Portfolio manager’s Letter January 2009
It will not come as a shock that 2008 investment results were not a good year in investment. Unfortunately, the fact that we have been predicting this sort of market for a few years does not seem to eliminate the pain from watching asset values decline. While it was easy to see the accident about to happen, we were still surprised by its magnitude.
Ther 2008 investment results for Losch Management Company’s average long term account was down about 23% – 25%, and the average short term account down somewhat less. This compares to a 37% decline in the S&P 500 Average, a 40% decline in the NASDAQ Composite, a 45% decline in international markets, and a 55% decline in emerging market equities. So we did manage to beat the market by a nice margin and add a point or two to our long term advantage. This probably offers little comfort right now, and we would be much happier if the gap were a lot larger.
A look Losch Management Company’s performance tables (enclosed) that include 2008 investment results shows that a few points of a performance advantage over the major averages for a period of years can make a huge difference in the investor’s results. The 21-year chart shows that with an investment of $100,000, a 7.5% annual advantage over the S&P 500 means the difference between $536,000 and $2,187,000.
Over the long term, equities will out-perform other investments; bonds are less volatile, but in the end, that advantage will be eaten by inflation. With equities, there will be secular bear markets like we have experienced for the last ten years. Within those secular bears, there will be terrible years like the 2008 investment results. The Ten Year table that we have enclosed shows that if you had put $100,000 in an index fund based on the S&P 500 10 years ago, it would be worth $87,000 today.
The annual return of minus -1.38% is substantially below the long term average and nicely defines our 2008 investment results present bear market. The good news is that market investment results will eventually return to their long term trend (about +9%), and so our results are likely to be a good deal better for the next ten years than they have been for the last ten.
Good stocks always eventually recover and go higher but patience is required. The last time we had a bear market this severe was 1974, and hopefully we will not have to put up with a market this bad for another 34 years.
Losch Management Company’s strategy of heavy investment concentration in Berkshire Hathaway was working well for our 2008 investment results until October. Still, then the “mark to market” charge for the put options Buffett sold seems to have scared the bejesus out of Mr. Market. As of the end of the third quarter Berkshire Hathaway has written off $6.8 billion, and that total could go too well over $9.0 billion by the end of the fourth quarter. This is a non-cash charge for a position that almost certainly will turn out to be hugely profitable for Berkshire Hathaway by the time the options expire in 12 – 17 years.
Keep in mind that this nine billion dollar charge works both ways, and it will be added back into Berkshire Hathaway’s earnings reports as the market recovers. While Berkshire Hathaway earnings will suffer in the fourth quarter of 2008 investment results, and for as long as the market continues to decline because of the charge, 2009 could be a very different story. When the investment market does start to recover, the year over year earnings growth is likely to look spectacular. For instance, a year-long rally that takes us back to where we were a year ago would add a couple of billion dollars a quarter of earnings just from these put contracts.
In the third quarter Berkshire Hathaway showed $1.1 billion in investment income. Next year they will receive $200 million additional per quarter just from the GE and Goldman Sachs preferred they purchased in October, and $120 million or so for its investment in Hershey. There will be additional dividend income from his purchases of Conoco Phillips and Burlington Northern.
Judging by what we read about the chaos in the debt markets it would not be a surprise if Berkshire Hathaway has invested in some high yield debt as they did in 2002, so does not take much imagination to figure the Berkshire Hathaway’s return on its’ fixed income portfolio will improve over the figure in the 2008 investment results.
Underwriting profit suffered in the 2008 investment results because of a weak reinsurance market. Still, derivative problems at insurance companies (think AIG) have tightened up the insurance market nicely, so barring a bad storm season or another major disaster Berkshire Hathaway’s underwriting profit will experience a strong recovery in 2009.
Virtually the only part of Berkshire Hathaway where we cannot expect improvement next year is the operating companies whose earnings are likely to remain weak at least until the end of 2009, but even with that and given the market does start to recover it will be easy for Berkshire Hathaway to register big year over year earnings gains in 2009. This will be in an environment where most companies’ earnings will be going south. Where Berkshire Hathaway is concerned about what the market took away from us in the future 2008 investment results results, it is likely to give back in 2009, and the company’s performance relative to the rest of the market should be strong.
Hedge funds lump all their customers’ money together into one big fund. This fundamentally different approach than we use were all assets are left in the customer’s name at an independent custodian. Hedge funds like this method because it allows them to invest without having to reveal their trading strategies to the outside world, and also perhaps because it is easier to administer. This lack of transparency is useful if you have a good idea that you do not want to share the 2008 investment results with the competition.
Unfortunately for the investor it has a couple of downsides. In the first place it means that the investor can not use the investment manager’s ideas to manage his unmanaged assets. The other downside to this lack of transparency comes in very handy to someone like Bernie Madoff that wants to run a Ponzi scheme.
One reason we like dealing with individual accounts and with an independent custodian is that we feel it is better for the customer. It is much more transparent, and this transparency will eliminate many opportunities for fraud is reports kike the 2008 investment results. It is easier for the customer to see what is being done with her money. There is no way to run a Ponzi scheme in this structure, so the customer has one less thing to worry about.