Berkshire Hathaway 2005 Shareholder Letter: Briefing Document
Source: Excerpts from the Berkshire Hathaway 2005 Shareholder Letter
Purpose of the Letter: To provide Berkshire Hathaway shareholders with a review of the company's 2005 performance, discuss key business segments, acquisitions, investment strategies, management philosophy, and address important issues like intrinsic value, executive compensation, and risk management. The letter also serves as an invitation to the annual shareholder meeting.
Main Themes and Important Ideas/Facts:
1. Strong Long-Term Performance, Decent 2005:
Berkshire's per-share book value increased by 6.4% in 2005.
Over the 41 years since present management took over (1965-2005), book value has grown from $19 to $59,377, a compound annual growth rate of 21.5%.
While 2005 was a "decent year," it was significantly impacted by Hurricane Katrina, which cost Berkshire an estimated $2.5 billion, with Hurricanes Rita and Wilma adding another $0.9 billion in losses.
Despite the hurricane losses, the insurance business overall performed well, particularly GEICO, which saw a remarkable 32% improvement in productivity in just two years. Buffett lauded GEICO's CEO, Tony Nicely, stating, "One statistic stands out: In just two years, GEICO improved its productivity by 32%. Remarkably, employment fell by 4% even as policy count grew by 26% – and more gains are in store."
2. Intrinsic Value and Business Diversification:
Buffett emphasizes the importance of estimating Berkshire's intrinsic value, acknowledging that it is "necessarily imprecise and often seriously wrong."
He notes that Berkshire's wide variety of relatively stable earnings streams, strong liquidity, and minimal debt make its intrinsic value more precisely calculable than that of most companies.
The increasing diversification of Berkshire, now owning 68 distinct businesses, makes a simple examination of consolidated financial statements insufficient for estimating intrinsic value.
Berkshire clusters its businesses into four logical groups for discussion in the report: Insurance, Regulated Utility Business, Finance and Financial Products, and Manufacturing, Service and Retailing Operations.
Buffett raises the question of whether Berkshire's ownership adds value compared to shareholders directly owning shares in each of its businesses.
3. Strategic Acquisitions for Future Growth:
Organic growth of current businesses is expected to be modest; major acquisitions are necessary for truly satisfactory gains.
2005 was an "encouraging" year for acquisitions, with agreements to purchase five companies (two closed in 2005, one after year-end, and two expected to close soon).
Crucially, none of the deals involved the issuance of Berkshire shares, a point Buffett stresses because "When a management proudly acquires another company for stock, the shareholders of the acquirer are concurrently selling part of their interest in everything they own."
Key acquisitions in 2005 included:
Medical Protective Company (MedPro): A medical malpractice insurer. Buffett highlighted their underwriting discipline and financial strength.
Forest River: A recreational vehicle manufacturer. Buffett praised the entrepreneurship of its owner, Pete Liegl.
Business Wire: A press release distribution service. Buffett was impressed by the company's efficient operations and technological focus, quoting President Cathy Baron Tamraz: "We run a tight ship and keep unnecessary spending under wraps. No secretaries or management layers here. Yet we’ll invest big dollars to gain a technological advantage and move the business forward."
Applied Underwriters: Offers payroll services and workers' compensation insurance to small businesses. Buffett noted their operational base in Omaha as a "brilliant insight."
PacifiCorp (through MidAmerican Energy): A major electric utility serving six Western states. Buffett states that while regulated utilities don't offer outsized profits, they allow for the deployment of large sums at fair returns, making them "good sense for Berkshire."
Berkshire also continues to make "bolt-on" acquisitions within its existing subsidiaries.
Unlike many buyers, Berkshire has no "exit strategy"; they "buy to keep." Their "entrance strategy" focuses on businesses meeting six criteria and available at a reasonable return.
4. The Importance of "Float" in the Insurance Business:
"Float" is defined as money that doesn't belong to Berkshire but is temporarily held (primarily from premiums paid upfront and the time lag in settling claims).
