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Berkshire has worst year; Buffett still optimistic

Saturday, February 28, 2009 | 8:43 p.m. CST; updated 5:49 p.m. CST, Sunday, March 1, 2009

OMAHA, Neb. — Warren Buffett remains optimistic about the prospects for his company and the nation even though Berkshire Hathaway Inc. turned in its worst performance in 2008 and the widely followed investor says the economy will likely remain a mess beyond this year.

Buffett used his annual letter Saturday to reassure shareholders that the Omaha-based insurance and investment company has the financial strength needed to withstand the current turmoil and improve after the worst showing of Buffett's 44 years as chairman and CEO.

Buffett wrote he's certain "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."

In between the news of Berkshire's sharply lower profit and a thorough explanation of its largely unrealized $7.5 billion investment and derivative losses, Buffett offered a hopeful view of the nation's future.

He said America has faced bigger economic challenges in the past, including two World Wars and the Great Depression.

"Though the path has not been smooth, our economic system has worked extraordinarily well over time," Buffett wrote. "It has unleashed human potential as no other system has, and it will continue to do so. America's best days lie ahead."

But what will the market say?

Buffett's letter appeared to mollify the concerns of many who follow the company, but it's not yet clear whether that will help Berkshire's Class A stock extend its rebound from the new five-year low it set last Monday at $73,500. On Friday, it closed up $250 at $78,600.

"If anything, I feel better than I did before I read it," Morningstar analyst Bill Bergman said. Berkshire's results could have easily been worse, he said.

But Buffett estimates Berkshire's book value — assets minus liabilities — declined 9.6 percent to $70,530 per share in 2008 — the biggest drop since he took control of the company in 1965. Berkshire's book value declined only one other time under Buffett, and that was a 6.2 percent drop in 2001 when insurance losses related to the Sept. 11 terrorist attacks hurt results.

Berkshire's Class A shares remain the most expensive U.S. stock, but they fell nearly 32 percent in 2008 and have declined 48 percent since setting a high of $151,650 in December 2007. That high came after an exceptionally profitable quarter that was helped by a $2 billion investment gain.

The S&P 500 fell 37 percent in 2008.

Success in utility and insurance

Within Berkshire, Buffett said the company's retail businesses, including furniture and jewelry stores, and those tied to residential construction, such as Shaw carpet and Acme Brick, were hit hard last year. Net income for those businesses slipped 3 percent to $2.28 billion, and Buffett said they will likely continue to perform below their potential in 2009.

But he said Berkshire's utility and insurance businesses, which includes Geico, both delivered outstanding results in 2008 that helped balance out the other businesses.

The Des Moines, Iowa-based utility division, MidAmerican Energy Holdings, contributed $1.7 billion to Berkshire's net income in 2008 thanks to more than $1 billion in proceeds from MidAmerican's failed takeover of Constellation Energy. That's up from the $1.1 billion utility profit that Berkshire recorded in 2007.

The insurance division, which also includes reinsurance giant General Re, contributed $1.8 billion in earnings from underwriting — a drop of 17 percent from 2007. Buffett praised Geico CEO Tony Nicely's efficiency and his ability to increase Geico's market share to 7.7 percent of the auto insurance market last year.

"As we view Geico's current opportunities, Tony and I feel like two hungry mosquitoes in a nudist camp. Juicy targets are everywhere," Buffett wrote.

Overall, Berkshire's 2008 profit of $4.99 billion, or $3,224 per Class A share, was down 62 percent from $13.21 billion, or $8,548 per share, in 2007.

Berkshire's fourth-quarter numbers were even worse. Buffett's company reported net income of $117 million, or $76 per share, down 96 percent from $2.95 billion, or $1,904 per share, a year earlier.

Losses from derivatives

Buffett devoted nearly five pages of his letter to shareholders to explain the role derivatives played in the company's investment losses last year.

The derivatives Berkshire offers operate similar to insurance policies. Some of them cover whether certain stock market indexes — the S&P 500, the FTSE 100 in the United Kingdom, the Euro Stoxx 50 in Europe and the Nikkei 225 in Japan — will be lower 15 or 20 years in the future. Others cover credit losses at groups of 100 companies, and some cover credit risks of individual companies.

Buffett said he initiated all of Berkshire's 251 different derivative contracts because he thinks they were mispriced in Berkshire's favor.

Analyst Justin Fuller, who works with Midway Capital Research & Management in Chicago, said he thinks the details Buffett offered about Berkshire's derivatives will help.

Fuller said two key things make Berkshire's derivatives different from the complex financial bets of the same name that other companies have used. Berkshire requires most payment upfront, so there's little risk the other party to the derivative will fail to pay. And Berkshire won't take part in derivatives that require the company to post substantial collateral when the value of the contract falls.

"I think laying those out as plainly and simply as he did with examples should calm investors' fears about derivatives," said Fuller.

Berkshire has received $8.1 billion in payments for derivatives, which can be invested until the contracts expire years from now.

Choosing a formula

But Berkshire has to estimate the value of its derivatives every quarter. Buffett said he supports that mark-to-market accounting, but the Black-Scholes formula used to estimate that value tends to overstate Berkshire's liability on long-term contracts.

"Even so, we will continue to use Black-Scholes when we are estimating our financial-statement liability for long-term equity puts. The formula represents conventional wisdom and any substitute that I might offer would engender extreme skepticism," Buffett wrote.

Buffett said he made at least one major investing mistake last year by buying a large amount of ConocoPhillips stock when oil and gas prices were near their peak.

Berkshire increased its stake in ConocoPhillips from 17.5 million shares in 2007 to 84.9 million shares at the end of 2008. Buffett said he didn't anticipate last year's dramatic fall in energy prices, so his decision cost Berkshire shareholders several billion dollars.

Buffett says he also spent $244 million on stock in two Irish banks that appeared cheap. But since then, he's had to write down the value of those purchases to $27 million.

Not counting on 'the kindness of strangers'

But Buffett also had several investing successes in 2008.

Berkshire committed $14.5 billion to fixed income investments in Goldman Sachs Group Inc. and General Electric Co. Those investments carry high interest rates and give Berkshire the option to acquire stock in those companies.

To fund those investments, Buffett said he had to sell some of Berkshire's holdings in Johnson & Johnson, Procter & Gamble Co. and ConocoPhillips even though he would have rather kept that stock.

"However, I have pledged — to you, the rating agencies and myself — to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow's obligations," Buffett said.

In that regard, Berkshire should be OK because the company finished 2008 with $24.3 billion cash on hand. That's down significantly from the $37.7 billion the company held at the end of 2007, reflecting the investments Buffett made during the year.

Berkshire owns a diverse mix of more than 60 companies, including insurance, furniture, carpet, jewelry, restaurants and utility businesses. And it has major investments in such companies as Wells Fargo & Co. and Coca-Cola Co.

 


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