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Berkshire 2003 Shareholder Letter - Cliff's Notes Version

This is the twenty-seventh 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 2003 letter weighs in at 13,120 words, a 9% decrease from 14,550 words the prior year. Berkshire's gain in net worth during 2003 was $13.6 billion, or 21% of beginning 2003 net worth.


Buffett continues in the vein of the prior year's letter, discussing the woeful state of corporate governance in America. He states that Berkshire has established its governance system to ensure that Directors bear the pain of bad corporate decisions, just as they benefit from good ones; in other words, heads I win, tails I lose. On most boards, however, the equation is heads I win, tails I win (and shareholders lose), since directors (A) are handed their equity stakes gratis instead of buying them with their personal funds on the open market and (B) are insulated, by virtue of D&O insurance policies, from almost all legal liability caused by poor corporate decision-making. Buffett summarizes his points as follows:

True independence – meaning the willingness to challenge a forceful CEO when something is wrong or foolish – is an enormously valuable trait in a director. It is also rare. The place to look for it is among high-grade people whose interests are in line with those of rank-and-file shareholders – and are in line in a very big way.

We’ve made that search at Berkshire. We now have eleven directors and each of them, combined with members of their families, owns more than $4 million of Berkshire stock. Moreover, all have held major stakes in Berkshire for many years. In the case of six of the eleven, family ownership amounts to at least hundreds of millions and dates back at least three decades. All eleven directors purchased their holdings in the market just as you did; we’ve never passed out options or restricted shares. Charlie and I love such honest-to-God ownership. After all, who ever washes a rental car?

In addition, director fees at Berkshire are nominal (as my son, Howard, periodically reminds me). Thus, the upside from Berkshire for all eleven is proportionately the same as the upside for any Berkshire shareholder. And it always will be.

The downside for Berkshire directors is actually worse than yours because we carry no directors and officers liability insurance. Therefore, if something really catastrophic happens on our directors’ watch, they are exposed to losses that will far exceed yours.

The bottom line for our directors: You win, they win big; you lose, they lose big. Our approach might be called owner-capitalism. We know of no better way to engender true independence. (This structure does not guarantee perfect behavior, however: I’ve sat on boards of companies in which Berkshire had huge stakes and remained silent as questionable proposals were rubber-stamped.)

In addition to being independent, directors should have business savvy, a shareholder orientation and a genuine interest in the company. The rarest of these qualities is business savvy – and if it is lacking, the other two are of little help. Many people who are smart, articulate and admired have no real understanding of business. That’s no sin; they may shine elsewhere. But they don’t belong on corporate boards. Similarly, I would be useless on a medical or scientific board (though I would likely be welcomed by a chairman who wanted to run things his way). My name would dress up the list of directors, but I wouldn’t know enough to critically evaluate proposals. Moreover, to cloak my ignorance, I would keep my mouth shut (if you can imagine that). In effect, I could be replaced, without loss, by a potted plant.

Regarding the last paragraph, it is interesting to compare Berkshire's current board with the directors with which Elizabeth Holmes had stocked Theranos's board as of 2015. Below are descriptions of the respective groups of directors:

Berkshire Board as of April 2017 [source: 2017 Proxy Statement]: Gender Makeup: 9 men, 3 women; Combined Age: 870; Average Age: 72.5; Significant Relevant Business Experience: 11/12 [Exception: Howard Buffett]; Significant Capital Allocation Experience: 8/12 [Warren Buffett, Burke, Gates, Gottesman, Munger, Murphy, Scott and Witmer]; Stock Ownership: 316,773 A shares and 70,378,425 B shares, worth an aggregate of $89,283,000,000 [as of April 21st]. Member biographies:

WARREN E. BUFFETT, age 86, has been a director and the controlling shareholder of the Corporation since 1965 and has been its Chairman and Chief Executive Officer since 1970.

