Warren Buffett's Annual Shareholder Letter

It's that time of the year again. Warren Buffett released his annual letter to shareholders. I encourage everyone to go read it here.

Here are my favorite quotes in no particular order.

1. Buffett is great at managing shareholder expectations:

It’s a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. Prices are down, and exposures inexorably rise. Even if the U.S. has its third consecutive catastrophe-light year, industry profit margins will probably shrink by four percentage points or so. If the winds roar or the earth trembles, results could be far worse. So be prepared for lower insurance earnings during the next few years. (Page 3)

Berkshire’s past record can’t be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future. (Page 4)

2. Buffett's ability to buy a company quickly and with cash makes him the acquirer of choice:

This deal was done in the way Jay would have liked. We arrived at a price using only Marmon’s financial statements, employing no advisors and engaging in no nit-picking. I knew that the business would be exactly as the Pritzkers represented, and they knew that we would close on the dot, however chaotic financial markets might be. During the past year, many large deals have been renegotiated or killed entirely. With the Pritzkers, as with Berkshire, a deal is a deal.

I think this is hilarious because what Warren calls "nit-picking" most people would just call "due diligence."

3. Buffett consistently praises his CEO's and recognizes the competitive advantage they give him:

A second, somewhat related, point about these managers is that they have exactly the job they want for the rest of their working years. At almost any other company, key managers below the top aspire to keep climbing the pyramid. For them, the subsidiary or division they manage today is a way station – or so they hope. Indeed, if they are in their present positions five years from now, they may well feel like failures.

Conversely, our CEOs’ scorecards for success are not whether they obtain my job but instead are the long-term performances of their businesses. Their decisions flow from a here-today, here-forever mindset. I think our rare and hard-to-replicate managerial structure gives Berkshire a real advantage.

4. Buffett's "simple" investment philosophy:

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stock market purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

5. The first time Buffett ever agreed to increase his offer for a company:

We agreed to purchase 35,464,337 shares of MidAmerican at $35.05 per share in 1999, a year in which its per-share earnings were $2.59. Why the odd figure of $35.05? I originally decided the business was worth $35.00 per share to Berkshire. Now, I’m a “one-price” guy (remember See’s?) and for several days the investment bankers representing MidAmerican had no luck in getting me to increase Berkshire’s offer. But, finally, they caught me in a moment of weakness, and I caved, telling them I would go to $35.05. With that, I explained, they could tell their client they had wrung the last nickel out of me. At the time, it hurt.

6. Buffett isn't joking when he says he likes to buy enduring franchises with strong brands:

In 2007, American Express, Coca-Cola and Procter & Gamble, three of our four largest holdings, increased per-share earnings by 12%, 14% and 14%. The fourth, Wells Fargo, had a small decline in earnings because of the popping of the real estate bubble. Nevertheless, I believe its intrinsic value increased, even if only by a minor amount.

In the strange world department, note that American Express and Wells Fargo were both organized by Henry Wells and William Fargo, Amex in 1850 and Wells in 1852. P&G and Coke began business in 1837 and 1886 respectively. Start-ups are not our game.

Note that this quote contrasts with Buffett's early comments regarding Lebron James:

"If Lebron were an IPO, I'd buy it." - Buffett

7. Would Buffett buy Google stock? Well, its probably not seasoned enough, but he does like the cash flow:

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

8. Buffett on sovereign wealth funds:

There’s been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here. Why should we complain when they choose stocks over bonds?

9. Buffett is bullish on America:

At Berkshire, we will attempt to further increase our stream of direct and indirect foreign earnings. Even if we are successful, however, our assets and earnings will always be concentrated in the U.S. Despite our country’s many imperfections and unrelenting problems of one sort or another, America’s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce evergrowing prosperity for its citizens.

10. Quotes:

Wells Fargo CEO John Stumpf on the Banking Industry- “It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine.”

Mitt Romney asked his wife, Ann, "When we were young, did you ever in your wildest dreams think I might be president?" To which she replied, "Honey, you weren't in my wildest dreams."

Former Senator Alan Simpson: "Those who travel the high road in Washington need to fear heavy traffic."

Barry's Imaginary Fed Statement

Opening statement of the FOMC Chair, Senate Testimony
February 27, 2008:

Senators, we find ourselves in a very challenging situation.

