A letter a day!

A letter a day!

Letter #64 2010

Key learning:

1. Berkshire has always released more money when the economy as a whole was substantially weak.

“Last year – in the face of widespread pessimism about our economy – we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment. Of this amount, $5.4 billion – or 90% of the total – was spent in the United States. Certainly our businesses will expand abroad in the future, but an overwhelming part of their future investments will be at home. In 2011, we will set a new record for capital spending – $8 billion – and spend all of the $2 billion increase in the United States.”

2. Berkshire’s intrinsic value cannot be precisely calculated, two of its three key pillars can be measured.

The first component of value is investments: stocks, bonds, and cash equivalents.

The second component of value is earnings that come from sources other than investments and insurance underwriting.

The third component is the efficacy with which retained earnings will be deployed in the future.

“This “what-will-they-do-with-the-money” factor must always be evaluated along with the
“what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.”

3. Trust in the people rather than the process.

“At Berkshire, managers can focus on running their businesses: They are not subjected to meetings at headquarters nor financing worries nor Wall Street harassment. They simply get a letter from me every two years (it’s reproduced on pages 104-105) and call me when they wish. And their wishes do differ: There are managers to whom I have not talked in the last year, while there is one with whom I talk almost daily. Our trust is in people rather than process. A “hire well, manage little” code suits both them and me”.

4. A sound insurance operation requires four disciplines:

(1) An understanding of all exposures that might cause a policy to incur losses;

(2) A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does;

(3) The setting of a premium that will deliver a profit, on average,after both prospective loss costs and operating expenses are covered;

(4) The willingness to walk away if the appropriate premium can’t be obtained.

5. Warren Buffett on Leverage:

“Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

6. Berkshire is known for keeping a lot of cash many times. This inspiration is taken from Ernest whose youngest son is Buffett’s Uncle Fred. Ernest never went to business school – he never in fact finished high school – but he understood the importance of liquidity as a condition for assured survival. Buffett shares a letter written by Ernest to Uncle Fred.

When he was about to die, he had $1000 which was his cash reserve and which he passed on to his grandchildren Fred and Cathrine. He advised them

“You might feel that this should be invested and bring you an income. Forget it, the mental satisfaction of having $1000 laid away where you can put your hands on it, is worth more than what interest it might bring, especially if you have the investment in something that you could not realize quickly.”