Tuesday, March 4, 2014

Warren Buffett's 2013 Shareholder Letter: Gems From The Chairman

We are usually on Berkshire Hathaway's Letter to Shareholders earlier than this, but it was buried under a huge pile of back reading.  The 2013 edition doesn't break any new ground, but it has a few gems for anybody interested in wisdom distilled into relatively few words.

Talking about the non-insurance businesses, the letter notes that the "Powerhouse Five" earned $10.8 billion in pre-tax earnings in 2013.  The five all-stars include MidAmerican Energy, BNSF, Iscar, Lubrizol and Marmon. In 2014, these five companies could increase their pre-tax earnings by $1 billion or more, assuming no economic downturn. The rest of the non-insurance portfolio produced $4.7 billion in pre-tax earnings, so the Powerhouse Five accounted for 70% of the income from this portfolio of  non-insurance businesses. Remarkable performance from easy to understand businesses like a railroad and a regulated utility, among others. BRK paid about $3.5 billion to acquire the rest of Marmon and Iscar formerly owned by the founding families.

The Heinz deal is something we considered remarkable from the announcement, both in the target and the private equity structure of the deal.  At some point, the letter makes it clear that BRK might bid for the rest of the equity (47.4%) which it does not own now.  The gem in all this discussion?  "...better to own a partial interest in the Hope diamond than to own all of a rhinestone."

Messrs. Buffett and Munger don't overpay for acquisitions with expensive stock either. Of the Powerhouse Five, BRK issued shares only for the acquisition of Burlington Northern Santa Fe; stock was used to pay for 30% of the deal, and dilution was 6% for the premier company in the industry, which itself is undergoing an economic renaissance of sorts.

As I work through Larry Haeg's book, "Harriman vs. Hill: Wall Street's Great Railroad War," I understand much better why Ben Graham and his student Warren Buffett had railroads on their minds. As the letter points out, in terms of freight efficiency over long hauls rail is hard to match: 550 ton-miles on a gallon of diesel fuel. (lots lower sulfur now),

The insurance underwriting business contributed $3 billion in profit in 2013.  The performance of these businesses, given what I have seen about Property and Casualty is breathtaking.  Whereas State Farm Group is the largest direct premium writer of insurance in P+C at $54 billion, and a well managed company according to the Oracle of Omaha, it has sustained underwriting losses in nine of the twelve years ending in 2012.

By contrast, Berkshire Hathaway's insurance businesses have had an underwriting profit for eleven consecutive years, with a cumulative total of $22 billion income earned. The Chairman regularly skewers his favorite GAAP accounting peeves---acquisition accounting and the treatment of insurance float.  The latter has been vital to the success of the holding company over the years.

Rather than being treated as a liability for the purposes of focusing on solvency by NAIC, it should be regarded as a revolving fund.  Berkshire paid $17 billion in 2013 to 5 million claimants for old claims, but with new business being written, the float continues to grow.  Even as the letter notes several old contracts are rolling off, the worst case scenario might have the float declining by something like 3% in a year.

The Berkshire Hathaway Reinsurance Group generated $37 billion in float in 2013.  CEO Ajit Jain also started a business called BH Specialty Insurance under a new senior executive, and it is being well received in an industry crying out for capacity and financial strength. General Re's float was $20 billion. GEICO, despite its irritatingly cutesy Gekko, weighs in with $13 billion of float through an efficient, low cost gathering system. All told, these insurance businesses supplied the holding company with $77 billion in float in 2013.

I hadn't realized the critical role that Berkshire Hathaway played in the reorganization of Lloyd's which was on the brink from catastrophic losses and a failure of some of their newer names.  The company took on Lloyd's pre-1993 claims book in exchange for a policy with a $15 billion limit. Clearly, in the property and casualty reinsurance business, BRK has the bluest of reputational blue blood.  Or, maybe the greenest.

One peculiar reference is to the importance of wind energy in the MidAmerican Energy portfolio.  I looked up the financials and the notes, and it's clear that without federal subsidies and some "wink, wink" reporting this industry wouldn't exist. Looking at the financials of MidAmerican, wind and hydro renewable sources of energy are not reported at their total facility accredited net generating capacities, but rather at a name plate capacity provided by the manufacturers under specific conditions,  The upshot of all this? The wind portfolio might have a name plate capacity of $2,369 MW, but the equivalent accredited net generating capacity might be nearer 286 MW.  All of this capacity, built and under construction cost about $5 billion.

The good news is that the utility is guaranteed an ROE of 12%, which is about the historical rate of growth of BRK's book value over time.  The notes to the financials state that wind depends on, among other subsidies, the federal production tax credits.  As the Chairman notes, "...we put a large amount of trust in future regulation." Or to put it another way, we put a large amount of trust in the largess of our friends in the federal government.

New investment managers Combs and Wechsler each manage about $7 billion in portfolios which have outperformed the holding company.  BRK increased its stakes in WFC (8.7% to 9.2%) and IBM (6% to 6.3%) through purchases of additional shares.  Stakes in AMEX and KO increased as a result of sustained corporate share repurchases. The company has options to purchase 700 million shares in Bank of America for $5 billion, and the Chairman says he anticipates exercising the option as he likes the company.  The tax basis for the equity investment portfolio is $56,581 million while the market value is $117,505 million.

The equity base is $225 billion. I am not going into the last few pages of the letter which have a nice primer on investment lessons learned and applied by the Master.  Take out a pencil and enjoy this perennial educational read.

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