Following the dot com implosion, my predecessor at the Fed slashed rates to a generational low of 1%; the FOMC then kept rates at 1% for over a year.

While that re-inflated the economy, it also set off a shock wave of inflation unseen since the 1970s. Houses doubled in price, Oil is up 5 fold, food stuffs have tripled, and the dollar has collapsed. Gold is at multi-decade highs.

As always happens, these price increases in hard assets attracted speculators, and that made the situation -- especially in housing -- much more complex. Even worse, the housing speculation contributed to a debacle, while these other assets are actually accelerating in price.

Further, as was the political fashion, deregulation and a lack of interest in the oversight role of the banking system allowed an unprecedented expansion of credit, including to the least credit worthy consumers. Additionally, derivative selling -- at is heart, an unregulated form of insurance -- expanded from a few billion dollars to $46 trillion dollars.

The credit crunch is unprecedented, far worse than the S&L collapse and Long Term Capital Management -- combined.

All of these factors have combined to create our present situation. Inflation remains very elevated and worse, quite sticky. Growth continues to slide towards zero -- and possibly beyond.

Like many others, our forecasts in these areas have been wrong. We expected the slowing economy to moderate inflation, and so far, that has not happened. Demand for commodities from China and India is keeping prices elevated. The weakening dollar -- now at levels last seen in the 1960s -- is forcing all dollar denominated commodities higher. I don't necessarily believe in "Peak Oil," but the fact that the Saudis are one of the world's biggest investors in alternative energy research might tell you something.

The last time a slowing economy failed to moderate prices was the 1970s. Even as the economy slid into recession, we had major spikes in the prices of energy, food, clothing.

What is particularly worrisome to me is that as we have slashed interest rates 225 basis points, consumer loans -- mortgages and revolving credit -- have actually moved higher.

Gentleman, this is a major problem. And our internal, non-public projections forecast it is only going to get worse for the next 4 quarters . . .

I think we can all agree that Barry imaginary central banker would make a horrible Fed Chairman, he's just too honest. I think even the worst central banker have been given basic training on words to avoid, among which "implosion" is probably up near the top next to "explosion", "meltdown"and "contagion." But, Barry makes his point: in public conversations the Fed Chairman must sugar-coat everything in order to maintain confidence in the US financial system.

That being said I think that increasing concern over the Fed's "independence" is warranted. There is no reason for the largest economy in the world to fear the lower part of the business cycle. Most sane economists agree that recessions are a healthy and necessary part of longer term economic growth. When faced with a recession, the policy of devaluing the currency and fueling inflation is not a sound long-term strategy for the United States. Bernanke is risking a repeat of the 1970's stagflation nightmare. From everything we've learned, inflation is a pernicious, resilient foe. It seeps in and is tough to fight back. Let us hope that Bernanke doesn't forget about inflation this year. But, in the meantime lets buy all the non-dollar denominated real assets we can get our hands on -- asian currencies, agricultural commodities, base metals and emerging market materials stocks.

Grab Your Snorkel

Hat Tip: Ritholtz

Leap Years Are Not Lucky

As we all enjoy this fifth Friday in February, we can look back on all the other Leap Year trading days. Not a very good track record unfortunately:

Hat Tip: Bespoke

Where is the RMB ETF when you need it?

Will the RMB continue to appreciate? Michael Pettis seems to thinks so:

According to today’s Bloomberg:

The yuan fell by the most in almost two weeks versus the dollar on speculation the central bank wants to slow the appreciation to limit the impact on exporters. The currency dropped for a third day as the People's Bank of China may seek to deter speculators from betting on one-way moves after the yuan had its biggest advance last week of 2008. Forward contracts yesterday showed traders were the most bullish on the outlook for gains in the currency since a link to the dollar was scrapped in July 2005.

I am not sure if the PBoC is trying primarily to help exporters or to scare off speculators, but if the latter, as I suspect, it suggests that hot money inflows are a problem, although regular readers probably already knew that I would say that. As an aside, the Ministry of Commerce announced yesterday that January FDI was $11.2 billion, more than twice what it was in January 2007 ($5.3 billion). They didn’t explain why the big jump occurred, especially surprising since the increased corporate income tax on foreign investors which took effect this year should have caused FDI to be accelerated last year, but I wonder if part of the reason for the surge is that even “real” investors want to take advantage of the expected RMB appreciation. It is worth watching FDI numbers over the next few months to see if they remain high – this really doesn’t make the PBoC’s job much easier.

