• Conventional wisdom has it that America’s best days are behind it and economic might is going to inevitably shift eastward. Buffett, however, is optimistic about America’s prospects. He says that the country’s best days lie ahead because America’s system for unleashing the human potential is the same it has been in the past. (Pages 3-4).
• If you invest is stocks, you have to have confidence that management will invest retained earnings sensibly. Buffett points out that a dollar of earnings in the hands of Sears Roebuck’s CEO had a far different story than a dollar entrusted with Sam Walton. (Pages 7-8).
• Next, Buffett explains the business results in Insurance (Pages 8-11), Berkshire’s vast empire selling everything from candies to underwear (Pages 12-14), Railroads and utilities (Pages 14-15) and stock holdings. (Pages 17-18).
• Buffett warns investors against putting too much stock in net earnings, which can be gamed by management. Instead, he counsels investors to pay close attention to changes in book value and a company’s operating earnings. (Pages 20-21).
• Buffett counsels investors to eschew leverage, which can magnify gains but can turn lethal to a portfolio. Instead, he explains why despite very low interest rates investors Berkshire keeps plenty of cash around just in case things go horribly wrong as they did in September 2008. If there is only one thing you can read in this year’s letter, it should be Pages 22 to 25.

Quotes

On Leverage: “And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

On reaching for yield: “We agree with investment writer Ray DeVoe’s observation, “More money has been lost reaching for yield than at the point of a gun.””

On availability of credit: “Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees.”

On market volatility: “As one investor said in 2009: “This is worse than divorce. I’ve lost half my net worth – and I still have my wife.””

On homeownership: “But a house can be a nightmare if the buyer’s eyes are bigger than his wallet and if a lender – often protected by a government guarantee – facilitates his fantasy. Our country’s social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford.”

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Notes from the 2010 Berkshire Hathaway Annual Report is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

Buffett and Protégé made their bet on Long Bets (as an aside, the Long Bets website has all sorts of fascinating bets ranging from computers continuing to fail the Turing test to where extra-terrestrial life forms will be discovered), which offers an arena for making long-term bets as a way of fostering long-term thinking. The details of the bet are available here. Both bettors contributed $320,000, which was used to purchase a strip bond that will be worth $1 million at the conclusion of the bet. The winner’s charity will receive the entire proceeds of the bet.

Buffett may be trailing but he likes the low-cost index fund’s chances:

A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.

For their part, Protégé Partners are putting faith in their hedge fund picking capabilities even though they have a very high fee hurdle to overcome. For starters Protégé charges investors a 1% annual management fee and 5% of any gains made by its hedge fund picks. The hedge funds themselves charge another 1.5% annual fee and 20% of any profits. The Vanguard S&P 500 Index fund, on the other hand, charges just 0.07%.

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1. Buffett’s portfolio is valued at $1.86 billion and the portfolio has an annual yield of $42.58 million.
2. The portfolio has just 10 stocks and the top holding — Wells Fargo (WFC) — makes up nearly a quarter of the portfolio.
3. More than half the portfolio is held in four Dow Jones component stocks: Johnson & Johnson (JNJ), Procter & Gamble (PG), Kraft Foods (KFT) and Wal-Mart (WMT). In fact, two more stocks (Exxon Mobil and GE) in the portfolio are Dow Components.
4. The Morningstar article points out that every single business in Buffett’s portfolio has been around for more than a century. The newest business would be UPS, which was founded as recently as 1907.

I went looking through SEC filings to figure out how Buffett’s portfolio holdings have changed over time. The furthest I could go was 2006 because prior to that Buffett’s holdings were either not reported or were combined with reporting from other related entities. The following table lists the holdings (number of shares) of Buffett’s personal portfolio as of December 31st for the period 2006-09:

Some interesting points:

1. 2009 was a busy year for Buffett. He increased his holdings in Wells Fargo significantly, added Wal-Mart and Exxon Mobil and sold Constellation Energy.
2. Other major holdings are also recent additions. US Bancorp, Procter & Gamble and Kraft Foods were purchased in 2007.
3. Overall, the portfolio has very low turnover. Other than Constellation Energy, which was purchased in 2008 and sold in 2009, Buffett adds stocks to the portfolio but rarely sells them.

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1. Berkshire Hathaway acquired Burlington Northern Sante Fe (BNSF), a railroad operator, in 2009. As part of the acquisition was paid in BRK stock, Berkshire now has tens of thousands of new shareholders. Mr. Buffett explains why he measures Berkshire’s business results through changes in per-share book value. He also clarifies what new investors can expect him not to do. (Pages 3-5).
2. The next few pages cover Berkshire’s business results for 2009. Mr. Buffett thinks the residential housing problems should be largely over within a year or so because housing starts in the US are running at a rate far below household formation.
3. Berkshire’s investment holdings are discussed in pages 14-15. It includes this quote: “When it’s raining gold, reach for a bucket, not a thimble”.
4. Mr. Buffett calls attention to “an inconvenient truth”: management paying a premium to acquire another company while paying for it with its own undervalued stock. Clearly, he is explaining why the BNSF acquisition was partially paid for in BRK stock, while at the same time, he publicly criticized the price that Kraft paid in acquiring Cadbury (part of which was paid in KFT stock). Pages 16-18.

Warren Buffett’s letters to Berkshire Hathaway shareholders going back to 1977 are available here. You can read Michael James’ take here. It is not often that you read columns that are critical of Buffett but there were two recently: David Olive of The Star says Buffett doesn’t practice what he preaches and Ian McGugan calls out what he says are Mr. Buffett’s “minor sins”.

