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Berkshire 2005 Shareholder Letter - Cliff's Notes Version

May 4, 2017

This is the twenty-ninth in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2016. For all of the prior shareholder letters, see here.

 

The 2005 letter weighs in at 13,230 words, a 9.5% decrease from 14,620 words the prior year. Berkshire's gain in net worth during 2005 was $5.6 billion, or 6.4% of beginning 2005 net worth. 

 

BUFFETT MUSES ON CLIMATE CHANGE

 

In the 2005 letter, Buffett wrings his hands over climate change, wondering aloud whether the phenomenon that "everybody" seems to agree on (i.e., climate change and its supposedly devastation future effects on humanity) will cause more damaging hurricanes in the future:

 

It’s an open question whether atmospheric, oceanic or other causal factors have dramatically changed the frequency or intensity of hurricanes. Recent experience is worrisome. We know, for instance, that in the 100 years before 2004, about 59 hurricanes of Category 3 strength, or greater, hit the Southeastern and Gulf Coast states, and that only three of these were Category 5s. We further know that in 2004 there were three Category 3 storms that hammered those areas and that these were followed by four more in 2005, one of them, Katrina, the most destructive hurricane in industry history. Moreover, there were three Category 5s near the coast last year that fortunately weakened before landfall.

 

Was this onslaught of more frequent and more intense storms merely an anomaly? Or was it caused by changes in climate, water temperature or other variables we don’t fully understand? And could these factors be developing in a manner that will soon produce disasters dwarfing Katrina? 

 

Well, it seems to have been an anomaly, as there has been just a single Category 5 hurricane in the Atlantic since 2007 (Hurricane Matthew in 2016), after a total of eight occurred from 2003 through 2007 (see full historical list here). This shows how difficult it can be to predict the effects of climate change. Ironically, Hurricane Sandy, the 2nd costliest storm in U.S. history, was not even classified as a hurricane when it made landfall in the northeast United States in 2012 (rather, by then it was considered a post-tropical cyclone).

 

BUFFETT MAKES A PREDICTION REGARDING BERKSHIRE'S EQUITY PORTFOLIO

 

Here is Buffett's prediction from the 2005 letter:

 

Expect no miracles from our equity portfolio. Though we own major interests in a number of strong, highly-profitable businesses, they are not selling at anything like bargain prices. As a group, they may double in value in ten years. The likelihood is that their per-share earnings, in aggregate, will grow 6- 8% per year over the decade and that their stock prices will more or less match that growth. (Their managers, of course, think my expectations are too modest – and I hope they’re right.) 

 

And here are the results for the decade from 2005 to 2015 for Berkshire's eight largest equity holdings as of year-end 2005 (in each case excluding dividends):

 

1. KO - price at year-end 2005: $20.70; price at year-end 2015: $43.00; Appreciation: 108%;

 

2. AXP - price at year-end 2005: $52.30; price at year-end 2015: $69.60; Appreciation: 33%;

 

3. WFC - price at year-end 2005: $31.70; price at year-end 2015: $54.40; Appreciation: 72%;

 

4. PG - price at year-end 2005: $58.90; price at year-end 2015: $79.40; Appreciation: 35%;

 

5. MCO - price at year-end 2005: $63.40; price at year-end 2015: $100.30; Appreciation: 58%;

 

6. Petrochina H Shares - price at year-end 2005: $6.30; price at year-end 2015: $5.10; Appreciation: Minus 19%;

 

7. BUD - price at year-end 2005: $40; price at year-end 2015: $117; Appreciation: 193%;

 

8. Washington Post / GHC - price at year-end 2005: $765; price in mid-2015 [just prior to spin off of Cable One]: $1080; Appreciation: 41%;

 

Average price appreciation for the top-8 during the decade: 65%; CAGR 5.1%. So Buffett's prediction didn't quite come to fruition, however he clearly wasn't expecting a major financial crisis to pop up, nor do these calculations include dividends received. All things considered, however, a CAGR of just over 5% plus dividends for Buffett's "Elite 8" is very pedestrian given his absurdly great historical stock-picking track record. This simply reinforces the notion that in investing (as opposed to most other businesses) size and scale are the enemies of outstanding performance.

 

EVEN MORE ON THE WOEFUL STATE OF CORPORATE GOVERNANCE

 

Buffett continues his monologue from prior years' letters on the pathetic state of corporate governance in America, which has not been remedied down to the present day. Buffett's further observations--all of which are still relevant currently--on egregious executive compensation practices are included in full, as follows:

 

Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.

 

Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let’s say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock.

 

Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.

 

Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred’s option will deliver him $63 million. Meanwhile, his shareholders will wonder what happened to the “alignment of interests” that was supposed to occur when Fred was issued options.

 

A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces less extreme results but still can provide lush rewards for managers who achieve nothing.

 

CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options. I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they somehow forget to tell shareholders that fixed-price options give them capital that is free.

It doesn’t have to be this way: It’s child’s play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But – surprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation “experts,” who are nevertheless encyclopedic about every management-friendly plan that exists. (“Whose bread I eat, his song I sing.”)

 

Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets. Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all-too-prevalent rule is that nothing succeeds like failure.

 

Huge severance payments, lavish perks and outsized payments for ho-hum performance often occur because comp committees have become slaves to comparative data. The drill is simple: Three or so directors – not chosen by chance – are bombarded for a few hours before a board meeting with pay statistics that perpetually ratchet upwards. Additionally, the committee is told about new perks that other managers are receiving. In this manner, outlandish “goodies” are showered upon CEOs simply because of a corporate version of the argument we all used when children: “But, Mom, all the other kids have one.” When comp committees follow this “logic,” yesterday’s most egregious excess becomes today’s baseline.

 

Comp committees should adopt the attitude of Hank Greenberg, the Detroit slugger and a boyhood hero of mine. Hank’s son, Steve, at one time was a player’s agent. Representing an outfielder in negotiations with a major league club, Steve sounded out his dad about the size of the signing bonus he should ask for. Hank, a true pay-for-performance guy, got straight to the point, “What did he hit last year?” When Steve answered “.246,” Hank’s comeback was immediate: “Ask for a uniform.” 

 

CONCLUSION

 

For the record, in 2005 Berkshire's stock rose 1%, trailing the S&P 500 by 4%, the White Sox beat the Astros 4-0 in the World Series, the Steelers beat the Seahawks 21-10 in Super Bowl XL and on December 31st a Leap Second was added to the year.  Next up, 2006, the last year of calm and prosperity before the first waves of the Financial Crisis came ashore in the United States.

 

 

 

 

 

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