Warren Buffett’s annual letter to shareholders: 2008

I spent a few hours this morning reading Warren Buffett’s new 2008 letter to shareholders.

Maybe I should be worried the direction my life is taking, but Buffett’s annual letter has become a highlight of the year for me. It’s hard to write about investing in an engaging way (as Monevator subscribers will doubtless confirm) and yet Buffett’s letter is always a corker.

Indeed, I was disappointed to discover in Buffett’s biography The Snowball that the letter is co-written by Fortune journalist and long-time Buffett follower Carol Loomis. But I was also pretty relieved. It didn’t seem fair that Buffett, like his mentor Benjamin Graham, could write as well as invest better than me!

For those with more exciting lives or less time, I’ve snipped the essential highlights of Buffett’s letter below.

I’ve also added a few modest thoughts on what Buffett’s letter tells us about investing right now.

Warren who? Warren Buffett is one of the world’s greatest investors and businessmen. He has a net wealth of $50 billion, and is famous for his adherence to ‘value investing’ and his folksy down-to-earth style. Read Buffett’s Wikipedia entry if you need more information, then come back and read on!

Highlights of Warren Buffett’s 2008 letter

Berkshire Hathaway is the holding company that incorporates all Buffett’s businesses. His letter reveals that in 2008, Berkshire’s book value fell 9.6%, versus a fall of 37% for the S&P 500 index.

In other words, Berkshire held its value far better than the overall market.

But shareholders aren’t happy. The share price fell 32% in 2008, and it’s down around 20% in 2009 so far. (If the pound wasn’t so weak against the dollar and Buffett was ten years younger, I’d be thinking about buying.)

At least Berkshire Hathaway shareholders get a great explanation of what’s going on from their CEO…

Buffett on the bear market:

[As well as equities] the period was devastating for corporate and municipal bonds, real estate and commodities. By year end, investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game.

Inflation likely consequence of Fed action:

In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome  aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.

Bad times are nothing new:

In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21 1⁄ 2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of  challenges.

Predicting the market short-term is futile:

We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.

Bad news is good news:

Berkshire is always a buyer of both businesses and securities, and the disarray in markets gave us a tailwind in our purchases. When investing, pessimism is your friend, euphoria the enemy.

Buffett can feel guilty about losing money, too:

During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt… Furthermore, I made some errors of omission, sucking my thumb when new facts came in.

Stocks down? Who cares if you’re buying:

We enjoy such price declines if we have funds available to increase our positions. Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.

Berkshire’s investments declined 13.9% in 2008:

In 2008, our investments fell from $90,343 per share of Berkshire (after minority interest) to $77,793, a decrease that was caused by a decline in market prices, not by net sales of stocks or bonds.

Beware financial theory:

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.

Buffett was caught by the collapse in oil:

I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.

He was also caught out buying banks:

During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At year end we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”

Buffett agrees with me that Treasuries were in a bubble in 2008:

The investment world has gone from underpricing risk to overpricing it. […] When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long.

I’ve probably stretched what I’m legally allowed to quote from Buffett’s 22-page letter without infringing on his copyright, but in my defense he shouldn’t make it so damn readable!

I haven’t even considered:

• Buffett’s updated thoughts on derivatives
• His views on the housing market and mortgages
• His thoughts on the U.S. economy (a ‘shambles’, he says)

Naturally, I’d urge you to download Buffett’s letter to read it all. (If you don’t want to download a document from a link here, then download it yourself from Berkshire Hathaway’s Buffett letter archive).

Is Buffett really ‘Buying America’?

Let’s think for a moment about what insights Buffett’s letter has for us as investors.

Buffett’s two main businesses, insurance and utilities, are fairly uncorrelated from the markets, which is what bouyed Berkshire Hathaway’s performance. (Those benefits of portfolio diversification again!)

Why can also see that despite Buffett writing in The New York Times that it was time to “Buy America” in the mayhem of October 2008, Berkshire’s fresh stock market investing during 2008 was modest. (In fairness, Buffett did write in that letter he was buying stocks for his personal account).

Even where Buffett has bought, he’s used Berkshire Hathaway’s strength to ensure he gets unusually great terms.

As he says:

We made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus.

These positions are rather akin to convertible bonds, except with really great yields despite the iconic stature of the companies involved, and thus much less risk than typical convertibles.

Buffett will collect billions as income from these investments over the years, provided the companies don’t go bust. And if markets rally hard then he (or more likely his successor) will eventually see a capital gain to boot.

There’s no point sniping about these terms, as some commentators do. Buffett has earned the premium his money gets by being a financial ‘rock’ for 40-odd years.

But it’s not an investment that we can easily copy.

Buffett REALLY enjoys Berkshire’s AAA status

Maintaining Berkshire’s position of financial strength is probably why Buffett won’t put enormous sums into a market he surely sees as cheap.

There’s plenty of clues in Buffett’s letter that he thinks stocks are being sold at knock-down prices. But that he won’t risk taking huge new positions with Berkshire’s cash shows his golden rule in full effect:

No.1: Never lose money.

Rule No.2: Never forget rule No.1.

The market may go anywhere from here, and Buffett knows it. Buffett the man can take risky positions on stocks, despite knowing that nothing is certain. But if the giant Berkshire bets on the markets in a truly meaningful tens-of-billion-dollars way and it goes wrong, the company could also lose its cherished AAA status, as well as first refusal on every deal in town.

True, Buffett took these risks 30 years ago, but Buffett wasn’t really Buffett then. Nobody understood how Berkshire Hathaway made money, or the connection between his insurance float and his investing.

Today, Buffett and Berkshire are the biggest beasts left in a jungle where giants like Bear Sterns, Merril Lynch and AIG have gone extinct.

This reality is giving Berkshire plenty of innovative and safer ways to make money, without gambling on stocks that could derail his special advantage.

In this climate, Buffett doesn’t need to buy stocks for Berkshire.