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Asked if even the Oracle of Omaha has learned an investment lesson in all this, Buffett replied: “Well, it’s always a terribly interesting thing obviously to watch… but, the dangers of leverage, the dangers of everybody getting a belief of some huge asset class that can do nothing but go up… you know… the dangers of joining the crowd just because the crowd made money yesterday and the week before… all of those things they just recur throughout history. So, you’ve seen an extreme version in certain aspects of the economy but there is really nothing new”.

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• Buffet acknowledges that we are facing unprecedented economic times and Government did not have an option – it had to take action on a massive scale. If you recall, the intervention came for criticism over bailouts but Buffet reminds us: “Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.”
• He suspects that the intervention will “almost certainly bring on unwelcome aftereffects” with inflation a likely consequence.
• Buffett is optimistic that America will overcome the latest obstacle like it has done many times before. “America’s best days like ahead.”
• He cautions readers from leaping to conclusions about stock market returns based on current economic conditions. “We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.”
• “Beware of geeks bearing formulas”, Buffet often likes to say. The huge losses in mortgage-backed securities are a direct result of investors, rating agencies and Wall Street extrapolating the loss experience of a past housing market with modest price appreciation and negligible speculation to a diametrically different market.
• Buffett calls his purchase of ConocoPhillips when oil and gas prices were at a peak “a major mistake of commission”. Berkshire purchased fixed-income securities in Wrigley, Goldman Sachs and General Electric and sold some of investments in Johnson & Johnson, Proctor & Gamble and ConocoPhilips.
• From underpricing risk, the market has swung completely the other way and is now overpricing it. In fact, Buffett goes as far as calling a bubble in US treasuries and reiterates the point he made in a New York Times Op-ed: “Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.”
• Buffett shows that the Black-Scholes formula for pricing options can produce absurd results if it is applied to extended time periods.

The entire archive of Buffet’s letter to shareholders is available here.

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• Recent price action — Berkshire Hathaway shares have fallen some 23% since the beginning of this month. The report speculated that the fall in BRK price might be due to mounting losses on its derivative contracts. BRK had previously entered into contracts insuring against the default of some junk bonds and had sold put options on some market indicies (i.e. betting that markets will be higher at contract expiry than when the contracts were entered into).
• The cost of insuring BRK’s AAA-rated debt has soared recently.

The reporter didn’t seem to have read the Berkshire Hathaway annual reports. In the 2007 report, Warren Buffet mentioned that he expects the derivative contracts to be profitable on premium revenues alone and noted that investors should be cognizant of the accounting treatment of derivatives:

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

You would think that business reporters would have a stronger case before writing off Buffett but fools continue to rush in where angels fear to tread.

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Buffett losing his touch? Don’t bet on it is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

It is very rare for Mr. Buffett to write an article in a major newspaper or magazine on the level of the stock market. While the timing of his latest piece remains to be seen, the last time he publicly took an opinion on the stock market, his timing was impeccable.

In late 1999, investors were enthusiastically bidding up stocks to sky-high levels. It wasn’t just the dot-coms, which hadn’t earned a dime in their entire existence, going public and fetching multiples of their IPO price. Many blue-chip, growth stocks were trading at unheard of multiples. Mr. Buffett, written off as a fuddy-duddy who didn’t “get” the new economy, wrote this article in Fortune magazine making a strong case for lower equity returns:

Let me summarize what I’ve been saying about the stock market: I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like–anything like–they’ve performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate–repeat, aggregate–would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that’s 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.

He further reminded investors the sorry history of new-fangled industries destroying their wealth:

Move on to failures of airlines. Here’s a list of 129 airlines that in the past 20 years filed for bankruptcy. Continental was smart enough to make that list twice. As of 1992, in fact–though the picture would have improved since then–the money that had been made since the dawn of aviation by all of this country’s airline companies was zero. Absolutely zero.

Sizing all this up, I like to think that if I’d been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough–I owed this to future capitalists–to shoot him down. I mean, Karl Marx couldn’t have done as much damage to capitalists as Orville did.

Within a few short months, the dot-coms bombed and equity markets began a long, slow, painful slide that finally ended in 2002. Surely, investors who read that article would have wished they had taken Mr. Buffett’s advice (I read that column and was stupid enough to buy Yahoo! shortly thereafter). Could this time be any different?

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• Jason Zweig of Money magazine reported on the Q&A from the “Woodstock for Capitalists”.
• Jason Zweig also covered the press conference where Buffett and Munger took questions from print reporters and came away with the highlights.
• Jeff Hull, a financial advisor, covered the annual meeting for The Financial Post. He wrote posts on how Buffett is bullish on Korea, his thoughts on the Canadian dollar, U.S. recession, sub-prime mortgages and the Bear Stearns bailout.
• Forbes carried video footage of snippets of conversation with Buffett.
• Larry MacDonald links to recent additions to Buffettology.

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1. Page 3: Mr. Buffett quotes Wells Fargo’s CEO for describing the sub-prime fiasco: “It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine.”
2. Pages 6 to 8: Mr. Buffett discourses on the qualities he looks for in a business that he buys in full or in part and explains what makes a business great, good or gruesome.
3. Pages 15 to 16: The Chairman explains Berkshire’s investments in public companies and how he evaluates the progress of BRK’s investments (“we evaluate their performance by the two methods we apply to the businesses we own. The first test is improvement in earnings, with our making due allowance for industry conditions. The second test, more subjective, is whether their “moats” – a metaphor for the superiorities they possess that make life difficult for their competitors – have widened during the year.”)
4. Pages 16 to 18: Berkshire has bet on a weak US dollar by taking positions in the Brazilian real.
5. Pages 18 to 20: Mr. Buffett flays Corporate America’s fairy-tale treatment of stock options and explains how management further juices earnings by assuming generous investment return assumptions on their pension plans. These pages are a must-read for estimating the returns of our own portfolios.

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