Warren Buffett on How We Measure Ourselves

 

All the passages below are taken from Berkshire Hathaway 2009 Annual report.

 

                  www.berkshirehathaway.com

 

                                  Berkshire’s Corporate Performance vs. the S&P 500

 

                                           Annual Percentage Change

Year

 

in Per-Share

Book Value of

Berkshire

(1)

 

in S&P 500

with Dividends

Included

(2)

 

Relative

Results

(1)-(2)

 

1965

23.8

10.0

13.8

1966

20.3

(11.7)

32.0

1967

11.0

30.9

(19.9)

1968

19.0

11.0

8.0

1969

16.2

(8.4)

24.6

1970

12.0

3.9

8.1

1971

16.4

14.6

1.8

1972

21.7

18.9

2.8

1973

4.7

(14.8)

19.5

1974

5.5

(26.4)

31.9

1975

21.9

37.2

(15.3)

1976

59.3

23.6

35.7

1977

31.9

(7.4)

39.3

1978

24.0

6.4

17.6

1979

35.7

18.2

17.5

1980

19.3

32.3

(13.0)

1981

31.4

(5.0)

36.4

1982

40.0

21.4

18.6

1983

32.3

22.4

9.9

1984

13.6

6.1

7.5

1985

48.2

31.6

16.6

1986

26.1

18.6

7.5

1987

19.5

5.1

14.4

1988

20.1

16.6

3.5

1989

44.4

31.7

12.7

1990

7.4

(3.1)

10.5

1991

39.6

30.5

9.1

1992

20.3

7.6

12.7

1993

14.3

10.1

4.2

1994

13.9

1.3

12.6

1995

43.1

37.6

5.5

1996

31.8

23.0

8.8

1997

34.1

33.4

0.7

1998

48.3

28.6

19.7

1999

0.5

21.0

(20.5)

2000

6.5

(9.1)

15.6

2001

(6.2)

(11.9)

5.7

2002

10.0

(22.1)

32.1

2003

21.0

28.7

(7.7)

2004

10.5

10.9

(.4)

2005

6.4

4.9

1.5

2006

18.4

15.8

2.6

2007

11.0

5.5

5.5

2008

(9.6)

(37.0)

27.4

2009

19.8

26.5

(6.7)

Compounded Annual Gain – 1965-2009

20.3%

9.3%

11.0

Overall Gain– 1964-2009

434,057%

5,430%

 

 

 

Notes: Data are for calendar years with these exceptions: 1965 and 1966, year ended 9/30; 1967, 15 months ended 12/31.

 

Starting in 1979, accounting rules required insurance companies to value the equity securities they hold at market rather than at the lower of cost or market, which was previously the requirement. In this table, Berkshire’s results through 1978 have been restated to conform to the changed rules. In all other respects, the results are calculated using the numbers originally reported.

 

The S&P 500 numbers are pre-tax whereas the Berkshire numbers are after-tax. If a corporation such as Berkshire were simply to have owned the S&P 500 and accrued the appropriate taxes, its results would have lagged the S&P 500 in years when that index showed a positive return, but would have exceeded the S&P 500 in years when the index showed a negative return. Over the years, the tax costs would have caused the aggregate lag to be substantial.

 

         Our gain in net worth during 2009 was $21.8 billion, which increased the per-share book value of both our Class A and Class B stock by 19.8%. Over the last 45 years (that is, since present management took over) book value has grown from $19 to $84,487, a rate of 20.3% compounded annually.*

 

Berkshire’s recent acquisition of Burlington Northern Santa Fe (BNSF) has added at least 65,000 shareholders to the 500,000 or so already on our books. It’s important to Charlie Munger, my long-time partner, and me that all of our owners understand Berkshire’s operations, goals, limitations and culture. In each annual report, consequently, we restate the economic principles that guide us. This year these principles appear on pages 89-94 [An Owner’s Manual] and I urge all of you – but particularly our new shareholders – to read them. Berkshire has adhered to these principles for decades and will continue to do so long after I’m gone.

 

In this letter we will also review some of the basics of our business, hoping to provide both a freshman orientation session for our BNSF newcomers and a refresher course for Berkshire veterans.

 

How We Measure Ourselves

 

Our metrics for evaluating our managerial performance are displayed on the facing page. From the start, Charlie and I have believed in having a rational and unbending standard for measuring what we have – or have not – accomplished. That keeps us from the temptation of seeing where the arrow of performance lands and then painting the bull’s eye around it.

 

Selecting the S&P 500 as our bogey was an easy choice because our shareholders, at virtually no cost, can match its performance by holding an index fund. Why should they pay us for merely duplicating that result?

 

A more difficult decision for us was how to measure the progress of Berkshire versus the S&P. There are good arguments for simply using the change in our stock price. Over an extended period of time, in fact, that is the best test. But year-to-year market prices can be extraordinarily erratic. Even evaluations covering as long as a decade can be greatly distorted by foolishly high or low prices at the beginning or end of the measurement period. Steve Ballmer, of Microsoft, and Jeff Immelt, of GE, can tell you about that problem, suffering as they do from the nosebleed prices at which their stocks traded when they were handed the managerial baton.

