Tuesday September 23, 2014

Annual Letter To Shareholders

Berkshire Hathaway CEO Warren Buffett addressed shareholders in his 2010 annual letter.

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.

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 Hathaway CEO Warren Buffett addressed shareholders in his 2010 annual letter.

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 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.

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:

  • Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth  that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But  the future then also included competitive dynamics that would decimate almost all of the  companies entering those industries. Even the survivors tended to come away bleeding.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.
  • We will never become dependent on the kindness of strangers. Too-big-to-fail is not a fallback position at Berkshire. Instead, we will always arrange our affairs so that any requirements for cash  we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be  constantly refreshed by a gusher of earnings from our many and diverse businesses.

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