WALL STREET JOURNAL: Berkshire Improves But Economy Crimps Results

By SCOTT PATTERSON

Download the 2009 Warren Buffett Letter & 2009 Annual Report to Berkshire Hathaway Shareholders

Hundreds of thousands of fresh Berkshire Hathaway Inc. shareholders got an update Saturday on how their investment performed in 2009.

The news was mixed. While Berkshire’s underlying returns rebounded strongly, helped by its vast stock holdings, pockets of weakness in several economically sensitive operating units crimped results.

In its annual shareholder letter, the conglomerate, which sells everything from ice cream to machine tools to house paint, reported that its book value gained 19.8% to $84,487 per share in 2009 from the prior year, based on a metric the company uses to track performance. In dollar terms, book value shot up $21.8 billion last year, a record.

Berkshire posted net income of $8.1 billion in 2009, up from $5 billion a year ago but down sharply from the $13.2 billion it earned in 2007. Revenue was $112 billion in 2009 from $108 billion in 2008.

Long a closely held company mostly for the wealthy, Berkshire in the past month vastly increased its shareholder base after it was included in the Standard & Poor’s 500-stock index, held by millions of investors in index and mutual funds that closely track it.

Last year’s gain–Berkshire’s best since 2003–marks a strong rebound from 2008, when book value per share slid 9.6%, the biggest decline since Warren Buffett, the chairman, took over the company in 1965 when it was a family-run textile manufacturer on the East Coast.

The gain was less than the S&P 500’s return of 26.5% in 2009, marking only the seventh time Berkshire has trailed the index under Mr. Buffett. But long-term investors aren’t likely to be disappointed. Berkshire outperformed the index over the lion’s share of the credit crisis, since losses in 2008 were far lower than the broader market’s.

“Our defense has been better than our offense, and that’s likely to continue,” Mr. Buffett wrote.

Berkshire’s inclusion in the index against which he measures his own performance came after the company agreed to split its Class B shares as part of its acquisition of Burlington Northern Santa Fe, the railroad giant. According to S&P, about $1 trillion in assets is held by funds that directly track the S&P 500.

In the letter, Mr. Buffett seemed to address his new shareholders directly. In sections titled “How We Measure Ourselves” and “What We Don’t Do,” he provided guidelines for how to gauge the performance of his firm, how Mr. Buffett and his long-time partner, Charlie Munger, size up companies and how the various pieces of Berkshire work together at a whole.

“We will never become dependent on the kindness of strangers,” Mr. Buffett wrote. “Too-big-to-fail is not a fallback position at Berkshire,” a reference to large financial institutions bailed out by the government after suffering billions in losses.

The investor boasted how Berkshire, fueled by its vast cash stockpile and protected by its aversion to overly risky bets, was able to pump cash into the financial system during the heat of the crisis. Berkshire “was a supplier of liquidity and capital to the system, not a supplicant,” he wrote.

A Transforming Berkshire

Of interest to new and old shareholders alike, Mr. Buffett discussed how he has been transforming Berkshire in recent years into a capital-intensive industrial conglomerate with big holdings in railroads and utilities and less exposure to cash-generating financial operations such as insurance. He said that while he used to shun capital intensive businesses, his perspective has changed. Berkshire will continue to spit out large amounts of cash, he wrote, and cash-hungry firms like utilities and railroads are among the best outlets for those dollars.

Those companies will deliver solid earnings, “albeit at the cost of our investing many tens —yes, tens—of billions of dollars of incremental equity capital,” he wrote.

The result, he said is that Berkshire’s “ever-growing collection of good to great businesses should produce above-average, though certainly not spectacular, returns in the decades ahead.”

Swings with the Market

Berkshire is distinct from some other big corporations in that it holds a substantial investment portfolio at the parent level whose success has a high influence on the company’s performance.

Last year, a rising stock market helped results. Berkshire’s huge stock portfolio, which includes blue-chip companies such as American Express Co., Johnson & Johnson and Wal-Mart Stores Inc., posted a strong gain last year, marking a sharp reversal from 2008 when stocks plunged.

