Berkshire Hathaway Inc. 2012 Shareholder Letter

Berkshire Hathaway Inc. 2012 Shareholder Letter: Briefing Document

Source: Excerpts from Warren Buffett's 2012 Letter to the Shareholders of Berkshire Hathaway Inc.

Key Themes:

• Berkshire's Strong Long-Term Performance: The letter emphasizes Berkshire's consistent outperformance of the S&P 500 over the long run, despite occasional periods of underperformance.

• Intrinsic Value as the Guiding Principle: Buffett reiterates that Berkshire's primary goal is to increase intrinsic business value per share, using book value as a significantly understated proxy.

• The Power of Berkshire's Diverse Businesses: The letter provides detailed updates on the performance and strategic importance of Berkshire's four major sectors: Insurance, Regulated Capital-Intensive Businesses (BNSF and MidAmerican Energy), Manufacturing, Service and Retailing, and Finance and Financial Products.

• Disciplined Capital Allocation: Buffett discusses Berkshire's approach to reinvesting in existing businesses, making bolt-on and large acquisitions (highlighting the Heinz deal announced in early 2013), repurchasing shares when significantly undervalued, and generally avoiding the issuance of Berkshire stock.

• The Debate on Dividends: Buffett presents a detailed argument against Berkshire paying dividends, favoring reinvestment and share repurchases when appropriate, and highlighting the tax disadvantages of dividends for shareholders compared to selling off a small portion of their holdings.

• Optimism for American Business: Despite acknowledging short-term uncertainties, Buffett expresses strong long-term confidence in the prospects of American business and the stock market.

• Emphasis on Management Quality: The letter consistently praises the talented and shareholder-oriented managers of Berkshire's subsidiaries and investment holdings as a key driver of the company's success.

• The Unique Culture of Berkshire Hathaway: The letter provides glimpses into the company's culture, including its lean corporate office, the importance of integrity, and the shareholder-focused mindset.

Most Important Ideas and Facts:

1. Berkshire's Performance:

• Long-Term Outperformance: From 1965 to 2012, Berkshire's per-share book value compounded annually at 19.7%, significantly outperforming the S&P 500's 9.4% (with dividends included). The overall gain over this period was 586,817% for Berkshire compared to 7,433% for the S&P 500.

• Recent Underperformance: The S&P 500 had outperformed Berkshire in the previous four years (2009-2012), potentially ending Berkshire's streak of never having a five-year period of underperformance. Buffett notes, "But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five-year wins will end."

• Focus on Intrinsic Value: Buffett emphasizes that long-term share price performance will follow intrinsic value growth: "It’s our job to increase intrinsic business value – for which we use book value as a significantly understated proxy – at a faster rate than the market gains of the S&P. If we do so, Berkshire’s share price, though unpredictable from year to year, will itself outpace the S&P over time."

2. Capital Allocation and Acquisitions:

• Missed Major Acquisition in 2012: Buffett expresses disappointment in not making a "major acquisition" in 2012, stating, "The second disappointment in 2012 was my inability to make a major acquisition. I pursued a couple of elephants, but came up empty-handed."

• Significant Heinz Acquisition Post-Year-End: The letter announces the agreement in early 2013 to acquire 50% of a holding company that will own H. J. Heinz, in partnership with Jorge Paulo Lemann's group. Berkshire will invest approximately $12 billion in the deal, including preferred shares with a 9% dividend and warrants.

• Record "Bolt-On" Acquisitions: Berkshire's subsidiaries completed a record $2.3 billion in "bolt-on" acquisitions in 2012, integrated into existing businesses without issuing Berkshire shares. Buffett remarks, "We had a record year for ‘bolt-on’ purchases, spending about $2.3 billion for 26 companies that were melded into our existing businesses. These transactions were completed without Berkshire issuing any shares."

3. Performance of Key Business Segments:

• Insurance Powerhouse: Berkshire's insurance operations had an exceptional year, generating a $1.6 billion underwriting profit (the tenth consecutive year of profitability) and $73 billion in float (free money to invest). Buffett states, "Our insurance operations shot the lights out last year. While giving Berkshire $73 billion of free money to invest, they also delivered a $1.6 billion underwriting gain, the tenth consecutive year of profitable underwriting. This is truly having your cake and eating it too."

• GEICO's Growth: GEICO continues to gain market share in the personal auto insurance market, growing from 2.5% in 1995 to 9.7% in 2012.

• BNSF and MidAmerican Energy: These regulated, capital-intensive businesses are crucial to the American economy. BNSF carries about 15% of all inter-city freight (by ton-miles) and is investing heavily in its infrastructure. MidAmerican Energy is a leader in renewable energy, owning a significant portion of the country's wind and soon-to-be solar generation capacity.