There are some rumors that the PBoC may generally slow the rate of appreciation this year because of concerns about the impact on the economy, but I don’t think this is very likely. I think it largely represents attempts to talk down the market, although if there is a sharp slowdown in the next few months at least some of the blame will go to the PBoC’s more rapid appreciation of the RMB. Nonetheless most analysts are raising their expectations about where the RMB will end this year.

One last piece of news, today the PBoC announced that the Corporate Goods Price Index (formerly known as the Wholesale Price Index) rose 1.1% month-on-month in January and rose 8.4% year on year. Not surprisingly these numbers were viewed with dismay since they suggest continued inflationary pressure. Every bank out there has been recently revising their 2008 inflation expectations upward - I expect these upward revisions will continue.

Retail investors looking to park money in RMB still don't have an easy way to buy the currency, but rumor has it a RMB ETF is in the works.

Hat Tip: China Financial Markets

Stimulus Saving?

A few weeks back a wrote a post on my blog about how people I know are planning to spend their stimulus checks. It turns out Americans may not plan to spend it at all. Here's the latest from Bloomberg:

The stimulus plan Congress approved this month may provide less of a jolt to the U.S. economy than intended, as most Americans plan to save rather than spend their tax rebates, a Bloomberg/Los Angeles Times survey shows.

Only 18 percent of respondents said they will spend their rebate on purchases, while slightly more than three in 10 said they prefer to use the money to pay off debt, and a third said they'll pocket it.

``People in Washington assume that about 40 percent of the money will be spent,'' said Douglas Elmendorf, a senior fellow at the Brookings Institution, a Washington-based research organization. ``Much less would be disappointing.''

We'll have to wait and see just how stimulating this stimulus package actually is. It turns out Americans may not be as Pavlovian as we originally thought.

December 2007 Case Shiller Update

Well the new Case-Shiller numbers for December are out and they show no signs of a stabilization in home prices. Frankly, this shouldn't surprise anybody. We already have a lot of other data from December and we already know that it is was one of the worst months for real estate in recent memory - the Case Shiller numbers just confirm that. Here's how San Dieg0, the 10 City Composite, and the 20 City Composite have performed since San Diego's peak:



Other Notes:
The 10 City Composite is down 11.37% since its peak in June 2006.
The 20 City Composite is down 10.49% since its peak in July 2006.

While Robert Shiller never gets too excited, he certainly doesn't sound thrilled with the housing numbers he is looking at or what it might mean for the economy. My favorite quote from the interview is the following:

"The market has been getting worse by the month, that's been the problem. I'm looking forward to the day when it is not getting worse, when it is going down but at a slower pace. It is not clear from this that we have that news yet."

I think it is safe to say that we are all looking forward to the day when it is getting worse at a slower pace, or even better when it starts getting better . . .

Commodities Extend Rally

I have been writing on this blog for over a year that I feel that most investors have a severe underweight to commodities in general and agricultural commodities specifically. This is just one part of the "Endowment Style" of investing that I think is missing from most portfolios. We have aggressively positioned ourself in real assets because we feel that the declining dollar, underestimated inflation, and strong global growth will lead to a sustained rally in commodities. In fact in our annual newsletter we said our top idea for this year is agricultural commodities (corn, wheat, grains, soybean, sugar).

	3 Months	1 Year
Corn	32%	22%
Wheat	31%	100%
Sugar	42%	26%
Soybeans	30%	72%

With each major ag commodity up over 30% over the past three months we feel validated, but recently we have become concerned. One of our agricultural commodities positions is already up nearly 25% this year and has captured nearly two thirds of the return we projected for the full year. Up until now we had been buying pull-backs but we stopped doing that when the position breached the 20% mark.

This bring up an interesting question: what do you do when a long-term position rises swiftly towards the target price you set for a long period of time? Do you let it ride? Do you trim and rebalance? Do you sell it all at the target?

In this case we are monitoring the position closely, watching the underlying fundamentals and putting in strategic sells stops to protect our gains. I think it is safe to say that you can expect more comments about the ongoing agricultural commodity run-up in the near future.