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Refreshingly, in his address to shareholders, Buffett immediately comes clean and takes responsibility for the disappointing year.
One glaring absentee is Walt Disney (NYSE: DIS). At the end of 1998, Berkshire had $1.5b of Disney stock. No mention is made of Disney at all in this year's report. Has Buffett fallen out with Mickey Mouse? It looks to be the case. Indeed, it's decidedly odd that the disposal of Disney is not remarked upon, as Buffett implies nothing too dramatic happened ("We made few portfolio changes in 1999") within the portfolio. His biggest winner in 1999 was American Express (NYSE: AXP), gaining 62% in the year. So who said Buffett was toast? Interestingly, the stock prices of the companies owned are "just not that attractive" for any further purchases at present.
After awarding himself a grade D performance, Buffett awards most of his operating managers a grade A after their 1999 performance. Reading between the lines, it appears Buffett is unhappy with the management performance at General Re. After the huge and "aberrational" underwriting loss, with another unsatisfactory year expected, he's altered the management incentive structure. Now pay packets at General Re are directly tied to the variables of float growth and the cost of float, the same variables that "determine value for the owners". Buffett is, of course, a big fan of owner-orientated management.
Whereas a typical chairman's annual statement is more akin to a public relations exercise, where even the most mediocre of accomplishments can be awarded a very complimentary interpretation, Buffett is renowned for his honest, straightforward and amusing remarks on the performance of Berkshire Hathaway. Not only does he present Berkshire shareholders the annual story in the no-nonsense manner that he would expect to receive were he a "passive" co-owner of the business, but he also throws in the odd bit of investment guidance and opinion as well. Obviously, with Buffett worth countless billions, the value of which was accumulated solely through stock market investment, it pays to take notice of what he writes.
I suspect this year's offering from Buffett was even more keenly anticipated than usual by those that follow the great man's actions. Why? Because believe it or not, Berkshire Hathaway was expected to report that 1999 was a year of underperformance. Prior to the publishing of the results, the well documented declines in the value of Berkshire's investments in Coca-Cola (NYSE: KO.) and Gillette (NYSE: G.) were probably the most high-profile indication of Berkshire's poor achievements. Numerous financial pundits remarking on Buffett's lack of exposure to the booming US "technology" sector didn't help much either.
The S&P 500 index increased 20% last year, and it was easy for all to see that Buffett's equity investments were being left behind. But, throughout 1999, the dismal operating performance within the General Re reinsurance subsidiary, I think, created more concern for the long-term Berkshire shareholders. I won't try to analyse and then venture an opinion on the results. Instead, I'll concentrate mainly on the equity investments and Buffett's words of wisdom, rather than looking in-depth at the myriad of operating figures.
Common Stock Investments
"Even Inspector Clouseau could find last year's guilty party: your Chairman... My grade for 1999 most assuredly is a D. What most hurt us during the year was the inferior performance of Berkshire's equity portfolio, and responsibility for that... is entirely mine."
How often do you get that sort of admission in an annual report?
It's interesting to note Berkshire's common stock investments, at the end of last year.
Company Cost Market Value
31/12/99
($m) ($m)
American Express (NYSE: AXP) 1,470 8,402
Coca-Cola (NYSE: KO.) 1,299 11,650
Freddie Mac (NYSE: FRE) 294 2,803
Gillette (NYSE: G.) 600 3,954
Washington Post (NYSE: WPO) 11 960
Wells Fargo (NYSE: WFC) 349 2,391
Other 4,180 6,848
Total 8,203 37,008
And unsurprisingly, no mention of the preferred Microsoft (Nasdaq: MSFT) stock bought last year either. It would have been very interesting to know the underlying reasoning and valuation techniques applied to this purchase. Especially when Buffett subsequently takes the opportunity to slate the "tech" stock phenomenon.
It's worth noting the comparable total cost and market values from 1998. Investments costing $7,044m had a market value of $37,265m at the end of that year. So, during 1999, Buffett invested a further $1,159m but the overall market value of the portfolio decreased by £257m. In fact, Buffett admitted in last year's annual report that he would have done better if he had "snuck off to the movies during market hours". I suspect he wishes he had snuck off in 1999.
