Investment Manager’s Letter March 2007
For those who have not read it, a copy of this year’s Chairman’s Letter is enclosed. Berkshire Hathaway’s 2006 earnings were spectacular. My, as investment manager, estimate (which I considered overly optimistic) for the fourth quarter, was for net of $3.2 billion, but the earnings actually came in at $3.6 billion. For the year net earnings were $11 billion or $7,144 per share. This was up 29% from last years $5,538 per share. It was up from $4,753 per share in 2004 and $2,795 per share in 2002 for a 4 year annual growth rate of per share earnings of 26.4%. My, as investment manager, early estimate for look-through earnings was $1010 per share, and that is probably low now with all of the new stock positions. Adding this figure to reported earnings gives Berkshire Hathaway a PE of 13. Obviously Berkshire Hathaway can not keep growing their earnings at 26% per year but at 13 times earnings Berkshire Hathaway appears to be priced for no growth at all. Most of the difference from my estimate seems to have come from what Charlie calls “Warren Buffett’s wacky investment pass-times”. That may not be his exact quote, but that was the general idea. The following quote from the Chairman’s Letter is interesting and may give us some foreshadowing for what could be Warren Buffett’s next big magic trick.
“I should mention that all of the direct currency profits we have realized have come from forward contracts, which are derivatives, and that we have entered into other types of derivatives contracts as well. That may seem odd, since you know of our expensive experience in unwinding the derivatives book at Gen Re and also have heard me talk of the systemic problems that could result from the enormous growth in the use of derivatives. Why, you may wonder, are we fooling around with such potentially toxic material?” The answer is that derivatives, just like stocks and bonds, are sometimes wildly mispriced. For many years, accordingly, we have selectively written derivative contracts – few in number but sometimes for large dollar amounts. We currently have 62 contracts outstanding. I manage them personally, and they are free of counterparty credit risk. So far, these derivative contracts have worked out well for us, producing pre-tax profits in the hundreds of millions of dollars (above and beyond the gains I’ve itemized from forward foreign-exchange contracts). Though we will experience losses from time to time, we are likely to continue to earn – overall – significant profits from mispriced derivatives.”
We do not know what derivates Warren Buffett is buying but the derivatives that were the most mispriced last fall were credit default swaps on the lower trances of collateralized mortgage obligations, and credit default swaps on junk bonds. Purchasing these instruments is essentially buying insurance against the default of a debt obligation. Last fall these CDS were priced as if there would never be another default, and buying this insurance was very cheap. Since the first of the year the price of this insurance going up rapidly, and if this is what Buffett was buying, Berkshire Hathaway is likely to have a very good first quarter. Some of the mortgage related CDS have tripled in the last couple of weeks because of problems with the sub-prime lenders. Indeed this is the type of mispricing that would seem to have an appeal for Warren Buffett (like junk bonds in 2002). With any kind of size these contracts could generate an lot more that a “few hundred million”.
Equity per share on December 31, 2006 was $70,319 up from $59,377 last year for gain of 18.4%. With the price on March 1 at $106,600 the stock was selling at 1.52 times book. It is interesting that even with a gain of 24% in the price of the stock (and about a 3% sell-off since the first of the year), Berkshire Hathaway is selling at almost exactly the same multiple to book that it was when the price was $88,800 at the end of 2005. Since we have Warren Buffett’s word that intrinsic value is growing “quite a bit” faster than book value it may even be that Berkshire Hathaway is cheaper today than it was in December 2005.
I, as investment manager, have attached is a list of Berkshire Hathaway’s Stock Holdings as of December 31, 2006. We have a much more detailed stock list in the Chairman’s Letter than ever before and this may be pretty much all of Warren Buffett’s stocks, with the rest of the stuff on the 13F belonging to Lou Simpson Notes on the Berkshire Hathaway’s stock holdings list: