Warren Buffett released his Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) 2011 shareholder letter last weekend and, as usual, it is chock full of investment wisdom. As I wrote a couple of years ago, 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 21 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 2011, Berkshire Hathaway’s book value finally outperformed the S&P 500 by 2.5 percentage points (4.6% vs. 2.1%) after having underperformed in both 2009 and 2010. Since Berkshire — in its entire 47-year history — had never underperformed the S&P 500 for three consecutive years, it was a pretty good bet that the company would manage to outperform in 2011.

Keep in mind that Buffett measure Berkshire’s performance in terms of changes in book value, not stock price. This type of performance measurement is consistent with Buffett’s value-investing philosophy of evaluating companies as businesses, not as pieces of paper. Buffett often quotes his mentor, Columbia University professor Benjamin Graham, who said (page 5 of 2008 shareholder letter):

Price is what you pay, value is what you get.

In terms of stock price, Berkshire actually outperformed the S&P in 2010 but underperformed in 2011:

Book Value and Stock Price Tell Very Different Stories

Year	Berkshire Hathaway				S&P 500 ETF (SPY)	Book Value Relative Performance	Stock Price Relative Performance
2009	Book Value			Stock Price	26.4%	-6.6%	-24.2%
	19.8%			2.2%
2010	Book Value		Stock Price		15.1%	-2.1%	+6.8%
	13.0%		21.9%
2011	Book Value	Stock Price			1.9%	+2.7%	-6.9%
	4.6%	-4.8%

 

Why such a wide performance discrepancy between book value and stock price? Chalk it up to human emotion and the fact that most investors look at changes in earnings rather than changes in book value.

Since retained earnings is another name for the change in a company’s book value, looking at the change in earnings is like a second derivative of book value and is more a measure of momentum (e.g., acceleration or deceleration) rather than actual wealth creation. Earnings momentum fluctuates much more wildly than changes in book value, so investors that base their buy/sell decisions on earnings momentum/growth churn their accounts much more frequently, which increases transaction costs and reduces long-term wealth.

Some investors are also influenced by a stock’s inclusion in — or exclusion from — an index, which Buffett would also view as unwise and irrelevant to a company’s true worth. For example, investors bid up Berkshire’s stock price in early 2010 in anticipation of it getting added to the S&P 500 index and the stock has languished ever since:

Joining the S&P 500 Index is the Kiss of Death

The good news is that stock prices eventually converge with actual business performance, so Berkshire’s positive increase in book value should lead to the stock price rising in the future.

On the negative side, Berkshire’s long-term annualized return (in terms of book value) fell below 20% for the first time ever (19.8%) after 2011. Furthermore, Buffett warned in this year’s letter (page 6) that Berkshire’s outperformance of the S&P 500 over each five-year rolling period since its 1965 “will almost certainly snap” at the end of 2013 if the S&P 500 has two more positive years to complement the three consecutive positive years it has already posted in 2009 through 2011.

Berkshire Hathaway’s Businesses

Berkshire’s businesses are doing well. Even the insurance business was able to eek out a small underwriting profit ($248 million) despite a horrible year for natural disasters (e.g., Japan tsunami, Australia and Thailand floods, New Zealand earthquake, U.S. tornadoes). In Berkshire’s second-quarter 10Q filing, the company reported an underwriting loss for the first six months of $828 million and Buffett had warned that it was “unlikely” that this underwriting loss could be recouped by the end of 2011. Fortunately, Buffett turned out to be overly pessimistic and Berkshire was able to post an underwriting profit for the ninth consecutive year.

Each of Berkshire’s five largest non-insurance businesses (Burlington Northern, Iscar, MidAmerican Energy, Lubrizol, and Marmon Group) all posted record operating earnings in 2011 and Buffett says that record earnings are expected again in 2012 if the economy doesn’t weaken ( a big “if” given ECRI’s recession prediction).

Taken together, I interpret Warren Buffett’s “state of the union” as very positive for 2012 and I think Berkshire’s stock will rise considerably this year. If Berkshire’s insurance operations can make a profit after an annus horribilis like 2011, I must conclude that much higher insurance profits are in the offing in 2012.

Berkshire Hathaway’s Stock Buyback Program Ensures a 24% Discount

Besides operational excellence, another reason to be positive on Berkshire Hathaway going forward is the stock buyback program the company recently put into place. As I wrote in September, Buffett has established an open-ended policy of buying back Berkshire shares any time they are trading at or below 110% of book value. Although he has not committed to buying any set number of shares at this price level, in his 2011 shareholder letter (page 6) he says that Berkshire will likely buy its stock “aggressively.” As of the end of 2011, Berkshire’s book value was $99,860 per class A share, or $66.57 per class B share. Multiply $66.57 by 110% yields a maximum buyback price of $73.23, which I consider to be a floor for the stock.

Buffett says that buying the stock at 110% of book value will be value-accretive to existing shareholders because the real “intrinsic value” of the stock is much higher than 110% of book.  This is obvious once you realize how Buffett calculates intrinsic value: he takes the market value of Berkshire’s security investments (including cash) and then adds to this the pre-tax earnings of Berkshire’s non-insurance private businesses times some unstated earnings multiple.  For 2011, Berkshire’s investments per class A share and pre-tax earnings per class A share were $98,366 and $6,990, respectively. You can’t just add these numbers together unless you think that Berkshire’s high-quality earnings deserve no higher than a 1.0 multiple, which would be absurd given that the S&P 500’s EV to EBITDA multiple is at least 9.

