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Sunday, February 28, 2010

How to generate a 801,516% Return (Berkshire Hathaway Annual Letter)

Warren Buffett published his annual letter to the shareholders of Berkshire Hathaway. Over a 45 year period, Buffett and Munger produced a total return of 801,516%. This is double that of the return of the S&P 500 in the same period, and represents a 20% compounded annual return.


Here is the link for the full letter.  


One can try to analyze and replicate Buffett's success, correctly or incorrectly. Buffett, however, attributes his success on what he does not do. It can best be summarized with a quote from Munger:



“All I want to know is where I’m going to die, so I’ll never go there.” 
Thinking in mathematical terms, to solve difficult problems:


“Invert, always invert"
Finally, in terms of music:


Sing a country song in reverse, and you will quickly recover your car, house and wife.
Berkshire Activity - A summary


Recall that in September 2008, when the financial markets seized, Berkshire had sufficient cash to inject in the market. In 2009, Berkshire bought a railway company (which is discussed on pages 3-4).


In 2009, Buffett stated in his letter that "the economy ...will be in shambles throughout 2009." His letter also contained 12,830 words which the media did not cover. While Buffett stated his disappointment in the way media covered stories, Buffett did explain that not all of Berkshire's business is doing well. That is, GEICO's entrance in the credit card market proved to be a losing business.


Berkshire also owns NetJets. While the company had its share of success, it has so far costed the company 157M in pre-tax loss, and debt soared from $102 Million (at the time of purchase) to $1.9B in April 2009. Buffett notes that its fortunes are beginning to turn around (debt reduced to $1.4B and earnings are profitable, after losing $711M in 2009).


On a more positive note, Buffett believes the housing problem is largely over (page 11).


Summary of Holdings for 2009:



12/31/09
Shares Company
Percentage of
Company
Owned Cost * Market
(in millions)


151,610,700 American Express Company ........................ 12.7 $ 1,287 $ 6,143
225,000,000 BYD Company, Ltd. .............................. 9.9 232 1,986
200,000,000 The Coca-Cola Company .......................... 8.6 1,299 11,400
37,711,330 ConocoPhillips .................................. 2.5 2,741 1,926
28,530,467 Johnson & Johnson ............................... 1.0 1,724 1,838
130,272,500 Kraft Foods Inc. ................................. 8.8 4,330 3,541
3,947,554 POSCO ........................................ 5.2 768 2,092
83,128,411 The Procter & Gamble Company .................... 2.9 533 5,040
25,108,967 Sanofi-Aventis .................................. 1.9 2,027 1,979
234,247,373 Tesco plc ....................................... 3.0 1,367 1,620
76,633,426 U.S. Bancorp .................................... 4.0 2,371 1,725
39,037,142 Wal-Mart Stores, Inc. ............................. 1.0 1,893 2,087
334,235,585 Wells Fargo & Company .......................... 6.5 7,394 9,021
Others ......................................... 6,680 8,636
Total Common Stocks Carried at Market .............. $34,646 $59,034



Media reported that Berkshire sold positions in  ConocoPhillips, Moody’s, Procter & Gamble and Johnson & Johnson. The reason this was done was to raise cash to buy Dow and Swiss Re. In 2009, Berkshire was bullish on corporate and municipal bonds, a viewpoint that later proved to be correct when these issues rallied.


A Story


The story worth quoting from the letter is in regards to mergers and acquisitions, a theme that may play out this year as credits loosen, the appetite for risks increase, and as Berkshire itself considers other purchasing options:

The seller of the smaller bank – no fool – then delivered one final demand in his negotiations. “After
the merger,” he in effect said, perhaps using words that were phrased more diplomatically than these, “I’m going to be a large shareholder of your bank, and it will represent a huge portion of my net worth. You have to promise me, therefore, that you’ll never again do a deal this dumb.”We owned stock in a large well-run bank that for decades had been statutorily prevented from acquisitions. Eventually, the law was changed and our bank immediately began looking for possible purchases. Its managers – fine people and able bankers – not unexpectedly began to behave like teenage boys who had just discovered girls.
They soon focused on a much smaller bank, also well-run and having similar financial characteristics in such areas as return on equity, interest margin, loan quality, etc. Our bank sold at a modest price (that’s why we had bought into it), hovering near book value and possessing a very low price/earnings ratio. Alongside, though, the small-bank owner was being wooed by other large banks in the state and was holding out for a price close to three times book value. Moreover, he wanted stock, not cash.
Naturally, our fellows caved in and agreed to this value-destroying deal. “We need to show that we are in the hunt. Besides, it’s only a small deal,” they said, as if only major harm to shareholders would have been a legitimate reason for holding back. Charlie’s reaction at the time: “Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?”
The seller of the smaller bank – no fool – then delivered one final demand in his negotiations. “After the merger,” he in effect said, perhaps using words that were phrased more diplomatically than these, “I’m going to be a large shareholder of your bank, and it will represent a huge portion of my net worth. You have to promise me, therefore, that you’ll never again do a deal this dumb.”

Yes, the merger went through. The owner of the small bank became richer, we became poorer, and the managers of the big bank – newly bigger – lived happily ever after.
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