HOWARD G. BUFFETT, age 62, has been a director of the Corporation since 1993. For more than the past five years, Mr. Buffett has been President of Buffett Farms. Since 2013, Mr. Buffett has been the Chairman and Chief Executive Officer of the Howard G. Buffett Foundation, a charitable foundation that directs funding for humanitarian and conservation related issues. Between 1999 and 2013, he served as the President of the Howard G. Buffett Foundation. He is also a director of The Coca-Cola Company. He was a director of Lindsay Corporation until January 2016 and Sloan Implement Company until May 2015.

STEPHEN B. BURKE, age 58, has been a director of the Corporation since 2009. Mr. Burke has been the Chief Executive Officer of NBCUniversal and Executive Vice President of Comcast Corporation since January 2011. Prior to that time, from 2004 until January 2011, he was the Chief Operating Officer of Comcast Corporation, and President of Comcast Cable Communications from 1998 until January 2010. He is also a director of JPMorgan Chase & Co.

SUSAN L. DECKER, age 54, has been a director of the Corporation since 2007. Ms. Decker also serves on the boards of directors of Costco Wholesale Corporation, Vail Resorts, Inc. and Vox Media. Since 2016, she has been CEO and co-founder of Raftr, a digital media product, launched publicly in 2017. During the 2009-2010 school year, she served as Entrepreneur-in-Residence at Harvard Business School. Prior to that, from June 2000 to April 2009, Ms. Decker held various executive management positions at Yahoo! Inc., a global Internet brand, including President (June 2007 to April 2009), head of the Advertiser and Publisher Group (December 2006 to June 2007) and Chief Financial Officer (June 2000 to June 2007). Before Yahoo!, Ms. Decker spent 14 years with Donaldson, Lufkin & Jenrette. She is a Chartered Financial Analyst and served on the Financial Accounting Standards Advisory Council for a four-year term, from 2000 to 2004.

WILLIAM H. GATES III, age 61, has been a director of the Corporation since 2005. Mr. Gates currently serves as Co-Chair of the Bill & Melinda Gates Foundation. Mr. Gates is a director of Microsoft Corporation and served as Chairman of the Board from its incorporation in 1981 until February 2014. Mr. Gates is currently a Technology Advisor for Microsoft Corporation and was its Chief Executive Officer from 1981 until January 2000.

DAVID S. GOTTESMAN, age 90, has been a director of the Corporation since 2004. For more than the past five years, he has been a principal of First Manhattan Co., an investment advisory firm. Mr. Gottesman is Vice Chairman and a trustee of the American Museum of Natural History and a trustee of Mount Sinai Medical Center.

CHARLOTTE GUYMAN, age 60, has been a director of the Corporation since 2003. Ms. Guyman was a general manager with Microsoft Corporation until July 1999 and has been retired since that time. She is a director of Space Needle LLC, a trustee of Save the Children and was former Chairman of the Board of Directors of UW Medicine, an academic medical center.

CHARLES T. MUNGER, age 93, has been a director and Vice Chairman of the Corporation’s Board of Directors since 1978. Between 1984 and 2011, he was Chairman of the Board of Directors and Chief Executive Officer of Wesco Financial Corporation, approximately 80%-owned by the Corporation during that period. He also served as President of Wesco Financial Corporation between 2005 and 2011. Mr. Munger is also Chairman of the Board of Directors of Daily Journal Corporation, a director of Costco Wholesale Corporation and Chairman of the Board of Trustees of Good Samaritan Hospital.

THOMAS S. MURPHY, age 91, has been a director of the Corporation since 2003. Mr. Murphy has been retired since 1996. He was Chairman of the Board and Chief Executive Officer of Capital Cities/ABC, Inc. from 1966 to 1990 and from February 1994 until his retirement in 1996. Mr. Murphy is Chairman Emeritus of the Board of Trustees of Save the Children and a trustee of NYU Langone Medical Center.

RONALD L. OLSON, age 75, has been a director of the Corporation since 1997. For more than the past five years, he has been a partner in the law firm of Munger, Tolles & Olson LLP. He is also a director of Graham Holdings Company and Western Asset Trusts and a Trustee of California Institute of Technology.

