Client Letter March 2003

 My favorite quote from the material that was released on Wednesday from the Berkshire Hathaway 2002 annual report, was,

"The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks—if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pretax returns (which translate to 6% to 7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity."

Sitting on the sideline may be no fun, but it is hardly an accurate description of what has been going on at 1440 Kiewit Plaza for the last year. I have revised my table of recent acquisition activity to include figures for junk bond purchases and activity in the equity market (see below). If activity is the definition of fun, then Warren has been having a ball. Reading the first couple pages of the Chairman's Letter, I get the impression he is tap-dancing like crazy. Certainly 72 years has not dulled his sense of humor.

I include junk bonds because they are more like equities than they are traditional bonds. The risks involved are more like the risks in equities and the rewards for proper selection can compare favorably with the return you expect from an equity purchase.For example, let's look at two of Buffett's previous adventures into sub-prime debt. In 1983 and 1984 he bought $139 million in WPPSS (Washington Public Power Supply Systems) bonds. Two of the company's projects had gone into default and he was able to buy the bonds of the projects that had not defaulted at a steep discount. Berkshire held the bonds into the early 1990's and received a 16% tax-free return. In addition, the bonds were eventually redeemed at par for a capital gain of 100%, which would have brought the total return to something just short of 30% per year.

In 1989 and 1990 Buffett bought $440 million in RJR Nabisco bonds at a discount that produced a current yield of 16%. He was able to sell the bonds in 1990 and 1991 with again of about $200 million. If my math is correct, the net return on this investment with the gain added to the coupon was 31%. In 1992 the chairman made the following comment about his junk bond purchases. "Over the years, we've done well with fixed-income investments, having realized from them both large capital gains (including $80 million in 1992) and exceptional current income. Chrysler Financial, Texaco, Time-Warner, WPPSS, and RJR Nabisco were particularly good investments for us. Meanwhile, our fixed-income losses have been negligible: we've had thrills but so far no spills."

Investment	Price (million)
MidAmerica	$1,700
Cort	$386
Ben Bridge Jewelry (Est.)	$264
Justin	$570
US Investment (Est.)	$50
Benjamin Moore & Co	$1,100
Total Acquisitions	$4,070
Net Stock Purchases	-$2,725
Total Investments 2000	$1,345

Investment	Price (million)
Shaw Industries	$2,100
Johns Manville	$1,800
Mitek	$400
XTRA	$580
Total Acquisitions	$4,880
Net Equity Purchases	-$2,806
Junk Bonds (Estimated)	$1,000
Total Investments 2001	$3,074

Investment	Price (million)
Acquisitions
12.7% of Shaw industries.	$324
Albecca Inc.	$225
Fruit of the Loom	$730
Garan Incorporated	$270
CTB International	$180
Pampered Chef	$900
Total Acquisitions	$2,629
MidAmerica
Northern Natural Gas	$950
Kern River Acquisition	$900
Kern River Expansion	$1,200
Other	$2,250
MidAmerican Total	$5,300
Loans and Financings
LVLT Convert.	$100
Williams Co. Pref	$275
Williams Loan	$450
TXU Corp. Pref.	$250
Oakwood Homes	$215
Comdisco	$490
Insurance Syndicates (Est.)	$801
Financing Total	$2,581
Other Investments	$1,700
Acquisitions & Financing Total	$8,260
Junk Bonds	$7,000
Net Equity Purchases (Click here to see table)	$350
Total Investments 2002	$19,560

 

If you look to the figure in the bottom right hand corner of the table, you will find that what Warren describes as sitting on the side lines involves the expenditure of some thing like $19.5 billion. My first reaction is that the reason he is not doing much in the equity market is that he must be finding pretty good returns else were. My second thought about this is that any year in which the chairman is able to invest $19.5 billion is a good year for shareholders, regardless of what is happening on the bottom line, and regardless of what Mr. Market is saying. It has been said that, "You make all your money in bear markets. You just do not know it till later." I think that this clearly applies to Berkshire this year.

 

There are those that have accused Buffett of trying to talk the market down so he can buy stocks cheap. My own feeling is that: 1) He has real concerns about future, that derivatives and terrorists are a real and substantial threat to our financial future, and that either one or both of these factors may have a very negative impact on the stock market at some point in the not too distant future. 2) At the same time, the last thing that he really wants to do is attract attention to what he is really doing. The press, unwilling to look beneath the surface, immediately buys his package. For the last two days all we have heard is Buffett is bearish and how he is sitting on the side lines, when the fact is he has just spent the last year behaving/spending like an over-sexed teenager. We have two very recent examples about how competitive Mr. Buffett's business is. His attempts to buy Conseco and Burlington Industries were thwarted by competitive bidders, so Buffett fires a couple of shots at the equity markets to draw attention away from his all-out assault that he has launched on a different part of the capital markets.

The December 31 balance sheet lists $4.04 billion in other investments which many here have long assumed is silver. This is up from $2.3 billion at the end of 2001. Silver was up about $0.20 on a year-on-year basis, but that would only account for about $90 million. So there was an addition of $1.7 billion in other.This could be almost anything except equities or bonds. Does anyone have a clue? My guess is that he has added to silver, or purchased some other hard asset, on the theory that the current FED policy (and a war in Iraq) will eventually generate a significant amount of inflation.

It is interesting that in the last year MidAmerican acquired assets that are considerably in excess of the funding that has been provided by Berkshire. As noted in the annual report, Berkshire increased its funding of MidAmerica by $1.8 billion in 2002.During this period, MidAmeria's assets increased by $5.3 billion and its liabilities increased by $4.8 billion, so MidAmerican has leveraged Berkshire's investment by about $3.5 billion in internal debt. This is a significant level of leverage and could substantially raise the return we receive from our investment. A 10% return on $5.3 billion in assets would equate to a $31% return on our $1.7 billion investment.

I have revised my 2002 investment table again to reflect this investment by MidAmerican, and the addition of $1.7 billion in "Other Investments." This brings the total of funds invested during 2002 to $19.6 billion rather than the $15.6 billion I listed earlier. This is a huge sum and to my recollection, one that exceeds anything Mr. Buffett has accomplished in any prior year, by a factor of 4 or 5 times.