Warren Buffett’s Berkshire Hathaway Shareholder Letter

Every month, you’ll get a high double-digit yield with a steady dividend stream you can depend on.

Roger Conrad, Big Yield Hunting

Warren Buffett released his Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) shareholder letter over the weekend and, as usual, it is chock full of investment wisdom. As I wrote last year, Buffett’s shareholder letters are a” tutorial in investing par excellence.” You can learn more about investing by reading these annual letters than you can by going to business school or studying for the CFA examination. And they’re free to boot!

Since the letter is 27 pages long, I thought it would be useful to provide readers with a brief summary. Below are some of Warren’s “greatest hits” from this year’s letter:

Berkshire Hathaway’s Stock Performance

In 2010, Berkshire Hathaway underperformed the S&P 500 by 2.1 percentage points (13.0% vs. 15.1%). This is the second straight year of underperformance, since in 2009 Berkshire also underperformed the S&P 500 by 6.7 percentage points. Buffett says not to worry about short-term underperformance, pointing out that Berkshire has outperformed the S&P 500 over each five-year rolling period since its 1965 inception. That’s pretty amazing and underscores the importance of taking a long-term perspective in your investing. Buying Berkshire now after two consecutive sub-par years may be especially beneficial given the stock’s flawless five-year outperformance record.

Looking forward, Buffett said that he expects Berkshire’s annual performance “to average several points better than the S&P” over the long term. This forecast is actually more optimistic than four years ago when he predicted Berkshire’s future outperformance would only be “a couple of percentage points” better than the S&P 500.  Why the improved forecast? I can’t be sure, but it may have to do with his recent acquisition of the Burlington Northern railroad.

Railroad Investing is a Play on Energy

Buffett says that the Burlington Northern acquisition is:

working out even better than I expected. It now appears that owning this railroad will increase Berkshire’s “normal” earning power by nearly 40% pre-tax and by well over 30% after-tax.

Normalized earning power refers to annual earnings that are sustainable and not due to temporary factors like a one-time asset sale.  A 30% increase in normalized earnings is substantial and could explain Buffett’s new-found optimism.

This begs the question why Buffett is so optimistic about the railroad industry. I think the answer has to do with Buffett’s bullish view on global energy demand and his belief that oil prices are going to remain elevated for an extended period of time. Burlington Northern does not transport crude oil, but as I wrote in Warren Buffett is Betting Big on Coal, the railroad does transport 300 billion tons of coal annually. Coal is a power-generation fuel and in great demand throughout the developing world, including China and India.

But the earnings power of Burlington Northern does not hinge simply on coal demand. It also depends on oil prices. You may find this curious, since coal is not a transportation fuel like oil and cannot be substituted for oil. So, why would high oil prices boost business for Burlington Northern? The answer is because railroads use much less oil to transport goods than other forms of transport like trucking. As Buffett writes:

Railroads have major cost and environmental advantages over trucking, their main competitor. Last year Burlington Northern moved each ton of freight it carried a record 500 miles on a single gallon of diesel fuel. That’s three times more fuel-efficient than trucking is, which means our railroad owns an important advantage in operating costs. Concurrently, our country gains because of reduced greenhouse emissions and a much smaller need for imported oil. When traffic travels by rail, society benefits.

Optimism about America

Despite huge U.S. budget deficits and an exploding national debt, Buffett remains optimistic about America’s future. In fact, he claims that “America’s best days lie ahead.” Hard to believe and I might just have to chalk up this statement to the increasing sentimentality of an old man, albeit a very smart old man.

Still, he is putting his money where his mouth is. He notes that in 2010 Berkshire made 90% of its capital investments in the U.S. and will spend 100% of its 2011 investments in the U.S.

A key component to a sustainable U.S. economic recovery is the housing market. Buffett forecasts that “a housing recovery will probably begin within a year or so.” For the sake of my family’s perpetually-falling home equity, I sure hope he’s right.