On the regrettable common stock performance of late, touching upon tech companies as well, Buffet declared: "Several of our largest investees badly lagged the market in 1999 because they've had disappointing operating results. We still like these businesses and are content to have major investments in them. But their stumbles damaged our performance last year, and it's no sure thing that they will quickly regain their stride. Nevertheless, we believe these companies have important competitive advantages that will endure over time. This attribute... makes for good long-term investment results... Our problem is that we have no insights into which participants in the tech field possess a truly durable competitive advantage."
Three important words there, for the long-term investor seeking long-term companies, right at the end of that paragraph: "durable competitive advantage". Nothing here about how fast an industry is growing, or how it will change people's lives. What counts for Buffett is that an investor can identify how a company can protect and sustain its future profits.
The familiar "circle of competence" theme gets a mention too, with Buffett adding "Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. We just stick with what we understand." This leads on to tech stocks. These companies, and their investors, receive a few sideswipes in the report. "Equity investors currently seem wildly optimistic in their expectations about future returns", Buffett cautions, referring his shareholders to a Fortune interview from last year. "The S&P will do far less well in the next decade or two than it has done since 1982... this is inevitable", he warns.
But with equity prices at a current unappealing level, Buffett will bide his time. "Berkshire will someday have opportunities to deploy major amounts of cash in equity markets -- we are confident of that," he states, adding: "Meanwhile, if anyone starts explaining to you what is going on in the truly manic portions of this 'enchanted' market, you might remember another line of song: 'Fools give you reasons, wise men never try.'" The next time you hear "new paradigm of investment", beware!
Insurance And Buybacks
And again, Buffett mentions the key investment attribute when discussing GEICO, the motor insurance subsidiary, to reassure his long-term investors. "We believe that our costs of new business is well below that of the industry. Our operating costs for renewal business are the lowest among auto insurers. Both of these major competitive advantages are sustainable. Others may copy our model, but they will be unable to replicate our economies."
Stressing that you have sustainable competitive advantages is incredibly encouraging for shareholders, especially when the business operates in the cut-throat general insurance arena. With GEICO's cash pouring in, rather than going out, Buffett can't resist yet another tease at the new economy -- "No Internet economics here".
After the now regular accounting piece, where Buffett suggests improvements on the current "deeply troublesome" accounting practices, he steps into new territory with the topic of share repurchases. After criticising CEOs for share buybacks performed with a "show of confidence" or just fashion in mind, rather than any rational shareholder value enhancement, Buffett intriguingly gives an indication of the level he would initiate a buyback for Berkshire.
"When the A shares fell below $45,000, we considered making a repurchase. We delayed buying, if indeed we elect to do any, until shareholders have had the chance to review this report. We will make them if and when we believe that they represent an attractive use of the Company's money." Although any buyback will have a minimal overall effect on Berkshire's value, the fact that a figure is mentioned probably puts a floor under the tumbling Berkshire stock price. In fact, early trade today saw the stock jump $3,800 to $45,100.
Trying to do justice to Buffett's annual letters is impossible. They all just ooze common sense investment principles. Certainly Buffett has been left on the sidelines in the tech boom, but I just can't help feeling, sooner or later, he'll have the last laugh. Overall, he's had a truly bad year, but then again it's the first bad year for about twenty years. Has he suddenly lost his talent? Unlikely. Berkshire has $30b in bonds at the moment, a fair chunk of which, I suspect, could find its way into the equity market at some point. In the meantime, he waits for the "enchanted" market to become disenchanted. I'm sure Buffett will return to grade A investment performances quite soon.
Related Links
• Warren Buffett expresses his views in Fortune
• Berkshire Hathaway website
• Berkshire Hathaway discussion board (US Fool)
Note
The Qualiport was launched on December 19th 1997 with an initial investment of £4040.63, all in Rentokil Initial. Further cash was added as holdings in Emap, Marks & Spencer and Unilever were bought during 1998. The vagaries of the value per share accounting method caused percentage return calculations for calendar 1998 to be somewhat distorted. To avoid confusion and somewhat misleading figures, the Qualiport's returns are being measured from 1/1/99, at which point the total portfolio value, including cash, stood at £16,809.60. An additional £2000 cash is added to the portfolio on April 1st and October 1st each year. The total cash investment in the portfolio to date has been £20,184.62. To access the Qualiport's total trade history, click here.