WALTER SCOTT, JR., age 85, has been a director of the Corporation since 1988. For more than the past five years, he has been a director of Valmont Industries, Inc. Until 2014, Mr. Scott served as Chairman of the Board of Directors of Level 3 Communications, Inc., which is engaged in telecommunications and computer outsourcing and is a successor to certain businesses of Peter Kiewit Sons’, Inc. Mr. Scott is also Chairman of the Board of Policy Advisors of Peter Kiewit Institute for Information, Technology and Engineering.

MERYL B. WITMER, age 55, has been a director of the Corporation since 2013. For more than the past five years, Ms. Witmer has been a managing member of the General Partner of Eagle Capital Partners, L.P., an investment partnership. From 1989 through the end of 2000, she was one of two General Partners at Buchanan, Parker Asset Management which managed Emerald Partners L.P., an investment partnership. Ms. Witmer is a trustee of University of Virginia Investment Management Company.

Theranos Board as of 2015 [source: 2015 Fortune Article]: Gender Makeup: 11 men, 1 woman; Combined Age: 831; Average Age: 69.3; Significant Business Experience: 5/12 [Holmes, Frist, Kovacevich, Bechtel and Balwani]; Significant Medical Background/Experience: 4/12 [Holmes, Frist, Foege and Balwani]; Significant Political and/or Military Background: 7/12 [all but Holmes, Kovacevich, Bechtel, Foege and Balwani]; Stock Ownership: Unknown. Member biographies [name links are to respective Wikipedia pages]:

CEO and Chairwoman Elizabeth Holmes, Age 31 [as of mid-2015]

Former Secretary of State Henry Kissinger, Age 91

Former Secretary of Defense Bill Perry, Age 87

Former Secretary of State George Shultz, Age 94

Former Senator Sam Nunn, Age 77

Former Senator Bill Frist (who, it should be noted, is a surgeon), Age 63

Former Navy Admiral Gary Roughead, Age 63

Former Marine Corps General James Mattis, Age 64

Former Wells Fargo CEO Dick Kovacevich, Age 71

Former Bechtel CEO Riley Bechtel, Age 63

Former epidemiologist William Foege, Age 79

Theranos' president and CEO Sunny Balwani, Age 48

What's fascinating is that Theranos's board, excluding Holmes, had an average age that was one year greater than Berkshire's board, excluding Buffett, and also exhibited less gender diversity. This seems downright bizarre considering that Theranos's CEO was a female chief executive in her early 30s running a (supposedly) cutting-edge tech company. It was almost as if Holmes wanted a board with recognizable names simply for PR and potential fundraising purposes, but which would be virtually silent on business strategy. In retrospect, this makes sense now, given what has been revealed about Theranos in the past year and a half. But the signs that all was not right at this company were apparent just by looking at the bizarre composition of its board.


In 2002 and 2003 Buffett engaged in some kind of fixed-income arbitrage involving AAA-rated securities, using borrowed money. It's not clear exactly what securities Buffett was buying, but they produced apparently risk-free profits of $932 million on an average asset base of approximately $11 billion over those 2 years, or about 4.2% per annum. Here is Buffett's description of these mystery trades:

I manage a few opportunistic strategies in AAA fixed-income securities that have been quite profitable in the last few years. These opportunities come and go – and at present, they are going....Though far from foolproof, these transactions involve no credit risk and are conducted in exceptionally liquid securities. We therefore finance the positions almost entirely with borrowed money. As the assets are reduced, so also are the borrowings. The smaller portfolio we now have means that in the near future our earnings in this category will decline significantly. It was fun while it lasted, and at some point we’ll get another turn at bat.


