Client Letter February 2005

2004 was not a great year. With the market down or flat for most of the year, our results pretty well followed suit. The composite return for our managed accounts was 7.1% on a size-weighted basis and 9.1% when all accounts are weighted equally. This compares to 10.9% for the S&P. Our five-year record, however, still looks much better with Losch Management at plus 13% per year versus the minus 2.8% per year for the Wilshire 5000. This advantage (15.8% per year) easily put us way ahead of most mutual funds, and I suspect ahead of about 90% of all hedge funds.

As you can see, small accounts generally did better than large accounts. This is partially because large capital gains make the bigger accounts somewhat less mobile. But more important is the fact that these small accounts are mostly IRAs and are nontaxable. With short-term gains not taxable, these accounts have been traded more aggressively.

It says something about the nature of the current market, when it is easier to make money by taking short-term gains than it is with buy and hold. We much prefer the long-term buy/hold approach—it provides us with more leisure time—but with the capital markets flooded with surplus investment funds from all over the world, we see little chance that the returns will be any better this year than they were last year.

Our view of the market remains the same as it has been for some time: that this is a cyclical (short-term) bull market within a secular (long-term) bear market. With stock valuations at today's high level, it is hard to envision much more than single-digit returns from a traditional long-term buy/hold approach.

In bear markets, the most important rule is preservation of capital. In the long run, bear markets always present buying opportunities, and the bigger the bear, the better the eventual opportunity. If you can get to that opportunity with your capital largely intact, the rest is easy. At the 1975 bottom (after a 45% correction in the Dow), it was easy to find stocks that would increase by 500 to a 1,000% in the next 10 years. Bubbles and long bear markets are the product of human psychology and have very little to do with rational evaluation. As long as human nature stays as it is, there will be mean, nasty bear markets. But the prospect does not bother us, because this is the time when decisions are easy and when you make all your money; you just do not know it until later.

During the lean periods, patience is the most important virtue. Preservation of capital should be the primary investment goal. Our response to these conditions is a three-pronged approach that incorporates bigger than normal (sometimes much bigger) positions in cash and in Berkshire Hathaway and to hold our nose, grit our teeth, and keep pushing the buy and sell buttons more rapidly.

Our basic Market strategy involves a large position in Berkshire, because Berkshire is reasonably priced at present levels and with very solid long-term prospects. But more than this, it offers a hedge against a substantial market decline. With its huge cash positions and with Buffett to make the investment decisions, Berkshire is one stock that will get more valuable if the market declines.

At the end of the third quarter, Berkshire had $43 billion in cash, plus, as Charlie pointed out at last year's WESCO meeting, they really do not like to own bonds and would prefer to have that money in something with a better return. So, you can add their $23 billion bond position to the company's buying power. With $66 billion in buying power, a nice market crash would allow Buffett to substantially increase his company's cash flow. A 7% after-tax return (criteria he has often used) would increase Berkshire's cash flow by between $4 and $5 billion. A really bad market might present Buffett with his last great buying opportunity, so it is not inconceivable that he might try to leverage his purchases with joint ventures or short-term debt. With his cash committed, $20 billion in debt would represent something less than two years of cash flow.

Buying power of $66 billion represents about $43,000 per A Share, $1,433 per B share, or about 47% of the current market value. Does this mean that if you are 100% invested and all your money is in Berkshire Hathaway, you still have 47% in cash? Of course not, but is it not the functional equivalent?

Recently, Berkshire has displayed some tendency to move counter to the market. There have been a lot of days when the overall market is down and Berkshire goes up. But in a prolonged bear market, sooner or later everything gets hit. But even if the market price of the stock goes down, Warren still has his $66 billion. Actually, he would have more; Berkshire is a cash cow of prodigious capacities, and it is now generating cash at a rate close to a billion dollars every couple of months.

So, your functional buying power is increasing as the market goes down, and to compensate for the bother of the changes in Mr. Market's daily offers, you have the comfort that comes from knowing that Warren will handle the decisions about timing and selection. In this respect, Berkshire offers the investor the ability to remain invested and still keep a cash reserve. In the investment world, this is the closest you will come to being able to have your cookie and to eat it at the same time.

The recent purchase of Gillette will have a positive effect on Berkshire Hathaway, which owns 96 million shares of Gillette. Gillette pays a $0.65/share dividend. P&G pays $1.00. So, the purchase benefits Berkshire with a $35-million increase in dividend income.

Gillette's earnings were $1.62 per share versus $2.42 per share for P&G; so in addition to the $35 million in dividend income, the transaction will increase Berkshire's look-though earnings by another $45 million. This $80-million net increase equals about $52 per "A" share.

If you figure 18 is a decent PE for Berkshire, then P&G's purchase of Gillette adds about $930 per A share—to Berkshire's intrinsic value, without Berkshire having to raise a finger. And Warren has been able to lower the risk profile of his stock portfolio (by trading a stock with a 32 PE for one with 22 PE) without incurring tax liability. Sweet!

Somewhere I read that Kilts approached P&G. You don't suppose there was a nudge from Omaha, do you? Na, Warren would never do that.

Still he was out playing cheerleader and "pump up P&G" big time—actions that are not normally part of his job description. If you have a really suspicious mind, it does create a faint aroma of Omaha cooking.