A big boost came from Berkshire’s investment in Chinese battery and car maker BYD Co. Its $232 million investment in the company in 2008—a deal advocated by Mr. Munger—surged to nearly $2 billion by the end of last year.

The letter was peppered with the usual mix of witticisms, hard-core investment advice and folksy wisdom. Mr. Buffett said he scooped up corporate and municipal bonds in 2009, which he called “ridiculously cheap.” But, he wrote, “I should have done far more. Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.”

Derivatives Bright Spot

The company also got a boost from several derivatives contracts it entered into in recent years. The contracts are insurance policies against long-term declines in U.S. and foreign stocks and expire during the next two decades. Berkshire will have to pay money if the indexes are below where they were when it initially entered the contracts.

Broadly, Berkshire posted an after-tax gain in derivative contracts of $486 million in 2009, compared with a loss of $4.6 billion the previous year.

Muted Gains in Operations

Outside of Berkshire’s investment-related gains, the picture was much-less positive. While many units in his vast conglomerate were in the black, its holdings in companies that make everything from mobile homes to carpets to machine tools have taken a big hit amid the economic turmoil.

Much of Berkshire’s operations remained heavily exposed to the economy, a factor that will only get more pronounced with the purchase Burlington Northern. Berkshire’s utilities and energy units gained $1.1 billion in 2009, down from $2.3 billion in 2008, results that included roughly $1 billion in one-time gains related to a failed merger with Constellation Energy Group Inc.

Earnings by its manufacturing, service and retailing operations slid to $1.1 billion from $2.3 billion the previous year. The 2009 results took a hit from Berkshire’s jet-rental company NetJets, which posted a pretax loss of $711 million.

Its insurance businesses reported a net underwriting gain of $1 billion last year, down from $1.8 billion in 2008, as Berkshire pulled in its horns slightly in insurance amid lower premiums. For 2010, Mr. Buffett said growth in Berkshire’s auto insurance giant Geico could slow due to weakening auto sales and high unemployment, which causes some drivers to forego auto insurance.

Berkshire’s Class A shares gained just 3% in 2009. But its shares have been on a roll of late, gaining nearly 20% since early November, when the Berkshire said it planned to purchase Burlington.

Housing Outlook

Mr. Buffett didn’t comment at length on his view on the broader economy, but he did drop one glimmer of hope. He said that “within a year or so residential housing problems should be largely behind us.” If he’s right, that should provide a boost to a number of Berkshire companies heavily exposed to housing, such as the paint company Benjamin Moore, and Shaw Industries, a carpet maker.

On Management

In discussing management of his operations, Mr. Buffett maintained that he and Mr. Munger did not want to be micromanagers but instead wanted decisions made “at the operating level.”

But he also indicated the approach doesn’t always succeed. Calling NetJets “the major problem for Berkshire last year,” he said “It’s clear that I failed you in letting NetJets descend into this condition.” He said the unit was on the mend with his appointment of David Sokol, chairman of MidAmerican Energy Holdings Co., to its helm.

He also took responsibility for the “fiasco” of a Geico-issued credit card.

Geico’s “managers, it should be emphasized, were never enthusiastic about my idea,” he wrote. “They warned me that instead of getting the cream of GEICO’s customers we would get the——well, let’s call it the non-cream. I subtly indicated that I was older and wiser. I was just older.”

Mr. Buffett didn’t hesitate to dish some heat out as well. He said CEOs of failed companies “have largely gone unscathed” even as shareholders suffered massive losses. “Their fortunes may have been diminished by the disasters they oversaw,” he writes, “but they still live in grand style.” Mr. Buffett has said CEO compensation packages should include onerous terms that would wipe out their — and their spouses — net wealth if their firm required a government bailout.

Post Script

In a nod to its massive acquisition of Burlington Northern, in the section on preparations for Berkshire’s annual shareholder meeting in May, Mr. Buffett closed with this postscript:

P.S. Come by rail.

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