Get Ready for More Acquisitions

Buffett says that most of the future growth at Berkshire will come from acquiring entire operating businesses and not from minority stakes in publicly-traded stock investments. He writes: “Our elephant gun has been reloaded, and my trigger finger is itchy.” Berkshire has $35 billion in cash, so that’s quite an impressive elephant gun. It’s likely that Buffett will deploy this cash in yet more “regulated, capital-intensive businesses” like Burlington Northern and Mid-American Energy. Buffett doesn’t want to spend time with small, piecemeal acquisitions that don’t move the needle much on Berkshire’s performance. He wants to make a few huge purchases that deploy Berkshire’s cash quickly and utility-like companies fit the bill.

Curiously, he claims that MidAmerican Energy, the Iowa electric utility owned by Berkshire, generates more energy from wind (2.9 gigawatts) than “any other regulated electric utility in the country.” Has he forgotten about NextEra Energy’s (NYSE: NEE) eight gigawatts of wind power?  Perhaps Buffett meant that MidAmerican provides the largest amount of wind power directly to its own electricity customers? That could be, since much of NextEra’s wind power is sold wholesale to other electric utilities. According to the American Wind Energy Association, however, MidAmerican is second to Xcel Energy (NYSE: XEL) even on this metric.

Stock Investments: Buffett Likes Reinsurance

Warren Buffett may be de-emphasizing Berkshire’s stock investments compared to its whole-business acquisitions, but I still like to know what stocks he is buying and selling.

The biggest change in Berkshire’s stock holdings year-over-year is its new 10.5% stake in the world’s largest reinsurance company, a German reinsurer named Munich Re (Other OTC: MURGY.PK). You’d think Buffett would try to explain the rationale for this new investment, but he doesn’t talk about it at all.  Perhaps he’s remaining quiet so he can continue to buy more at low prices? According to a Wall Street Journal article from last October, Buffett stated that he finds reinsurance an “attractive investment.” He should know, since Berkshire is the third-largest reinsurance company in the world. Berkshire also owns a 3% stake in the world’s second-largest reinsurer, Swiss Re (Other OTC: SWCEY.PK).

Besides Munich Re, the two largest increases in Berkshire’s stock ownership were in Johnson & Johnson (NYSE: JNJ) and Wells Fargo (NYSE: WFC). The largest decreases were in ConocoPhillips (NYSE: COP) and Kraft Foods (NYSE: KFT).

Lastly, although Buffett didn’t increase his holdings in Coca-Cola (NYSE: KO), he made a very positive statement about it, calling it a “wonderful business” and predicting that Coke’s dividend would double over the next ten years.

Big Yield Hunting Has an “Income Plus” Investment Philosophy

Berkshire Hathaway may, as Mr. Buffett forecasts, beat the market by several percentage points in upcoming years, but the fact remains that the stock doesn’t pay a dividend and probably never will. That just doesn’t cut it for income investors.

For double-digit yields, check out Big Yield Hunting, the high-yield investment service from Roger Conrad and David Dittman. Roger and David take an “income plus” approach to their recommendations. High yield alone is not enough; they demand high yield “plus” a healthy and growing business:

High yields without strong businesses behind them will be at perpetual risk of devastating dividend cuts. And they have no chance of growing either, so they’re guaranteed losers if inflation emerges.

In contrast, only growing and healthy companies will continue to pay their distributions. If we see more inflation, growth is our best chance of keeping pace. Adopting an “income-plus” strategy won’t save your portfolio from all volatility if credit or inflation conditions worsen. But it remains the best approach.

An “income plus” investment standard disqualifies many high-yield companies from Roger and David’s consideration. So far, Big Yield Hunting has recommended two Canadian income trusts, three telecommunications companies, a master limited partnership (MLP), and a fascinating stock/bond hybrid security. All of these top-notch stocks sport very high yields that are stable and sustainable.

Give Big Yield Hunting a try today!

Disclosure: Jim Fink owns shares of Berkshire Hathaway.