Berkshire's float has grown from $20 million in 1967 to $49 billion in 2005 through internal growth and acquisitions.
Float is "wonderful if it doesn't come at a high price," with its cost determined by underwriting results. An underwriting profit makes float better than free.
Despite the $3.4 billion in hurricane losses in 2005, Berkshire's float was costless due to strong performance in other insurance activities, particularly GEICO.
5. Challenges and Opportunities in Specific Business Segments:
GEICO: Achieved significant market share gains in auto insurance due to its low-cost structure and effective advertising. Buffett believes their brand strength has grown significantly.
Reinsurance (General Re and National Indemnity): Faced significant hurricane losses. Buffett discusses the uncertainty surrounding the frequency and intensity of future mega-catastrophes, leading to a more cautious approach to writing such policies at higher prices. He invokes Pascal's wager in this context.
Other Primary Insurers: Delivered outstanding underwriting profits in 2005, though MedPro's loss reserves were increased upon acquisition.
Regulated Utility Business (MidAmerican Energy): The repeal of PUHCA allowed Berkshire to consolidate MidAmerican's financials. The acquisition of PacifiCorp will significantly expand its customer base and assets. Buffett emphasizes the stable and diversified earnings of MidAmerican, making its debt "unquestionably secure."
Finance and Financial Products (Clayton Homes): Performed strongly despite a disappointing manufactured-housing market. Clayton has become a preeminent player by acquiring loan portfolios. Buffett details the financing arrangement between Berkshire and Clayton.
Derivatives at Gen Re Securities: Buffett expresses significant regret over the continued losses in this operation and his delay in shutting it down. He uses this as a cautionary tale for managers, auditors, and regulators regarding the dangers of complex and long-dated derivative contracts. He states, "The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation." He warns about the mushrooming number and value of global derivative contracts.
Manufacturing, Service and Retailing Operations: This diverse group achieved a respectable 22.2% return on average tangible net worth with minor financial leverage. Rising raw material and energy costs are a challenge, but strong business franchises and management have allowed for respectable results. Highlights include strong performance at Fruit of the Loom, Ben Bridge, and R. C. Willey. NetJets' U.S. operation experienced a significant dip into the red due to falling efficiency and soaring costs, which Buffett believes Rich Santulli will resolve without compromising quality. See's Candies saw a leadership transition from the long-tenured and highly successful Chuck Huggins to Brad Kinstler.
6. "Widening the Moat" - Sustaining Competitive Advantages:
Buffett reiterates the crucial concept of "widening the moat" around Berkshire's businesses, meaning strengthening their long-term competitive positions through delighting customers, eliminating unnecessary costs, and improving products and services.
He emphasizes that long-term moat-widening must take precedence over short-term earnings targets. He cites the auto and airline industries as examples of the consequences of prioritizing short-term gains over building sustainable competitive advantages.
7. Investment Portfolio and Views on Market Returns:
Berkshire's common stock investments are detailed, with major holdings in companies like American Express, Coca-Cola, Moody's, Procter & Gamble, and Wells Fargo.
Buffett does not expect "miracles" from the equity portfolio, as these are not bargain-priced stocks. He anticipates aggregate per-share earnings growth of 6-8% per year over the next decade.
The P&G-Gillette merger resulted in a $5.0 billion pre-tax capital gain for Berkshire, which Buffett deems a "meaningless" bookkeeping entry from an economic standpoint.
He highlights the importance of CEO quality, praising Jim Kilts' impact at Gillette.
Buffett criticizes the often-ridiculous misalignment of executive compensation with performance in the U.S., where mediocre CEOs can receive excessive rewards through poorly designed compensation arrangements like fixed-price options. He explains how such options can enrich CEOs even if the underlying business stagnates or declines. He advocates for boards to design options that account for retained earnings.
He also criticizes the "slaves to comparative data" mentality in compensation committees, leading to a perpetual upward ratcheting of executive pay and perks.