• Manufacturing, Service and Retailing: This diverse group of businesses earned a strong 16.3% after-tax return on net tangible assets. Buffett acknowledges some past capital allocation mistakes in this segment.

• Finance and Financial Products: Clayton Homes, CORT, and XTRA performed well, with Clayton becoming the largest homebuilder in the U.S.

4. Investments:

• Large Equity Holdings: The letter lists Berkshire's major common stock investments with market values exceeding $1 billion, including American Express, Coca-Cola, IBM, and Wells Fargo.

• New Investment Management Talent: Todd Combs and Ted Weschler, Berkshire's investment managers, both outperformed the S&P 500 by double-digit margins in 2012. The letter notes the inclusion of their combined holdings in the list of major investments, with DIRECTV being the first such stock. "In 2012 each outperformed the S&P 500 by double-digit margins. They left me in..." (referring to their investment acumen).

5. Derivatives:

• Winding Down Insurance-Like Derivatives: Berkshire continues to reduce its portfolio of derivatives that assumed insurance-like risks.

• Profitable Credit Default Swaps: The credit protection contracts on corporate bonds are expected to yield a pre-tax profit of approximately $1 billion.

• Long-Term Stock Index Puts: Berkshire holds long-term put options on major stock indices, with a significant decrease in the immediate settlement liability in 2012. Buffett believes the final liability will likely be less than the current book value.

6. Newspapers:

• Acquisition of 28 Daily Newspapers: Despite the industry's challenges, Berkshire acquired a significant number of local newspapers, believing that those providing comprehensive local news and having a sensible internet strategy can remain viable. "During the past fifteen months, we acquired 28 daily newspapers at a cost of $344 million. This may puzzle you for two reasons. First, I have long told you in these letters and at our annual meetings that the circulation, advertising and profits of the newspaper industry overall are certain to decline. That prediction still holds."

• Importance of Local News and Pay Models: Buffett emphasizes the continued relevance of local news and the need for newspapers to find successful internet pay models, citing the Arkansas Democrat-Gazette as an early adopter.

7. Dividends vs. Share Repurchases:

• Argument Against Dividends: Buffett presents a detailed mathematical and philosophical argument against Berkshire paying dividends, favoring reinvestment in high-return opportunities and share repurchases when the stock is significantly undervalued. He highlights the tax inefficiency of dividends compared to shareholders selling a small portion of their stock.

• Share Repurchase Policy: Berkshire will repurchase its shares when they trade at a meaningful discount to intrinsic value, with a current limit of 120% of book value. "Indeed, disciplined repurchases are the surest way to use funds intelligently: It’s hard to go wrong when you’re buying dollar bills for 80¢ or less."

8. Optimism for the Future:

• Confidence in American Business: Buffett remains highly optimistic about the long-term future of American business and the stock market, despite short-term uncertainties. "American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance."

• Call to Action for CEOs: Buffett encourages CEOs with large, profitable projects to contact Berkshire if short-term worries are causing them to delay investment. "If you are a CEO who has some large, profitable project you are shelving because of short-term worries, call Berkshire. Let us unburden you."

9. Berkshire's Shareholder Meeting:

• Annual Event Highlights: The letter provides details about the upcoming annual meeting, including shopping opportunities with Berkshire subsidiaries, the Berkshire 5K race, and special events at Borsheims and local restaurants.

• Analyst Panel: The analyst panel at the meeting will include experts on insurance and non-insurance operations, and Berkshire is seeking a credentialed "bear" on the company to join the panel.

Quotes:

• "It’s our job to increase intrinsic business value – for which we use book value as a significantly understated proxy – at a faster rate than the market gains of the S&P."

• "Our insurance operations shot the lights out last year. While giving Berkshire $73 billion of free money to invest, they also delivered a $1.6 billion underwriting gain, the tenth consecutive year of profitable underwriting. This is truly having your cake and eating it too."

• "We had a record year for ‘bolt-on’ purchases, spending about $2.3 billion for 26 companies that were melded into our existing businesses. These transactions were completed without Berkshire issuing any shares."

• "During the past fifteen months, we acquired 28 daily newspapers at a cost of $344 million. This may puzzle you for two reasons. First, I have long told you in these letters and at our annual meetings that the circulation, advertising and profits of the newspaper industry overall are certain to decline. That prediction still holds."

• "Indeed, disciplined repurchases are the surest way to use funds intelligently: It’s hard to go wrong when you’re buying dollar bills for 80¢ or less."

• "American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance."

This letter provides valuable insights into Warren Buffett's investment philosophy, Berkshire Hathaway's operational performance, and his outlook for the future. The emphasis remains on long-term value creation, disciplined capital allocation, and investing in high-quality businesses with excellent management.