This is the thirty-third 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 2009 letter weighs in at 10,930 words, a 14.3% decrease from 12,760 words the prior year. Berkshire's increase in net worth during 2009 was $21.8 billion, or 19.8% of beginning 2009 net worth.
BERKSHIRE'S 41-CYCLE HITTING STREAK; AND A BEATLE REFERENCE
In the 2009 letter, Buffett starts with a short sermon on how shareholders should measure Berkshire's progress (or lack thereof) over time. He says the ideal yardsticks should be growth in intrinsic value per share, in comparison to growth in the S&P 500, measured over an appropriately long time period (to smooth out random fluctuations in either yardstick). However, since intrinsic value cannot be measured exactly, he opts for growth in Berkshire's book value per share as a rough proxy (note that, at least for Berkshire generally, book value is seldom artificially skewed higher or lower by the payment of dividends, share repurchases or stock issuances). Buffett also makes the following interesting point regarding rolling 5-year measurement periods:
[W]e have never had any five-year period beginning with 1965-69 and ending with 2005-09 – and there have been 41 of these – during which our gain in book value did not exceed the S&P’s gain.
This is a fairly astounding statement--41 consecutive measurement periods without losing to the S&P once. Again, this just demonstrates Buffett's sheer capital allocation brilliance, unlikely to be ever approached again for any sustained period by another investor. Little did he realize it when penning the above line, though, his streak would finally come to an end with the 2009-2013 measurement period, as Berkshire's book value per share increase of 92% during that period trailed the 128% advance in the S&P 500.
All things must pass, all things must pass away, as George Harrison [RIP] once sang.
DO BERKSHIRE'S IBM AND APPLE INVESTMENTS CONSTITUTE STYLE DRIFT FOR BUFFETT?
One of Buffett's consistent cornerstones of his investment philosophy historically had always been...consistency (in financial results, in brand equity, in cost control, etc.) In other words, he has always insisted that his investee companies retain "wide moats" to protect their respective economic castles. Coca-Cola would be a prime example of the kind of company Buffett has looked for; GEICO would be another. Indeed, Buffett repeats this theme in the 2009 letter:
Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes.
This insistence on "reasonably predictable" businesses meant that Buffett historically had to avoid investing in high tech companies, which were susceptible to being overthrown by upstart competitors. Yet since 2009 two of Buffett's largest investments have been, you guessed it, large cap tech companies, namely IBM and Apple. Perhaps because Berkshire has grown to be so large and Buffett's potential targets so rare (he constantly talks about stalking "elephants", since smaller prey won't move the needle--for example see here), he has been forced to lower his standards. Unfortunately, Buffett recently had to declare the IBM investment a disappointment after 5 years of stasis (for news coverage, see here). It remains to be seen whether Apple will pan out differently for Buffett.
BERKSHIRE AS SUBPRIME LENDER
Buffett makes some interesting comments regarding Berkshire's status as a subprime lender in the 2009 letter. Wait--did we just say "Berkshire's status as a subprime lender"??? Normally, this designation ranks just above "kid toucher" or "serial killer" in the common lexicon. However, it's true, Berkshire through its Clayton Homes subsidiary makes loans to subprime borrowers for the purchase of mobile homes. Buffett includes the following commentary on why he believes these loans actually represent sound financing:
Last year I told you why our [Clayton Home] buyers – generally people with low incomes – performed so well as credit risks. Their attitude was all-important: They signed up to live in the home, not resell or refinance it. Consequently, our buyers usually took out loans with payments geared to their verified incomes (we weren’t making “liar’s loans”) and looked forward to the day they could burn their mortgage. If they lost their jobs, had health problems or got divorced, we could of course expect defaults. But they seldom walked away simply because house values had fallen. Even today, though job-loss troubles have grown, Clayton’s delinquencies and defaults remain reasonable and will not cause us significant problems.
Note that the exact same rationale could apply to subprime auto loans--these borrowers need their vehicles to get to work, go to the grocery store, pick up their children from school, etc., so they are highly unlikely to default just because (A) they are temporarily between jobs or (B) the resale value of their vehicles declines. This argument appears to refute one of the main planks in the recent bearish thesis regarding automakers like GM and Ford, i.e., that too many of their sales are financed by subprime vehicle loans (Berkshire owned approximately 50,000,000 shares of GM as of the end of Q1 2017).
