To get a handle on this, we talked to software developer and Warren Buffett aficionado Steve Ritter, who has read every letter and goes to Berkshire's annual meetings each year.
Right away, Buffett tackles the notion that earnings performance is a good way to measure managerial performance:
Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital. In 1977 our operating earnings on beginning equity capital amounted to 19%, slightly better than last year and above both our own long-term average and that of American industry in aggregate. But, while our operating earnings per share were up 37% from the year before, our beginning capital was up 24%, making the gain in earnings per share considerably less impressive than it might appear at first glance.
In his 1983 letter, Buffett wrote about the importance of "economic goodwill" in the companies he invested in:
We own several businesses that possess economic Goodwill (which is properly includable in intrinsic business value) far larger than the accounting Goodwill that is carried on our balance sheet and reflected in book value...
...You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.
The next year, in 1984, Berkshire highlighted its purchase of Nebraska Furniture Mart. Buffett was a huge fan of NFM's chairman, the 91-year-old Rose Blumkin, who he affectionately referred to as "Mrs. B."
Here's an excerpt:
I have been asked by a number of people just what secrets the Blumkins bring to their business. These are not very esoteric. All members of the family: (1) apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts; (2) define with extraordinary realism their area of special competence and act decisively on all matters within it; (3) ignore even the most enticing propositions failing outside of that area of special competence; and, (4) unfailingly behave in a high-grade manner with everyone they deal with. (Mrs. B boils it down to “sell cheap and tell the truth”.)
Our evaluation of the integrity of Mrs. B and her family was demonstrated when we purchased 90% of the business: NFM had never had an audit and we did not request one; we did not take an inventory nor verify the receivables; we did not check property titles. We gave Mrs. B a check for $55 million and she gave us her word. That made for an even exchange.
That's trust.
Buffett is a long-time investor in the insurance business. In his 2001 letter, he described the economics of the industry, writing, " Our main business – though we have others of great importance – is insurance. To understand Berkshire, therefore, it is necessary that you understand how to evaluate an insurance company."
Buffett reflects on the World Trade Center attacks of September 11, 2001, and how the prospect of terrorism altered the insurance business:
The events of September 11th made it clear that our implementation of rules 1 and 2 at General Re had been dangerously weak. In setting prices and also in evaluating aggregation risk, we had either overlooked or dismissed the possibility of large-scale terrorism losses. That was a relevant underwriting factor, and we ignored it.
In pricing property coverages, for example, we had looked to the past and taken into account only costs we might expect to incur from windstorm, fire, explosion and earthquake. But what will be the largest insured property loss in history (after adding related business-interruption claims) originated from none of these forces. In short, all of us in the industry made a fundamental underwriting mistake by focusing on experience, rather than exposure, thereby assuming a huge terrorism risk for which we received no premium.
Finally, there was 2008 – the year of the Lehman Brothers failure and the global financial crisis.
Buffett's 2008 letter is pretty wide-ranging, given the lessons investors learned that year.
In one section, Buffett touched on the dangers of derivatives, which played a big part in the crisis. Buffett, as a long-time investor in the insurance business, had plenty of experience with the instruments himself.
He wrote:
Indeed, recent events demonstrate that certain big-name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie and me in this hapless group: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.”
Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them. When I read the pages of “disclosure” in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is going on in their portfolios (and then I reach for some aspirin).
The excerpts above are, of course, only a very small sample of the type of writing that has made Buffett's letters a must-read for investors year-in and year-out.
