Dear Berkshire Hathaway shareholders, [Update] | FT Alphaville

Dear Berkshire Hathaway shareholders, [Update]

The annual letter from Warren Buffett is out. We’ve picked out some excerpts below, or click to read the annual report in full, the chairman’s message starts on page 3.

One thing jumps out straight away though, the mea culpa for underperforming over five years was last year’s news. Five years, yes, but six…

Over the stock market cycle between year ends 2007 and 2013, we overperformed the S&P. Through full cycles in future years, we expect to do that again. If we fail to do so, we will not have earned our pay. After all, you could always own an index fund and be assured of S&P results.

Anyway, you know how barely any hedge fund managers with more than $1bn managed to beat the S&P last year, not so the two Buffett deputies:

In a year in which most equity managers found it impossible to outperform the S&P 500, both Todd Combs and Ted Weschler handily did so. Each now runs a portfolio exceeding $7 billion. They’ve earned it.

Who fit right in, in Omaha, by the way:

Todd and Ted have also created significant value for you in several matters unrelated to their portfolio activities. Their contributions are just beginning: Both men have Berkshire blood in their veins.

Meanwhile, more deals please:

With Heinz, Berkshire now owns 81⁄2 companies that, were they stand-alone businesses, would be in the Fortune 500. Only 4911⁄2 to go….

While Charlie and I search for elephants, our many subsidiaries are regularly making bolt-on acquisitions. Last year, we contracted for 25 of these, scheduled to cost $3.1 billion in aggregate. These transactions ranged from $1.9 million to $1.1 billion in size.

And they don’t have to management to run them anymore, necessarily:

We completed two large acquisitions, spending almost $18 billion to purchase all of NV Energy and a major interest in H. J. Heinz. Both companies fit us well and will be prospering a century from now.

With the Heinz purchase, moreover, we created a partnership template that may be used by Berkshire in future acquisitions of size. Here, we teamed up with investors at 3G Capital, a firm led by my friend, Jorge Paulo Lemann. His talented associates – Bernardo Hees, Heinz’s new CEO, and Alex Behring, its Chairman – are responsible for operations.

But let Warren tell you how awesome the rest of Berkshire is. Insurance produced an underwriting profit again:

Concurrently, our underwriting profit has aggregated $22 billion pre-tax, including $3 billion realized in 2013. And all of this all began with our 1967 purchase of National Indemnity for $8.6 million.

Not like those losers over at State Farm:

State Farm, by far the country’s largest insurer and a well-managed company besides, incurred an underwriting loss in nine of the twelve years ending in 2012 (the latest year for which their financials are available, as I write this). Competitive dynamics almost guarantee that the insurance industry – despite the float income all companies enjoy – will continue its dismal record of earning subnormal returns as compared to other businesses.

As noted in the first section of this report, we have now operated at an underwriting profit for eleven consecutive years, our pre-tax gain for the period having totaled $22 billion.

But don’t forget the stock investments. The big four holdings are Wells Fargo, American Express, Coke and IBM:

Going by our yearend holdings, our portion of the “Big Four’s” 2013 earnings amounted to $4.4 billion. In the earnings we report to you, however, we include only the dividends we receive – about $1.4 billion last year. But make no mistake: The $3 billion of their earnings we don’t report is every bit as valuable to us as the portion Berkshire records.

Or how the Sage extorted rescued Bank of America from the bathtub. One item not listed in the $117.5bn of major stock holdings is:

We can buy 700 million shares of Bank of America at any time prior to September 2021 for $5 billion. At yearend these shares were worth $10.9billion. We are likely to purchase the shares just before expiration of our option. In the meantime, it is important for you to realize that Bank of America is, in effect, our fifth largest equity investment and one we value highly.

Incidentally, how confident in your position do you have to be to quote a Woody Allen joke about sexuality to support your point, right now?

Our flexibility in capital allocation – our willingness to invest large sums passively in non-controlled businesses – gives us a significant advantage over companies that limit themselves to acquisitions they can operate. Woody Allen stated the general idea when he said: “The advantage of being bi-sexual is that it doubles your chances for a date on Saturday night.” Similarly, our appetite for either operating businesses or passive investments doubles our chances of finding sensible uses for our endless gusher of cash.

(Possibly when you can also say this:

Since 1970, our per-share investments have increased at a rate of 19.3% compounded annually, and our earnings figure has grown at a 20.6% clip.)

Anyway, the sage says buy index funds, which is what is in his will:

My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.

When it comes to valuation, look at net earnings.

Every dime of depreciation expense we report, however, is a real cost. And that’s true at almost all other companies as well. When Wall Streeters tout EBITDA as a valuation guide, button your wallet.

And as for punditry:

Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)