According to Buffett in his 2010 shareholder letter (page 7), the multiple to put on a company’s earnings depends on your evaluation of management’s capital allocation skills. Will management invest the retained earnings wisely so that corporate value grows faster than simply investing in an S&P 500 ETF or will management waste the money on poor-return investments and destroy value? Buffett calls this issue the “what-will-they-do-with-the-money” factor.

A strong case can be made that the EBITDA multiple on Berkshire should be higher than the S&P 500’s 9 EBITDA multiple given Buffett’s superhuman skill at allocating capital to profitable uses. Buffett admirer and fund manager Whitney Tilson conservatively uses an 8 pretax multiple, but I’ll be even more conservative and use a multiple of 6.6 since this constitutes the median EV-to-EBITDA multiple of property & casualty insurers. Now we can estimate Berkshire’s intrinsic value:

Investments per class A share: $98,366

6.6 times pretax earnings per class A share of $6,990 = $46,134

Total intrinsic value of class A shares: $144,500

Total intrinsic value of class B shares: $96.33

I agree with Buffett that buying Berkshire class B stock that is worth at least $96.33 for no more than $73.23 – a 24% discount to intrinsic value – is a good use of investor capital!

Warren Buffett Buys IBM

With regard to Berkshire’s publicly-traded investment portfolio, the big news of 2011 was Buffett’s $10.9 billion purchase of a 5.5% stake in IBM (NYSE: IBM) for an average price of about $170 per share. IBM is now the second-largest stock position in Berkshire’s entire investment portfolio — Coca-Cola (NYSE: KO) is the largest. Buffett has historically avoided tech stocks because their business is hard to understand and technology continually changes making sustainable competitive advantage virtually impossible. So many analysts were perplexed that Buffett would not only buy a tech stock, but do so near its all-time high stock price!

In an interview with CNBC, Buffett explained that he views IBM less as a tech stock and more as a servicing company for corporate IT departments and such servicing contracts are very sticky and long-lasting, similar to relationships companies have with law firms and accountants. Buffett also pointed out that he had similarly come “late to the party” in acquiring stock in Coke (1988), GEICO (1996), and Burlington Northern (2006), buying all of them near their stocks’ all-time high prices and yet all three of these investments have performed wonderfully. For average investors, it must be heartening to listen to Buffett and realize that you can do very well in the stock market by purchasing well-established companies and don’t need to take huge risks investing in start-ups.

Warren Buffett Names a Successor for Berkshire Hathaway CEO

The last big piece of news in Berkshire’s 2011 shareholder letter (page 3) was Buffett’s announcement that a Berkshire CEO successor has finally been chosen for that sad day when Buffett can no longer do the job. In last year’s 10K filing (page 20), Buffett had narrowed the list down to four managers of Berkshire subsidiaries:

Ajit Jain – Reinsurance

Tony Nicely – GEICO

Matt Rose – Burlington Northern

David Sokol – MidAmerican Energy

Sokol has since departed because of an insider trading scandal involving the Lubrizol acquisition, so only three remain. Even though Berkshire has chosen the successor, Buffett refused to name him so we still don’t know! How infuriating. In a Feb. 27th interview with CNBC (3:05 minute mark), Buffett stated that even the chosen successor does not know that he has been chosen. Talk about secrecy! One commentator speculates that Buffett doesn’t want anybody to know who the “crown prince” is because Buffett wants to remain the center of attention until he’s gone plus Buffett doesn’t want the successor to be distracted from running his business:

No sooner would that man be named, than the press, colleagues and investors would lay siege to him, comb his life for clues to his brilliance, ready to place their blind faith in all of his pronouncements. The crown prince may not be ready for that kind of attention — and Buffett may not yet be ready to give it up. 

Most analysts believe that the successor is Ajit Jain. This makes sense since Buffett praises him lavishly in the 2011 shareholder letter, stating on page 9 that “Charlie [Munger] would gladly trade me for a second Ajit.” But Alice Schroeder, author of The Snowball: Warren Buffett and the Business of Life, has written that Jain doesn’t want the job.

Oh well, even without knowing who it is specifically, we do know all three of the candidates and they are all highly qualified. I think that Berkshire Hathaway shareholders feel more secure knowing that Berkshire will be in good hands after Buffett is gone. The CEO will be in charge of business acquisitions and overseeing business operations, so it makes sense that the CEO come from the ranks of Berkshire’s business subsidiaries.

All the pieces of succession are now complete. Besides the CEO, the other two important positions have already been named:

(1)   Buffett’s son Howard will be the non-executive Chairman of the Board, whose mission will be to preserve Berkshire’s culture of integrity and minimal risk-taking. Howard is a farmer, so don’t expect any investment decisions coming from him.

(2)   Todd Combs and Ted Weschler will run the investment portfolio of publicly-traded securities, as well as be “helpful” to the CEO in considering business acquisitions.

In case anyone is concerned that Buffett’s naming of a CEO successor is a hint that the 81 ½-year-old Sage of Omaha or 88-year-old Charlie Munger are in ill health, Buffett emphasizes in the shareholder letter that this is not the case:

Do not, however, infer from this discussion that Charlie and I are going anywhere; we continue to be in excellent health, and we love what we do.