BUFFETT’S LETTERS 2004

Our equity holdings (including convertible preferreds) have fallen considerably as a percentage of our net worth, from an average of 114% in the 1980s, for example, to less than 50% in recent years…. a fact that will normally cause us to underperform in years when stocks rise substantially and overperform in years when they fall.

Run your business as if it were the only asset your family will own over the next hundred years. Almost invariably they do just that and, after taking care of the needs of their business, send excess cash to Omaha for me to deploy.

I found very few attractive securities to buy. Berkshire therefore ended the year with $ 43 billion of cash equivalents, not a happy position.

In one respect, 2004 was a remarkable year for the stock market, a fact buried in the maze of numbers on page 2. If you examine the 35 years since the 1960s ended, you will find that an investor’s return, including dividends, from owning the S& P has averaged 11.2% annually (well above what we expect future returns to be). But if you look for years with returns anywhere close to that 11.2% —say, between 8% and 14% —you will find only one before 2004. In other words, last year’s “normal” return is anything but.

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

We particularly want you to understand the limited circumstances under which we will use debt, given that we typically shun it. We will not, however, inundate you with data that has no real value in estimating Berkshire’s intrinsic value. Doing so would tend to obfuscate the facts that count.

Our failure here illustrates the importance of a guideline —stay with simple propositions —that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for —if you’ll excuse an oxymoron —mono-linked chains.

Since Berkshire purchased National Indemnity (“ NICO”) in 1967, property-casualty insurance has been our core business and the propellant of our growth.

In aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that loss is large, float becomes expensive, sometimes devastatingly so. Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product. …Customers by the millions say “I need some Gillette blades” or “I’ll have a Coke” but we wait in vain for “I’d like a National Indemnity policy, please.” Consequently, price competition in insurance is usually fierce. Think airline seats.

Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers —but they left us.

Portrait of a Disciplined Underwriter: National Indemnity Company;
It takes a long time to learn the true profitability of any given year.

To combat employees’ natural tendency to save their own skins, we have always promised NICO’s workforce that no one will be fired because of declining volume, however severe the contraction. (This is not Donald Trump’s sort of place.) NICO is not labor-intensive, and, as the table suggests, can live with excess overhead. It can’t live, however, with underpriced business and the breakdown in underwriting discipline that accompanies it. An insurance organization that doesn’t care deeply about underwriting at a profit this year is unlikely to care next year either.

It takes real fortitude —embedded deep within a company’s culture —to operate as NICO does. … But living day after day with dwindling volume —while competitors are boasting of growth and reaping Wall Street’s applause —is an experience few managers can tolerate.

(It should be noted that only one of the four graduated from college. Our experience tells us that extraordinary business ability is largely innate.)

Another way to prosper in a commodity-type business is to be the low-cost operator.[GEICO]

But a man named Leo Goodwin had an idea for an even more efficient auto insurer and, with a skimpy $ 200,000, started GEICO in 1936. Goodwin’s plan was to eliminate the agent entirely and to deal instead directly with the auto owner.

Reinsurance —insurance sold to other insurers who wish to lay off part of the risks they have assumed —should not be a commodity product. At bottom, any insurance policy is simply a promise, and as everyone knows, promises vary enormously in their quality.

Investors should understand that in all types of financial institutions, rapid growth sometimes masks major underlying problems (and occasionally fraud). The real test of the earning power of a derivatives operation is what it achieves after operating for an extended period in a no-growth mode. You only learn who has been swimming naked when the tide goes out.

This eclectic group, which sells products ranging from Dilly Bars to fractional interests in Boeing 737s, earned a very respectable 21.7% on average tangible net worth last year, compared to 20.7% in 2003. It’s noteworthy that these operations used only minor financial leverage in achieving these returns…. We purchased many of them, however, at substantial premiums to net worth —a matter that is reflected in the goodwill item shown on the balance sheet —and that fact reduces the earnings on our average carrying value to 9.9%.

(When you walk on carpet you are, in effect, stepping on processed oil.)

Last year was not a fluke: During the past decade, the same-store sales gains of the company have averaged 8.8%.

Bill and Scott Hymas, his successor as CEO, then proposed a second Las Vegas store, only about 20 minutes away. I felt this expansion would cannibalize the first unit, adding significant costs but only modest sales. The result? Each store is now doing about 26% more volume than any other store in the chain and is consistently showing large year-over-year gains. … Initially, I was pretty puffed up about the fact that they were consulting me. But then it dawned on me that the opinion of someone who is always wrong has its own special utility to decision-makers.

