Berkshire 2001 Shareholder Letter - Cliff's Notes Version
This is the twenty-fifth in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2015. For all of the prior shareholder letters, see here.
The 2001 letter weighs in at 12,330 words, a 7.5% decrease from 13,320 words the prior year. Berkshire's loss [sic] in net worth during 2001 was just $3.5 billion, or -6.2% [sic] of beginning 2001 net worth.
PARALLEL UNIVERSE--BUFFETT LOSES MONEY
Buffett actually managed to lose money in 2001, for the first time...well, ever. Prior thereto, he had managed to register annual gains in book value per share as the head of Berkshire for an incredible 36 consecutive years [1965 through 2000]. Prior to that he had never had a down year while managing his partnership beginning in 1956. And given his prior comments in the annual letters, it appears he never had a down year in the 1950s managing his personal investments. In total, then, until 2001 Buffett had apparently strung together at least 50 straight up years as an asset manager / capital allocator, a mind-boggling record that will be impossible to match. Buffett made the following gloomy prediction in the 2001 letter, however...
One final thought about Berkshire: In the future we won’t come close to replicating our past record. To be sure, Charlie and I will strive for above-average performance and will not be satisfied with less. But two conditions at Berkshire are far different from what they once were: Then, we could often buy businesses and securities at much lower valuations than now prevail; and more important, we were then working with far less money than we now have. Some years back, a good $10 million idea could do wonders for us (witness our investment in Washington Post in 1973 or GEICO in 1976). Today, the combination of ten such ideas and a triple in the value of each would increase the net worth of Berkshire by only ¼ of 1%. We need "elephants" to make significant gains now--and they are hard to find.
Since 2001, however, Berkshire's book value per share has suffered just one annual decline--in 2008 it fell by slightly less than 10 percent; and in two-thirds of those years it has increased by double digits. Thus, even though Buffett's prediction was correct, Berkshire shareholders have continued to prosper.
A FEW THOUGHTS ON INSURANCE UNDERWRITING
In light of the catastrophe losses incurred by Berkshire from the events of 9/11, Buffett spends quite a bit of space in the 2001 letter discussing insurance. For example, he lays out the three key rules of underwriting, as follows...
What counts in this business is underwriting discipline. The winners are those that unfailingly stick to three key principles:
They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.
They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.
They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn't work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.
Buffett goes on to castigate Gen Re for being far too lax with respect to rules 1 and 2. AIG has recently been exposed in this respect as well, laying off large exposures on Berkshire earlier this year to stanch its red ink, which ultimately cost CEO Hancock his job.
Buffett also lampoons the terminology used in the insurance industry when company executives admit to underwriting mistakes [often long after they and/or their predecessors have banked years of bonuses for prior mirage-like 'record results']...
Bad terminology is the enemy of good thinking. When companies or investment professionals use terms such as "EBITDA" and "pro forma," they want you to unthinkingly accept concepts that are dangerously flawed. (In golf, my score is frequently below par on a pro forma basis: I have firm plans to "restructure" my putting stroke and therefore only count the swings I take before reaching the green.)
In insurance reporting, "loss development" is a widely used term--and one that is seriously misleading. First, a definition: Loss reserves at an insurer are not funds tucked away for a rainy day, but rather a liability account. If properly calculated, the liability states the amount that an insurer will have to pay for all losses (including associated costs) that have occurred prior to the reporting date but have not yet been paid. When calculating the reserve, the insurer will have been notified of many of the losses it is destined to pay, but others will not yet have been reported to it. These losses are called IBNR, for incurred but not reported. Indeed, in some cases (involving, say, product liability or embezzlement) the insured itself will not yet be aware that a loss has occurred.
When it becomes evident that reserves at past reporting dates understated the liability that truly existed at the time, companies speak of "loss development." In the year discovered, these shortfalls penalize reported earnings because the "catch-up" costs from prior years must be added to current-year costs when results are calculated. This is what happened at General Re in 2001: a staggering $800 million of loss costs that actually occurred in earlier years, but that were not then recorded, were belatedly recognized last year and charged against current earnings. The mistake was an honest one, I can assure you of that. Nevertheless, for several years, this underreserving caused us to believe that our costs were much lower than they truly were, an error that contributed to woefully inadequate pricing. Additionally, the overstated profit figures led us to pay substantial incentive compensation that we should not have and to incur income taxes far earlier than was necessary.
We recommend scrapping the term "loss development" and its equally ugly twin, "reserve strengthening." (Can you imagine an insurer, upon finding its reserves excessive, describing the reduction that follows as "reserve weakening"?) "Loss development" suggests to investors that some natural, uncontrollable event has occurred in the current year, and "reserve strengthening" implies that adequate amounts have been further buttressed. The truth, however, is that management made an error in estimation that in turn produced an error in the earnings previously reported. The losses didn't "develop"--they were there all along. What developed was management's understanding of the losses (or, in the instances of chicanery, management's willingness to finally fess up). A more forthright label for the phenomenon at issue would be "loss costs we failed to recognize when they occurred" (or maybe just "oops"). [emphasis added]
For brevity's sake, we at Seven Corners would endorse the 'oops' option.