Given Buffett's relentless bashing of hedge funds in recent years [for instance, see the details of his well-known bet against them here], it is strange in the 2003 letter to find that he had invested over $600 million of Berkshire's cash in a third-party hedge fund, in effect outsourcing part of Berkshire's investment strategy. Here is Buffett's description of this investment:

We have a $604 million investment in Value Capital, a partnership run by Mark Byrne, a member of a family that has helped Berkshire over the years in many ways. Berkshire is a limited partner in, and has no say in the management of, Mark’s enterprise, which specializes in highly-hedged fixed-income opportunities. Mark is smart and honest and, along with his family, has a significant investment in Value. Because of accounting abuses at Enron and elsewhere, rules will soon be instituted that are likely to require that Value’s assets and liabilities be consolidated on Berkshire’s balance sheet. We regard this requirement as inappropriate, given that Value’s liabilities – which usually are above $20 billion – are in no way ours. Over time, other investors will join us as partners in Value. When enough do, the need for us to consolidate Value will disappear.

Perhaps the main motivation for this investment was Buffett's personal friendship with the manger's father, Jack Byrne, ex-CEO of GEICO, who helped save that company in the 1970s after Berkshire took a large equity stake. In 2005, though, we find that--predictably--nepotism doesn't pay, as Value Capital had already fallen on hard times and Buffett was yanking Berkshire's money out. The following excerpt from a contemporary news article [source here] explains the details:

Buffett Takes Hit on Hedge Fund

Saturday, 26 Nov 2005 12:00 AM - A major hedge fund backed by billionaire Warren Buffett could lose up to $34 million due to a bad bet on interest rates. Bermuda-based Value Capital LP, a $570 million hedge fund, lost the money sometime in the first nine months of 2005, according to documents filed by the fund for the Securities and Exchange Commission (SEC) on November 4.

Fund manager Mark Byrne told Bloomberg this week that his bet that long-term borrowing costs would rise faster than short-term rates as the US economy strengthened backfired. That didn't happen as the gap between 2-year and ten-year bond yields, known as the yield curve, narrowed by more than 1 percentage point to the smallest since January 2001, as the Federal Reserve raised the overnight bank lending rate 12 times, Bloomberg reports. Byrne's fund is down five percent so far in 2005.

"I don't understand why the yield curve is so flat," a perplexed Byrne told the wire service. "We had bets in the direction of a steepening yield curve as the U.S. recovered from its cycle and the Fed started to raise rates."

Berkshire Hathaway had invested about $430 million in the seven-year-old fund through the end of 2002 and recorded $173 million of profits, a March 2003 filing with the SEC shows. The investment company sold $125 million from the fund in December, 2004, cutting its fund holdings to 62 percent from 90 percent on June 30, 2004, according to an SEC filing in March....

Value Capital has been in the black for the past six years, earning an average annual return of 7.5 percent for Berkshire Hathaway after fees and expenses. It's not Buffet's habit to entrust money in funds managed by outside fund managers. But there may be some nepotism in the air. Bloomberg reports that Byrne is the son of Jack Byrne, who became chief executive officer of Geico Corp. in 1976 and saved it from bankruptcy after Berkshire Hathaway invested in the auto insurer. Patrick Byrne, Mark Byrne's brother, worked from 1997 to 1999 as CEO of Fechheimer Brothers Co., a uniform maker owned by Berkshire Hathaway."We've made a lot of money with the Byrne family," Buffett told Berkshire Hathaway shareholders at the company's 2003 annual meeting. "I've looked at Mark's portfolio and I like the positions."

The 2006 Form 10-K for Berkshire [link here] indicates that the company's investment in Value Capital was "substantially liquidated as of June 30, 2006". Sayonara, Mr. Byrne.


For the record, in 2003 Berkshire's stock rose 16%, trailing the S&P 500 by 13%, the Marlins clubbed the Yankees 4-2 in the World Series, the Pats beat the Panthers 32-29 in Super Bowl XXXVIII and on December 13th U.S. forces captured Saddam Hussein. Next up, 2004, the year Athens hosted the Summer Olympics for the first time since 1896.

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