Warren Buffett published the 2003 Berkshire Hathaway Annual Report over the weekend. BRK certainly has an awesome year in 2003, with 90% jump in earnings and 21% increase in book value, the latter a good proxy of the intrinsic value that Buffett prefers to evaluate the company.
His trademark Chairman Letter is also a great read. Here are some of my takings. Apparently the Oracle of Omaha, sitting on a cash pile of $36 billion, does not find the current stock market anything attractive.
On Operating Earnings
When valuations are similar, we strongly prefer owning businesses to owning stocks. During most of our years of operation, however, stocks were much the cheaper choice. We therefore sharply tilted our asset allocation in those years toward equities, as illustrated by the percentages cited earlier.
In recent years, however, we’ve found it hard to find significantly undervalued stocks, a difficulty greatly accentuated by the mushrooming of the funds we must deploy. Today, the number of stocks that can be purchased in large enough quantities to move the performance needle at Berkshire is a small fraction of the number that existed a decade ago. (Investment managers often profit far more from piling up assets than from handling those assets well. So when one tells you that increased funds won’t hurt his investment performance, step back: His nose is about to grow.)
The shortage of attractively-priced stocks in which we can put large sums doesn’t bother us, providing we can find companies to purchase that (1) have favorable and enduring economic characteristics; (2) are run by talented and honest managers and (3) are available at a sensible price. We have purchased a number of such businesses in recent years, though not enough to fully employ the gusher of cash that has come our way. In buying businesses, I’ve made some terrible mistakes, both of commission and omission. Overall, however, our acquisitions have led to decent gains in per-share earnings.
On Corporate Governance
It’s understandable how pay got out of hand. When management hires employees, or when companies bargain with a vendor, the intensity of interest is equal on both sides of the table. One party’s gain is the other party’s loss, and the money involved has real meaning to both. The result is an honest-to-
But when CEOs (or their representatives) have met with compensation committees, too often one side – the CEO’s – has cared far more than the other about what bargain is struck. A CEO, for example, will always regard the difference between receiving options for 100,000 shares or for 500,000 as
monumental. To a comp committee, however, the difference may seem unimportant – particularly if, as has been the case at most companies, neither grant will have any effect on reported earnings. Under these
conditions, the negotiation often has a “play-money” quality.
Let me make a small suggestion to “independent” mutual fund directors. Why not simply affirm in each annual report that “(1) We have looked at other management companies and believe the one we have retained for the upcoming year is among the better operations in the field; and (2) we have negotiated a fee with our managers comparable to what other clients with equivalent funds would negotiate.”
On Berkshire Governance
We now have eleven directors and each of them, combined with members of their families, owns more than $4 million of Berkshire stock. Moreover, all have held major stakes in Berkshire for many years.
The bottom line for our directors: You win, they win big; you lose, they lose big. Our approach might be called owner-capitalism. We know of no better way to engender true independence. (This structure does not guarantee perfect behavior, however: I’ve sat on boards of companies in which Berkshire
had huge stakes and remained silent as questionable proposals were rubber-stamped.)
The primary job of our directors is to select my successor, either upon my death or disability, or when I begin to lose my marbles.
Our board knows that the ultimate scorecard on its performance will be determined by the record of my successor. He or she will need to maintain Berkshire’s culture, allocate capital and keep a group of America’s best managers happy in their jobs. This isn’t the toughest task in the world – the train is already moving at a good clip down the track – and I’m totally comfortable about it being done well by any of the four candidates we have identified. I have more than 99% of my net worth in Berkshire and will be happy to have my wife or foundation (depending on the order in which she and I die) continue this concentration.
On Finance and Financial Products
If our derivatives experience – and the Freddie Mac shenanigans of mind-blowing size and audacity that were revealed last year – makes you suspicious of accounting in this arena, consider yourself wised up. No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In Darwin’s words,
“Ignorance more frequently begets confidence than does knowledge.”
You may wonder why we borrow money while sitting on a mountain of cash. It’s because of our “every tub on its own bottom” philosophy. We believe that any subsidiary lending money should pay an appropriate rate for the funds needed to carry its receivables and should not be subsidized by its parent. Otherwise, having a rich daddy can lead to sloppy decisions. Meanwhile, the cash we accumulate at Berkshire is destined for business acquisitions or for the purchase of securities that offer opportunities for significant profit. Clayton’s loan portfolio will likely grow to at least $5 billion in not too many years and, with sensible credit standards in place, should deliver significant earnings.