A Sign Of Spring

The "sage of Omaha," the most successful stock market investor in history and the world's second-richest man (second only to Bill Gates), provides in his letter to shareholders an invaluable assessment of business affairs and a discussion of his investment philosophy. Although this year's letter to shareholders, which covers fiscal year 2006, is shorter than usual, it offers many useful insights.

Corporate America is highly dynamic and competitive, which creates opportunities and dangers for investors. Buffett noted that of the 10 "non-oil companies having the largest market capitalization in 1965 — titans such as General Motors, Sears, DuPont and Eastman Kodak — only one made the 2006 list." However, he added that "in fairness, we've seen plenty of successes as well, some truly outstanding." As examples, he cited Kenneth Chenault of American Express, Jeffrey Immelt of General Electric, and Richard Kovacevich of Wells Fargo, describing them as "giant company managers whom I greatly admire."

What does it take to identify solid investments? "Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior are vital to long-term investment success," Buffett wrote. "I've seen a lot of very smart people who have lacked these virtues."

Ultimate responsibility for a corporation's long-term success belongs to its board of directors, Buffett stressed. He stated that a corporation's board of directors should "be owner-oriented, business-savvy, interested and truly independent." He added that "many directors who are now deemed independent by various authorities and observers are far from that, relying heavily as they do on director's fees to maintain their standard of living."

For the last few years, a favorite subject for Buffett has been the huge pay packages bestowed on many corporate executives. He criticized the widespread practice whereby boards of directors rubber-stamp recommendations made by outside consultants who in turn are selected by management.

"Compensation reform will only occur if the largest institutional shareholders — it would only take a few — demand a fresh look at the whole system," he asserted. "The consultants' present drill of deftly selecting %91peer' companies to compare with their clients will only perpetuate present excesses." He described this as the "all the other kids have one" rationale for approval of excessive compensation packages.

Another subject that Buffett returned to is the proliferation of hedge funds. He questioned the long-term viability of the typical hedge fund, which he described as being run by "the 2-and-20 crowd" — managers who charge a 2% annual fee plus 20% of profits. "Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with the experience ends up with the money." Buffett recommended a low-fee index fund as a better alternative.

When it is revealed that Buffett has invested in a particular stock, the inevitable result is a sharp uptick in the price of that stock. This is obviously triggered by the assumption that if Buffett is buying, it must be a good bet. As a result, he does not discuss his ongoing investment plans.

Buffett admitted that he recently made purchases of stock in several companies, which purchases now have a market value of $1.9 billion, and is adding to these positions, but he would not disclose the names of the companies "because we continue to buy them," adding that "I could, of course, tell you their names. But then I would have to kill you."

The year 2006 was a good one for Berkshire Hathaway's core insurance companies, which spectacularly bounced back from sharp losses in 2005 caused by Hurricane Katrina and other natural disasters. Underwriting profits in 2006 were $3.8 billion, compared to a meager $53 million in the prior year. Buffett attributed this turnaround in part to luck, but while Mother Nature cooperated in 2006, a lot of the credit should be given to disciplined management. Buffett stressed that he will not seek market share at the cost of profits.

The wide variation in profitability from year-to-year of Berkshire Hathaway's insurance operations demonstrates the volatility of the industry and the degree to which results are dependent on forces outside our control.

GEICO is probably the Berkshire Hathaway unit with the highest profile. It spends more on advertising than any other insurance company. The company's advertising budget was $631 million last year, up from $238 million in 2003, but it has gotten impressive results. Sales increased to 8.1 million polices, from 5.7 million in 2003, a jump of more than 40%. Buffett noted that during the same period, the company's number of employees fell by 3.5%, which he concluded indicates an increase in productivity of 47%.

Although insurance operations constitute the largest part of Berkshire Hathaway, the conglomerate's holdings include dozens of companies in other fields, including MidAmerican Energy Holdings, which owns several electric utilities in the US and Great Britain, as well as natural gas pipelines in the US; NetJets, which sells fractional ownership in corporate jets; Dairy Queen; Fruit of the Loom underwear company; and many smaller enterprises, such as a candy company, regional furniture and jewelry retailers, and The Buffalo (NY) News. They are diverse, but all have superior management.

Buffett repeated an investment credo that he has uttered many times: Be fearful when others are greedy, and be greedy when others are fearful.

This contrarian view is applied by Buffett to the housing sector. Although the conventional wisdom is that the housing sector is in shambles, Buffett increased his exposure. Berkshire Hathaway expanded through acquisitions its MiTek subsidiary, which makes hardware for roof trusses, and also expanded HomeServices of America, a real estate brokerage owned by MidAmerican Energy Holdings. Although profits fell 50% at the brokerage unit, Buffett declared that he was seeking new acquisitions and that "a decade from now, HomeServices will almost certainly be much larger." Berkshire Hathaway also owns Shaw Industries, the nation's largest carpet manufacturer, which Buffett described as "a powerhouse and a major contributor to ... earnings"; Clayton Homes, a manufacturer of prefabricated houses; the Carefree awnings company; the Johns Manville insulation company; and the Acme brink company. Buffett also accumulated a significant stake in the Lowe's home improvement store chain.

In contrast to his bullish stand on US housing, Buffett is bearish on the US dollar, declaring, "as our US trade problems worsen, the probability that the dollar will weaken over time continues to be high." In anticipation of a weakening dollar, he increased his investments in foreign companies and in US firms that have significant business overseas. In part, this explains his purchase of an 80% stake in the Israeli metal-cutting equipment maker ISCAR Metalworking for $4 billion in May 2006. He also bought equity in Posco, the dominant Korean steel manufacturer, and Tesco, the British retail chain. In addition, he purchased stakes in US firms that derive a significant portion of their revenue from overseas, such as ConocoPhillips, Johnson & Johnson, Anheuser-Busch Cos., Procter & Gamble, Wal-Mart, and USG Corp.

A major question at Berkshire Hathaway is what will happen when Warren Buffett can no longer run the corporation. He addressed this issue by declaring, "Good news: At 76, I feel terrific and, according to all measurable indicators, am in excellent health. It is amazing what Cherry Coke and hamburgers will do for a fellow." His shareholders, as well as the investing public, undoubtedly welcome this health bulletin.