 

The ideal standard for measuring our yearly progress would be the change in Berkshire’s per-share intrinsic value. Alas, that value cannot be calculated with anything close to precision, so we instead use a crude proxy for it: per-share book value. Relying on this yardstick has its shortcomings, which we discuss on pages 92 and 93. Additionally, book value at most companies understates intrinsic value, and that is certainly the case at Berkshire. In aggregate, our businesses are worth considerably more than the values at which they are carried on our books. In our all-important insurance business, moreover, the difference is huge. Even so, Charlie and I believe that our book value – understated though it is – supplies the most useful tracking device for changes in intrinsic value. By this measurement, as the opening paragraph of this letter states, our book value since the start of fiscal 1965 has grown at a rate of 20.3% compounded annually.

 

We should note that had we instead chosen market prices as our yardstick, Berkshire’s results would look better, showing a gain since the start of fiscal 1965 of 22% compounded annually. Surprisingly, this modest difference in annual compounding rate leads to an 801,516% market-value gain for the entire 45-year period compared to the book-value gain of 434,057% (shown on page 2). Our market gain is better because in 1965 Berkshire shares sold at an appropriate discount to the book value of its underearning textile assets, whereas today Berkshire shares regularly sell at a premium to the accounting values of its first-class businesses.

 

Summed up, the table on page 2 conveys three messages, two positive and one hugely negative. First, we 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. Second, though we have lagged the S&P in some years that were positive for the market, we have consistently done better than the S&P in the eleven years during which it delivered negative results. In other words, our defense has been better than our offense, and that’s likely to continue.

 

The big minus is that our performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain to continue. To be sure, Berkshire has many outstanding businesses and a cadre of truly great managers, operating within an unusual corporate culture that lets them maximize their talents. Charlie and I believe these factors will continue to produce better-than-average results over time. But huge sums forge their own anchor and our future advantage, if any, will be a small fraction of our historical edge.

 

What We Don’t Do

 

Long ago, Charlie laid out his strongest ambition: “All I want to know is where I’m going to die, so I’ll never go there.” That bit of wisdom was inspired by Jacobi, the great Prussian mathematician, who counseled “Invert, always invert” as an aid to solving difficult problems. (I can report as well that this inversion approach works on a less lofty level: Sing a country song in reverse, and you will quickly recover your car, house and wife.)

 

Here are a few examples of how we apply Charlie’s thinking at Berkshire:

 

 

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.

 

 

When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity and capital to the system, not a supplicant. At the very peak of the crisis, we poured $15.5 billion into a business world that could otherwise look only to the federal government for help. Of that, $9 billion went to bolster capital at three highly-regarded and previously-secure American businesses that needed – without delay – our tangible vote of confidence. The remaining $6.5 billion satisfied our commitment to help fund the purchase of Wrigley, a deal that was completed without pause while, elsewhere, panic reigned.

 

We pay a steep price to maintain our premier financial strength. The $20 billion-plus of cash equivalent assets that we customarily hold is earning a pittance at present. But we sleep well.

 

 

With our acquisition of BNSF, we now have about 257,000 employees and literally hundreds of different operating units. We hope to have many more of each. But we will never allow Berkshire to become some monolith that is overrun with committees, budget presentations and multiple layers of management. Instead, we plan to operate as a collection of separately-managed medium-sized and large businesses, most of whose decision-making occurs at the operating level. Charlie and I will limit ourselves to allocating capital, controlling enterprise risk, choosing managers and setting their compensation.

 

 

To build a compatible shareholder population, we try to communicate with our owners directly and informatively. Our goal is to tell you what we would like to know if our positions were reversed. Additionally, we try to post our quarterly and annual financial information on the Internet early on weekends, thereby giving you and other investors plenty of time during a non-trading period to digest just what has happened at our multi-faceted enterprise.  (Occasionally, SEC deadlines force a non-Friday disclosure.) These matters simply can’t be adequately summarized in a few paragraphs, nor do they lend themselves to the kind of catchy headline that journalists sometimes seek.

 

Last year we saw, in one instance, how sound-bite reporting can go wrong. Among the 12,830 words in the annual letter was this sentence: “We are certain, for example, that the economy will be in shambles throughout 2009 – and probably well beyond – but that conclusion does not tell us whether the market will rise or fall.” Many news organizations reported – indeed, blared – the first part of the sentence while making no mention whatsoever of its ending. I regard this as terrible journalism: Misinformed readers or viewers may well have thought that Charlie and I were forecasting bad things for the stock market, though we had not only in that sentence, but also elsewhere, made it clear we weren’t predicting the market at all. Any investors who were misled by the sensationalists paid a big price: The Dow closed the day of the letter at 7,063 and finished the year at 10,428.

 

Given a few experiences we’ve had like that, you can understand why I prefer that our communications with you remain as direct and unabridged as possible.  [Pg 3-5]

 

February 26, 2010

Warren E. Buffett

Chairman of the Board

 

 

*All per-share figures used in this report apply to Berkshire’s A shares. Figures for the B shares are 1/1500th of those shown for A.