BUFFETT AS DISTRESSED DEBT INVESTOR
Buffett not only was and is a great stock picker. He was also an extremely skilled distressed debt investor. In prior letters he describes the killing he made on Washington Public Power Supply System (WPPSS) bonds [see, for example, the lengthy treatment of this investment in Berkshire's 1984 chairman's letter]. In the 2001 letter he describes Berkshire's investment in the debt of Finova--not every Buffett transaction is as simple as buying shares of Coca-Cola and then sitting on one's rear end for 30 years...
In late 2000, we began purchasing the obligations of FINOVA Group, a troubled finance company, and that, too, led to our making a major transaction. FINOVA then had about $11 billion of debt outstanding, of which we purchased 13% at about two-thirds of face value. We expected the company to go into bankruptcy, but believed that liquidation of its assets would produce a payoff for creditors that would be well above our cost. As default loomed in early 2001, we joined forces with Leucadia National Corporation to present the company with a prepackaged plan for bankruptcy.
The plan as subsequently modified (and I'm simplifying here) provided that creditors would be paid 70% of face value (along with full interest) and that they would receive a newly-issued 7½% note for the 30% of their claims not satisfied by cash. To fund FINOVA's 70% distribution, Leucadia and Berkshire formed a jointly-owned entity--mellifluently christened Berkadia--that borrowed $5.6 billion through FleetBoston and, in turn, re-lent this sum to FINOVA, concurrently obtaining a priority claim on its assets. Berkshire guaranteed 90% of the Berkadia borrowing and also has a secondary guarantee on the 10% for which Leucadia has primary responsibility. (Did I mention that I am simplifying?).
There is a spread of about two percentage points between what Berkadia pays on its borrowing and what it receives from FINOVA, with this spread flowing 90% to Berkshire and 10% to Leucadia. As I write this, each loan has been paid down to $3.9 billion.
As part of the bankruptcy plan, which was approved on August 10, 2001, Berkshire also agreed to offer 70% of face value for up to $500 million principal amount of the $3.25 billion of new 7½% bonds that were issued by FINOVA. (Of these, we had already received $426.8 million in principal amount because of our 13% ownership of the original debt.) Our offer, which was to run until September 26, 2001, could be withdrawn under a variety of conditions, one of which became operative if the New York Stock Exchange closed during the offering period. When that indeed occurred in the week of September 11th, we promptly terminated the offer.
Finova's asset collateral mainly consisted of aircraft, not exactly ideal in the aftermath of 9/11. Contemporary news coverage in the WSJ of the Finova / Berkadia transaction can be found at this link. Notably, though, the Berkadia joint venture still exists today and is discussed in Berkshire's 2016 10-K [see page 103].
As an aside having absolutely nothing to do with investing, this blogger began his professional career on Wednesday, September 5, 2001, with an office on the 40th Floor of Two World Trade Center. My employer was a law firm named Thacher Proffitt & Wood LLP, which traced its roots back to the mid-1800s as a firm originally specializing in maritime law [I was an associate in the Corporate & Financial Institutions department]. On my fifth day of work, for whatever reason my alarm wasn't set correctly and I didn't wake up until around 9:20 a.m. In a panic at being so late, I quickly dressed and hustled over to Astor Place to catch the N / R train downtown. The day was absolutely pristine, sunny and warm. On my way I overheard a few people mention that a small plane had crashed near Battery Park. Well, obviously that wasn't the case, as by then both towers had been hit, but apparently this confusion was a symptom of the 'fog of war'. Thinking nothing major was amiss, I got on the subway; people were still murmuring unsurely. Luckily for us, the train stopped at Canal Street and we were told to leave the train and exit the station. Upon surfacing we were met by hordes of office workers heading north on Broadway. Some were crying. Clearly it wasn't a 'small plane' that crashed. I could see the smoke trail against the blue sky but the towers were obscured by buildings, so I walked west to Canal and West Broadway and was met with a sight I could barely comprehend--both buildings engulfed in flames. After a few minutes of stupefaction, I headed north on West Broadway. All of a sudden people began screaming--it was Two World Trade collapsing. I can still see the glint of the steel and glass reflecting in the sun as it crumbled and dropped. Heart pounding, I decided to return to my apartment to let my parents know I was OK. That was my 9/11 experience. Fortunately, our entire firm made it out of the South Tower that day without major injury. The firm could not withstand the Financial Crisis, however, and dissolved in 2008.
For the record, in 2001 Berkshire's stock appreciated 6.5%, outperforming the S&P 500 by 18.5%, the Yankees fell to the Diamonbacks 4-3 in the World Series and the Patriots beat the Rams 20-17 in Super Bowl XXXVI. Next up, 2002, the final year of the early Aughts bear market.