quite nicely, especially when it comes to selling puts and calls on the crazy swings.
  • Not an Efficient world– Buffett, talks about the flaws in the Black-Scholes formula that underlines options trading stating: “The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probability weighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm a century from now.).” Read his letter to understand this from a specific example his shares on S&P500.
  • Current Scenario– “The investment world has gone from under pricing risk to overpricing it,” Buffett says. “This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”

Berkshire’s Class A shares have dropped 44% in the past year and hit a 5 1/2-year low of $73,500 earlier this week. The Class B shares carry 1/30th the economic value of the Class A shares.

Berkshire waded further into the financial sector during the fourth quarter, when Buffett bought $5 billion in the preferred stock of investment bank Goldman Sachs. He also invested $3 billion in preferred shares issued by GE, which has a large, struggling financial-services unit called GE Capital. The deals came with warrants that give Berkshire the right to buy 43.5 million Goldman shares at $115 each and 134.8 million shares of GE at $22.25 each. These contracts expire in October 2013.

Both Goldman and GE shares currently trade below these levels, battered by the financial crisis. Specifically, Goldman dropped 27% since Buffett’s investment in the firm was announced Sept. 23, while GE plunged fully 65% since Berkshire unveiled its investment in the industrial conglomerate on Oct. 1.

Soon after, Buffett wrote in a New York Times editorial that he’d been buying U.S. stocks for his personal account and recommended that other long-term investors do so too. Since that Oct. 17 article, the S&P 500 Index has slumped 22%.

Berkshire also recently invested in bonds issued by companies including Tiffany (TIF), Harley Davidson (HOG) and MBT.

These are just the tips, Download it here to read it for more insights.

Profitable Trading, OP

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