8. Concerns about Trade Imbalances:
Buffett's long-standing concerns about America's trade imbalances remain unchanged, costing Berkshire $955 million pre-tax in 2005 due to currency positions.
He explains the accounting treatment of long-term stock/bond positions versus currency positions.
Berkshire has partially shifted its non-dollar exposure from direct currency holdings to equities of multinational companies due to negative "carry" associated with holding most foreign currencies as U.S. interest rates have risen.
He believes the underlying factors affecting the U.S. current account deficit are worsening and that the situation, while currently benign, is unlikely to remain so indefinitely.
9. The Detrimental Impact of Excessive "Helpers" on Investment Returns:
Buffett argues that shareholders are significantly reducing their investment returns through excessive "frictional" costs incurred by a swelling army of "Helpers" in the financial industry (brokers, managers, consultants, hyper-helpers like hedge funds and private equity).
He uses the analogy of the "Gotrocks" family to illustrate how increased trading and the layers of fees paid to these helpers diminish the overall returns for owners of businesses.
He satirizes the contingent profit arrangements that disproportionately reward helpers for gains while leaving owners to bear the losses and fixed fees.
Buffett concludes that for investors as a whole, "returns decrease as motion increases." He provides a long-term example of the Dow's historical growth and the improbable rise required in the 21st century to match it, noting the Dow has gained nothing in the first six years.
10. Debt Management and Risk Aversion at Berkshire:
Despite the consolidation of MidAmerican's debt, Buffett emphasizes that Berkshire itself largely "shun[s] debt," using it only for specific purposes like short-term repos, financing predictable receivables (like Clayton's), and the debt residing solely within MidAmerican.
He stresses that MidAmerican's debt is secure due to its diversified and stable utility earnings.
Berkshire's aversion to significant debt at the parent level is driven by a commitment to the total security of its investors and insurance policyholders, even in the face of extreme economic or catastrophic events. He uses the powerful analogy: "a long string of impressive numbers multiplied by a single zero always equals zero."
11. Management Succession Planning:
Buffett addresses shareholder concerns about management succession.
He assures shareholders that Berkshire's businesses have strong momentum and excellent managers and will not miss a beat upon his death.
Berkshire has three "reasonably young and fully capable" CEO candidates, with the board unanimously agreeing on the successor if needed immediately.
The board regularly reviews the succession plan.
Buffett emphasizes the board's responsibility to make a change if his abilities decline due to age, even if he is delusional about his capabilities. He believes the board's financial alignment with shareholders provides strong motivation to act in their best interests.
He expresses confidence in the current board and his own current excellent health.
12. Invitation to the Annual Meeting:
Details of the 2006 Annual Meeting in Omaha are provided, including the date (Saturday, May 6th), time, and location.
Information about the Berkshire movie, Q&A session, and formal meeting are included.
The letter highlights the extensive shopping opportunities featuring products from Berkshire subsidiaries and the record sales achieved in the previous year.
Special events for shareholders at Nebraska Furniture Mart, Borsheim's, and Gorat's steakhouse are detailed, including special pricing and receptions.
Information on obtaining meeting credentials and making travel arrangements is provided.
Buffett and Munger express their enthusiasm for the annual meeting, calling it their "annual Woodstock for Capitalists."
Conclusion:
The 2005 Shareholder Letter provides a comprehensive overview of Berkshire Hathaway's performance and strategic thinking. While acknowledging the impact of significant hurricane losses, Buffett highlights the underlying strength of many of Berkshire's diverse businesses, particularly GEICO. He emphasizes the importance of strategic acquisitions, the unique advantages of Berkshire's insurance "float," and the critical focus on widening the moats of its businesses. The letter also delves into Buffett's strong opinions on intrinsic value, the flaws in executive compensation practices, the risks of excessive financial activity and derivatives, his continued concerns about trade imbalances, and the paramount importance of risk management and a robust management succession plan. As always, the letter is filled with insightful commentary, memorable analogies, and Buffett's characteristic blend of business acumen and folksy wisdom, inviting shareholders to engage with the company's long-term vision.
Share this post