As Berkshire Returns to Form, Buffett Blasts Wall Street
Buffett's outlook is certainly more positive than it was a year ago -- for good reason. During 2009, the company notched its best performance since 2003. Shareholder book value increased 19.8% after falling 9.8% in 2008. Berkshire's 2009 performance slightly trailed the S&P 500, however, but over the entire financial meltdown the company outperformed that index thanks to a comparatively small 2008 loss.
Blasting Wall Street
Buffett's letter was a mix of lively -- and occasionally pungent -- investment philosophy, contrition over Berkshire's missteps, and condemnation of those Buffett sees as bad actors on the financial stage. In particular, he criticized Wall Street executives and board-members for failing to control risk and then avoiding what he said should have been "severe" consequences. Without naming names, he castigated Wall Street honchos for engineering their own industry's doom and then shoveling the losses onto investors, all while maintaining lavish lifestyles.
"It has not been shareholders who have botched the operations of some of our country's largest financial institutions," Buffett wrote. "Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been 'bailed-out' is to make a mockery of the term."
"The CEOs and directors of the failed companies, however, have largely gone unscathed," Buffett continued. "Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price – one not reimbursable by the companies they've damaged nor by insurance."
Getting Back to Basics: Core Investment Principles
As usual, Buffett reiterated the core investment philosophy that has made him an investing legend, along with longtime partner Charlie Munger: invest in easy-to-understand companies run by honest and talented managers at a good price. Then, nurture those companies and investments over the long-term.
"Charlie and I avoid businesses whose futures we can't evaluate, no matter how exciting their products may be," Buffett wrote. "At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable."
In a not-so-subtle dig at profligate Wall Street firms that gambled on risky mortgage-based bets and then begged the federal government to save them, Buffett said Berkshire would never rely on taxpayers – or anyone else – for salvation. He has long decried excessive leverage as little more than irresponsible gambling that puts the entire enterprise at risk.
"We will never become dependent on the kindness of strangers," Buffett wrote. "Too-big-to-fail is not a fallback position at Berkshire. Instead, we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity."
Providing, Not Asking, for Aid
To prove his point, Buffett noted that instead of asking for help during the financial crisis, Berkshire actually dispensed aid to others in need -- thereby allowing the company to snap up bargain stakes in Goldman Sachs, GE and Harley Davidson.
"When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity and capital to the system, not a supplicant," Buffett wrote. "At the very peak of the crisis, we poured $15.5 billion into a business world that could otherwise look only to the federal government for help."
Buffett wholeheartedly rejected the short-term investment posture that leads many companies and shareholders to live from one quarter to the next, trading on earnings results and forecasts. "We make no attempt to woo Wall Street," he wrote.
And he offered a warning he's given increasingly in recent years: Don't expect Berkshire to repeat its stunning past performance. As the company has grown it has lost the some of the advantage it had as a smaller, more nimble company, he said.
"The big minus is that our performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain to continue," Buffett wrote, adding that "huge sums forge their own anchor and our future advantage, if any, will be a small fraction of our historical edge."
Taking the Blame for Major Missteps
Going forward, Buffett wrote, "we will make plenty of mistakes" -- and in his letter, he took clear blame for two major missteps. He called the performance of NetJets, the company's prized fractional ownership jet unit "the major problem for Berkshire last year." Buffett has been fond of Netjets, which he, his family, and company board members use frequently.
"In the eleven years that we have owned the company, it has recorded an aggregate pre-tax loss of $157 million," Buffett wrote. "Moreover, the company's debt has soared from $102 million at the time of purchase to $1.9 billion in April of last year. Without Berkshire's guarantee of this debt, NetJets would have been out of business. It's clear that I failed you in letting NetJets descend into this condition."
In a characteristic display of humor, Buffett said he had been "bailed out" by David L. Sokol, the Berkshire star who took over as CEO of NetJets last year. "Debt has already been reduced to $1.4 billion, and, after suffering a staggering loss of $711 million in 2009, the company is now solidly profitable," Buffett wrote. He described Sokol's leadership as "transforming."
Buffett was also blunt in blaming himself for last year's failed experiment to introduce credit cards to Geico customers. "Last year your chairman closed the book on a very expensive business fiasco entirely of his own making," he said. Buffett had thought that Geico policyholders "were likely to be good credit risks." But top managers warned him that "instead of getting the cream of GEICO's customers we would get the – – – – – well, let's call it the non-cream."
Buffett says he "subtly indicated that I was older and wiser." Turns out, he wrote, "I was just older." Berkshire lost over $50 million on the experiment.
Dealing With the Dangers of Financial Derivatives
Buffett also addressed a topic that has been a growing source of controversy for the company – its use of derivatives, the complex financial products that caused so much havoc during the financial meltdown. Buffett has famously called such products "financial weapons of mass destruction." How then to explain Berkshire's use of them? Lack of irresponsible leverage, for starters.
"The dangers that derivatives pose for both participants and society – dangers of which we've long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme," Buffett explained. "At Berkshire nothing like that has occurred – nor will it. It's my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It's simply too important."
"At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as MidAmerican, and the minor runoff contracts at General Re," Buffett wrote. "If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer."
Who Will Be Buffett's Successor?
As always, Buffett offered little guidance on his possible successor. (He has famously said that he has the name of his successor in a sealed envelope in his office. He's also made it clear that he'll most likely be followed by two managers – one to run Berkshire's operating businesses and the other to run the investment portfolio.)
One possible hint came in Buffett's glowing mention of Ajit Jain, the Berkshire superstar who runs the National Indemnity business. "If Charlie, I and Ajit are ever in a sinking boat – and you can only save one of us – swim to Ajit," he wrote. Buffett also praised Sokol, the intense chief of major Berskshire subsidiary MidAmerican Energy and recently-installed CEO of NetJets, who is also considered one of the top succession candidates.
But as usual, the Oracle of Omaha insists that he "skips to work every morning." Berkshire's annual meeting – often called the "Woodstock of capitalism" – will take place on May 1 in Omaha, Nebraska, where the company is headquartered.