"WHEN'S IT'S RAINING GOLD, REACH FOR A BUCKET"
Buffett had the following to say in the 2009 letter about investing during chaotic economic periods (far different from the tone reflected in today's placid markets, with a daily movement in excess of 1% in any major index a rare sighting):
We told you last year that very unusual conditions then existed in the corporate and municipal bond markets and that these securities were ridiculously cheap relative to U.S. Treasuries. We backed this view with some purchases, but I should have done far more. Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.
We entered 2008 with $44.3 billion of cash-equivalents, and we have since retained operating earnings of $17 billion. Nevertheless, at yearend 2009, our cash was down to $30.6 billion (with $8 billion earmarked for the BNSF acquisition). We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.
HOW TO PROPERLY EVALUATE A STOCK-FOR-STOCK MERGER
Buffett includes the following discussion regarding stock-for-stock mergers, noting the while the acquirer virtually always acknowledges that the target's stock is undervalued (hence, the need to pay a control premium), it never seems to occur to the acquirer's management that using their own stock as currency when it is undervalued is financially idiotic and detrimental to their shareholders:
In evaluating a stock-for-stock offer, shareholders of the target company quite understandably focus on the market price of the acquirer’s shares that are to be given them. But they also expect the transaction to deliver them the intrinsic value of their own shares – the ones they are giving up. If shares of a prospective acquirer are selling below their intrinsic value, it’s impossible for that buyer to make a sensible deal in an all-stock deal. You simply can’t exchange an undervalued stock for a fully-valued one without hurting your shareholders.
Imagine, if you will, Company A and Company B, of equal size and both with businesses intrinsically worth $100 per share. Both of their stocks, however, sell for $80 per share. The CEO of A, long on confidence and short on smarts, offers 11⁄4 shares of A for each share of B, correctly telling his directors that B is worth $100 per share. He will neglect to explain, though, that what he is giving will cost his shareholders $125 in intrinsic value. If the directors are mathematically challenged as well, and a deal is therefore completed, the shareholders of B will end up owning 55.6% of A & B’s combined assets and A’s shareholders will own 44.4%. Not everyone at A, it should be noted, is a loser from this nonsensical transaction. Its CEO now runs a company twice as large as his original domain, in a world where size tends to correlate with both prestige and compensation.
If an acquirer’s stock is overvalued, it’s a different story: Using it as a currency works to the acquirer’s advantage. That’s why bubbles in various areas of the stock market have invariably led to serial issuances of stock by sly promoters. Going by the market value of their stock, they can afford to overpay because they are, in effect, using counterfeit money. Periodically, many air-for-assets acquisitions have taken place, the late 1960s having been a particularly obscene period for such chicanery. Indeed, certain large companies were built in this way. (No one involved, of course, ever publicly acknowledges the reality of what is going on, though there is plenty of private snickering.)...
I have been in dozens of board meetings in which acquisitions have been deliberated, often with the directors being instructed by high-priced investment bankers (are there any other kind?). Invariably, the bankers give the board a detailed assessment of the value of the company being purchased, with emphasis on why it is worth far more than its market price. In more than fifty years of board memberships, however, never have I heard the investment bankers (or management!) discuss the true value of what is being given. When a deal involved the issuance of the acquirer’s stock, they simply used market value to measure the cost. They did this even though they would have argued that the acquirer’s stock price was woefully inadequate – absolutely no indicator of its real value – had a takeover bid for the acquirer instead been the subject up for discussion.
When stock is the currency being contemplated in an acquisition and when directors are hearing from an advisor, it appears to me that there is only one way to get a rational and balanced discussion. Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through. Absent this drastic remedy, our recommendation in respect to the use of advisors remains: “Don’t ask the barber whether you need a haircut.”
For the record, in 2009 Berkshire's stock appreciated 2.7%, trailing the S&P 500 by 24%, the Yankees beat the Phillies 4-2 in the World Series and the Saints throttled the Colts 31-17 in Super Bowl XLIV. Next up, 2010, the first year of the two-thousand tens (or, if one prefers, the twenty-tens).