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Berkshire 2004 Shareholder Letter - Cliff's Notes Version

April 25, 2017

This is the twenty-eighth 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 2004 letter weighs in at 14,620 words, an 11% increase from 13,120 words the prior year. Berkshire's gain in net worth during 2004 was $8.3 billion, or 10.5% of beginning 2004 net worth. 

 

NATIONAL INDEMNITY COMPANY - OR HOW TO (PROPERLY) RUN AN INSURER

 

Buffett identifies in the 2004 letter the secret to Berkshire's success with respect to its insurance operations. Since insurance is by nature a commodity business, it is quite difficult to create a brand to differentiate an insurer from its competitors (Buffett says that no customer says "We insist on a National Indemnity policy"; rather, much like with airline seats, consumers simply select the lowest price available). However, Buffett was able to instill one key advantage in National Indemnity that its competitors lacked--namely, a particular temperament to turn down business when not priced appropriately. Virtually every other insurance CEO secretly has his or her eye principally on growth rather than profitable underwriting (although they won't admit the fact). Below is National Indemnity's underwriting track record from 1980 through 2004:

 

Buffett's main point is that the 13-year decline in revenue from 1986-1999 would never be tolerated at another insurance company. This fact likely springs from a combination of three factors: (A) CEOs' inveterate optimism and animal spirits, which leads them to unwittingly misprice business, (B) the desire of CEOs to build their empires, which leads them to prioritize growth over profitability, and (C) the institutional imperative, which causes company executives to mindlessly imitate their peers, no matter how foolishly those peers are behaving. Obviously, Buffett, over the course of his investing career, became adept at identifying these potential pitfalls and avoiding them.

 

BUFFETT'S JEREMIAD REGARDING THE U.S. TRADE DEFICIT--A FORESHADOWING OF DONALD TRUMP'S POLITICAL RISE?

 

Buffett includes a long section in the 2004 letter warning about the U.S. trade deficit. His key points are as follows:

 

I argued in a November 10, 2003 article in Fortune...[that] our country’s trade practices are weighing down the dollar. The decline in its value has already been substantial, but is nevertheless likely to continue. Without policy changes, currency markets could even become disorderly and generate spillover effects, both political and financial. No one knows whether these problems will materialize. But such a scenario is a far-from-remote possibility that policymakers should be considering now. Their bent, however, is to lean toward not-so-benign neglect: A 318-page Congressional study of the consequences of unremitting trade deficits was published in November 2000 and has been gathering dust ever since. The study was ordered after the deficit hit a then-alarming $263 billion in 1999; by last year it had risen to $618 billion.

 

Charlie and I, it should be emphasized, believe that true trade – that is, the exchange of goods and services with other countries – is enormously beneficial for both us and them. Last year we had $1.15 trillion of such honest-to-God trade and the more of this, the better. But, as noted, our country also purchased an additional $618 billion in goods and services from the rest of the world that was unreciprocated. That is a staggering figure and one that has important consequences.

 

The balancing item to this one-way pseudo-trade — in economics there is always an offset — is a transfer of wealth from the U.S. to the rest of the world. The transfer may materialize in the form of IOUs our private or governmental institutions give to foreigners, or by way of their assuming ownership of our assets, such as stocks and real estate. In either case, Americans end up owning a reduced portion of our country while non-Americans own a greater part. This force-feeding of American wealth to the rest of the world is now proceeding at the rate of $1.8 billion daily, an increase of 20% since I wrote you last year. Consequently, other countries and their citizens now own a net of about $3 trillion of the U.S. A decade ago their net ownership was negligible.

 

The mention of trillions numbs most brains. A further source of confusion is that the current account deficit (the sum of three items, the most important by far being the trade deficit) and our national budget deficit are often lumped as “twins.” They are anything but. They have different causes and different consequences. A budget deficit in no way reduces the portion of the national pie that goes to Americans. As long as other countries and their citizens have no net ownership of the U.S., 100% of our country’s output belongs to our citizens under any budget scenario, even one involving a huge deficit.

