Portfolio manager’s Letter March 2005
Berkshire Hathaway’s 2004 Annual Report was posted on March 5, and the results were pretty much as expected. I felt that the fourth quarter would be good but probably not good enough to bring earnings for the whole year up over last year. That is pretty much how the results came in, with the 4th quarter up 40% over the same quarter in 2003, but with earnings for the full year at $7.3 billion, down 10% from 2003 because of lower investment gains. With characteristic self-deprecation, Warren Buffett labeled this as “lackluster performance”, but I do not think I agree.
Berkshire Hathaway is in full lockdown, the hurricane shutters are up, everything loose has been tied down, and the patio furniture has been thrown in the pool. There was no rhetoric to this effect in the chairman’s letter; Warren Buffett will not wander about yelling that the sky is falling. But if you read between the lines and pick at the numbers a bit, you can get a pretty good idea of how he feels the market will present lackluster performance for the next five to ten years.
First, there is Berkshire Hathaway’s massive pile of cash. A pile that has grown by $7.5 billion in the last year now amounts to $43 billion hardly lackluster performance. To this number, you can add the $22 billion in bond holdings. As Charlie said at last year’s WESCO meeting, they would prefer not to hold any bonds at all.
Then there is Warren Buffett’s bond trading. Berkshire Hathaway’s holdings of US government bonds have fallen from $8.8 billion three years ago to $1.6 billion at the end of 2004. His holdings of foreign bonds have increased from $2.5 billion to $7.1 billion in the same period. These actions speak volumes about Warren Buffett’s mindset relative to domestic interest rates and FOREX markets, and is not lackluster performance. These foreign bonds are in addition to the $21.7 billion face values in foreign-currency forward contracts.
As of December 31, Berkshire Hathaway still held $8.4 billion in corporate bonds. These are mostly what remains from the junk bonds that he purchased two years ago. These bonds currently are carrying $1.9 billion of unrealized gains. These unrealized gains are in addition to realized gains of $1.1 billion on the junk bonds that it sold in 2003 and another $730 million in gains on positions sold in 2004. All of this profit is in addition to the interest paid on the bonds, which in some cases has been as high as 20% of the price Berkshire Hathaway paid for the bonds.
On page 17 of the chairman’s letter is a table that makes me wonder about his complaints about his own “lackluster performance”. In just the last two years, Warren Buffett has realized $8.2 billion in his bond and FOREX trading. Add in another $1.9 billion of unrealized gains in the junk bonds he still holds, and maybe $200 to $300 per year in interest income. The chairman has enriched shareholders by about $10.5 billion with his trading skills in two years. This does not meet my definition of “lackluster performance”.
Further evidence of Warren Buffett’s opinion on the current equity markets can be found on page 49, a list of the asset mix for the company’s pension plans. Cash held in the plans increased from 29% last year to 33% at the end of 2004. The allocation of assets to equities securities has declined from 27% to 12% for the same period. That’s right, just 12% of the holdings in Berkshire Hathaway’s pension accounts are in equities. I have not looked, but I doubt that many other pension plans in the country are this bearish. This may look like a lackluster performance, but it may eventually prove to be wise.
Warren Buffett’s chairman’s letter’s tone was not altogether positive, while he was not exactly talking the stock down. My impression is Warren Buffett is happy with the stock price just about where it is, and it is not likely that this will lead to lackluster performance in the future. While there has been a lot of comment lately to the effect that Berkshire Hathaway sells substantially below intrinsic value, Warren Buffett may not wholly agree with this. Or, at least, he feels that market conditions are such that any substantial appreciation from this point will disappear as the market turns more bearish.
More than anything else, Berkshire Hathaway is today a play for a down market, and in my opinion, probably the best one around. Warren Buffett is not in a contest, at this point, to outperform the S&P 500. He focuses his attention on “rule number one” and lower Berkshire Hathaway’s risk profile. Just as underperformance in 1999 led out-performance in the next three years, underperformance in 2004 may best be understood as we look back from four or five years in the future. Today this may look like a lackluster performance, but it may turn out to be anything but.
It was another good year for the insurance business which showed an underwriting profit of $1.5 billion even in the face of four hurricanes and a tsunami. The four Florida storms have generated claims of 1.2 billion so far. Indeed most CEOs would have been bragging about their performance by explaining that without one-time items of $1.7 billion, their earnings would have been $9 billion or up 11%.
When I see how difficult it has been for Berkshire Hathaway to liquidate GenRe’s derivatives operation, after three years in a benign market, they still have 2,890 contracts left (as Warren says, “Like Hell derivative trading is easy to enter but difficult to leave”), this could be lackluster performance it is not hard to imagine Warren going to sleep at night with visions of sugarplums. (The telephone rings with the news that one of the big money center banks derivative portfolio has just blown up).
It is impossible to forecast how or when Berkshire Hathaway will eventually put its $65 billion in cash and bonds to work, but one thing is certain, the longer it takes, the bigger the cash pile will be.
Finally, the best news is that Berkshire Hathaway is not paying a dividend. The best news for Berkshire Hathaway shareholders that is — it may not be good news for the equity markets. If Warren Buffett did not feel he would eventually find a home for Berkshire Hathaway’s cash, that will provide better than lackluster performance. He would not hold this much cash. Indeed, if there is a significant correction sometime in the next few years the return received from this cash will be very nice.