I viewed the selection of a flight provider as akin to picking a brain surgeon: you simply want the best. (Let someone else experiment with the low bidder.)

Clearly, Berkshire’s results would have been far better if I had caught this swing of the pendulum. That may seem easy to do when one looks through an always-clean, rear-view mirror. Unfortunately, however, it’s the windshield through which investors must peer, and that glass is invariably fogged. Our huge positions add to the difficulty of our nimbly dancing in and out of holdings as valuations swing.

Nevertheless, I can properly be criticized for merely clucking about nose-bleed valuations during the Bubble rather than acting on my views. Though I said at the time that certain of the stocks we held were priced ahead of themselves, I underestimated just how severe the overvaluation was. I talked when I should have walked.

As an example, we bought € 254 million of Level 3 bonds (10 ¾% of 2008) in 2001 at 51.7% of par, and sold these at 85% of par in December 2004. This issue was traded in Euros that cost us 88 ¢ at the time of purchase but that brought $ 1.29 when we sold.

Portrait of A Disciplined Investor: Lou Simpson
Take a look at the facing page to see why Lou is a cinch to be inducted into the investment Hall of Fame.

About Foreign Currencie, us trade deficits and national budget deficit; praised ft.com

despite the constant handwringing by luminaries, they offer no substantive suggestions to tame the burgeoning imbalance.

A budget deficit in no way reduces the portion of the national pie that goes to Americans. As long as other countries and their citizens have no net ownership of the U.S., 100% of our country’s output belongs to our citizens under any budget scenario, even one involving a huge deficit. … [trade deficit] our U.S. “family” would then be delivering 3% of its annual output to the rest of the world simply as tribute for the overindulgences of the past. In this case, unlike that involving budget deficits, the sons would truly pay for the sins of their fathers.

Our spendthrift behavior won’t, however, be tolerated indefinitely. And though it’s impossible to forecast just when and how the trade problem will be resolved, it’s improbable that the resolution will foster an increase in the value of our currency relative to that of our trading partners.

And, again, our usual caveat: macro-economics is a tough game in which few people, Charlie and I included, have demonstrated skill. We may well turn out to be wrong in our currency judgments. (Indeed, the fact that so many pundits now predict weakness for the dollar makes us uneasy.)

John Maynard Keynes said in his masterful The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Or, to put it in less elegant terms, lemmings as a class may be derided but never does an individual lemming get criticized.)

I do this in the spirit of the farmer who enters his hen house with an ostrich egg and admonishes the flock: “I don’t like to complain, girls, but this is just a small sample of what the competition is doing.”

[dont understand ]Berkshire purchases life insurance policies from individuals and corporations who would otherwise surrender them for cash. As the new holder of the policies, we pay any premiums that become due and ultimately —when the original holder dies —collect the face value of the policies. The original policyholder is usually in good health when we purchase the policy. Still, the price we pay for it is always well above its cash surrender value (“ CSV”). Sometimes the original policyholder has borrowed against the CSV to make premium payments. In that case, the remaining CSV will be tiny and our purchase price will be a large multiple of what the original policyholder would have received, had he cashed out by surrendering it.

I fault myself for not putting them in place many years ago.

The second reform concerns the “whistleblower line,” an arrangement through which employees can send information to me and the board’s audit committee without fear of reprisal.

First, does the company have the right CEO? Second, is he/ she overreaching in terms of compensation? Third, are proposed acquisitions more likely to create or destroy per-share value?

Directors, moreover, sometimes lack the knowledge or gumption to overrule the CEO. Therefore, it’s vital that large owners focus on these three questions and speak up when necessary.

I can’t resist mentioning that Jesus understood the calibration of independence far more clearly than do the protesting institutions. In Matthew 6: 21 He observed: “For where your treasure is, there will your heart be also.” Even to an institutional investor, $ 8 billion should qualify as “treasure” that dwarfs any profits Berkshire might earn on its routine transactions with Coke.

In our view, based on our considerable boardroom experience, the least independent directors are likely to be those who receive an important fraction of their annual income from the fees they receive for board service (and who hope as well to be recommended for election to other boards and thereby to boost their income further).

Most directors of this type are decent people and do a first-class job. But they wouldn’t be human if they weren’t tempted to thwart actions that would threaten their livelihood. Some may go on to succumb to such temptations.

the non-expensing of stock options. I’m enclosing an op-ed piece I wrote for The Washington Post describing a truly breathtaking bill that was passed 312-111 by the House last summer.

Option-expensing is scheduled to become mandatory on June 15th. You can therefore expect intensified efforts to stall or emasculate this rule between now and then. Let your Congressman and Senators know what you think on this issue.