 

As a rich “family” awash in goods, Americans will argue through their legislators as to how government should redistribute the national output – that is who pays taxes and who receives governmental benefits. If “entitlement” promises from an earlier day have to be reexamined, “family members” will angrily debate among themselves as to who feels the pain. Maybe taxes will go up; maybe promises will be modified; maybe more internal debt will be issued. But when the fight is finished, all of the family’s huge pie remains available for its members, however it is divided. No slice must be sent abroad.

Large and persisting current account deficits produce an entirely different result. As time passes, and as claims against us grow, we own less and less of what we produce. In effect, the rest of the world enjoys an ever-growing royalty on American output. Here, we are like a family that consistently overspends its income. As time passes, the family finds that it is working more and more for the “finance company” and less for itself.

 

Should we continue to run current account deficits comparable to those now prevailing, the net ownership of the U.S. by other countries and their citizens a decade from now will amount to roughly $11 trillion. And, if foreign investors were to earn only 5% on that net holding, we would need to send a net of $0.55 trillion of goods and services abroad every year merely to service the U.S. investments then held by foreigners. At that date, a decade out, our GDP would probably total about $18 trillion (assuming low inflation, which is far from a sure thing). Therefore, our U.S. “family” would then be delivering 3% of its annual output to the rest of the world simply as tribute for the overindulgences of the past. In this case, unlike that involving budget deficits, the sons would truly pay for the sins of their fathers.

 

This annual royalty paid the world – which would not disappear unless the U.S. massively underconsumed and began to run consistent and large trade surpluses – would undoubtedly produce significant political unrest in the U.S. Americans would still be living very well, indeed better than now because of the growth in our economy. But they would chafe at the idea of perpetually paying tribute to their creditors and owners abroad. A country that is now aspiring to an “Ownership Society” will not find happiness in – and I’ll use hyperbole here for emphasis – a “Sharecropper’s Society.” But that’s precisely where our trade policies, supported by Republicans and Democrats alike, are taking us. 

 

Below is the trade deficit (in $ billions) by year since Buffett issued his 2004 warning [source here]:

 

2004: -609,883

2005: -714,245

2006: -761,716

2007: -705,375

2008: -708,726

2009: -383,774

2010: -494,658

2011: -548,625

2012: -536,773

2013: -461,876

2014: -490,176

2015: -500,361

2016: -500,560

 

Note that since 2004 nominal U.S. GDP has risen over 50% [source here]. Thus, the U.S. trade deficit as a percentage of nominal GDP has fallen from about 5% in 2004 to about 2.7% last year. While Americans are still mortgaging a small portion of their collective wealth to foreigners by overspending their means, the rate of overspend has fallen by 46% since 2004; and if the trade deficit stays fairly level, this number should continue to fall as GDP increases. 

 

Notice Buffett's prediction that "This annual royalty paid the world...would undoubtedly produce significant political unrest in the U.S.... [Americans] would chafe at the idea of perpetually paying tribute to their creditors and owners abroad". Ironically, Buffett appears in these statements to have foreshadowed the rise of Donald Trump, although he didn't know it at the time. Doubly ironic is the fact that Buffett actually mentions Trump in the 2004 letter, albeit in jest (in the section discussing National Indemnity, he states that they never lay off workers due to declining insurance premiums, which he says makes National Indemnity "not Donald Trump’s sort of place").

 

Perhaps Buffett in 2016 sided with his heart rather than his head (given his observations from 2004); however, the 17% rise in Berkshire's stock price since the Presidential election has proven that, at least with respect to Buffett's net worth (and despite the picture below), Trump and Buffett have been "stronger together".

 

 

CONCLUSION

 

For the record, in 2004 Berkshire's stock rose 4.3%, trailing the S&P 500 by 6.6%, the Red Sox beat the Cardinals 4-0 in the World Series, the Pats beat the Eagles 24-21 in Super Bowl XXXIX and on September 1st the Chechen rebel hostage crisis began.  Next up, 2005, the year the U.S. housing bubble began to crest.

 

 

 

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