The Oracle Told You So

The Oracle told you so.

While subdued in his message, choosing to use Aesop's "A bird in the hand is worth two in the bush" parable as his vehicle, Warren Buffett's annual letter to Berkshire Hathaway shareholders admonished investors who didn't believe his thesis last year that stocks were wildly overvalued. "Last year, we commented on the exuberance -- and, yes, it was irrational -- that prevailed, noting that investor expectations had grown to be several multiples of probable returns," Buffett wrote in the letter released with Berkshire's annual report Saturday morning.

He cited a PaineWebber-Gallup poll from December, 1999 indicating that investors expected the annual equity return over the next decade to average 19%. "That, for sure, was irrational expectation: For American business as a whole, there couldn't possibly be enough birds in the 2009 bush to deliver such a return."

Buffett's actions in Berkshire's common stock portfolio suggest he took his advice to heart. After a year of sidestepping questions on his views about government criticisms of both Freddie Mac FRE and Fannie Mae FNM, Buffett revealed that Berkshire sold nearly all positions in both organizations. At the end of 1999, Berkshire owned 59.5 million shares of Freddie Mac worth over $2.8 billion. Berkshire did not disclose its position in Fannie Mae in the 1999 report, as Buffett does not disclose specific equity positions smaller than a billion dollars.

Buffett's view of his other financial holdings appears mixed. Disclosures in his annual report indicate that Berkshire's stake in American ExpressAXP remained unchanged after the company's three-for-one stock split in April. He decreased Berkshire's position in Wells Fargo WFC from 59.1 million shares to just over 55 million.

And, while Berkshire's positions in Coca-Cola KO, Gillette G and The Washington Post WPO remain unchanged, Buffett isn't enamored with his portfolio or equities in general. "We see our equity portfolio as only mildly attractive," Buffett wrote. "We own stocks of some excellent businesses, but most of our holdings are fully priced and are unlikely to deliver more than moderate returns in the future. We're not alone in facing this problem: The long-term prospect for equities in general is far from exciting."

Instead, Buffett appears to have focused on the debt market, indicating that Berkshire bought the high-yield bonds of a few issuers -- "very few, the category is not labeled junk without reason" -- as well as additional positions in "high-grade, mortgage-backed securities." "We have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint," Buffett wrote. "Try to control your excitement."

In the letter he acknowledges Berkshire's involvement in the Finova Group FNV, yet chastises The Wall Street Journal for reporting that Berkshire purchased bonds issued by Conseco CNC. Citing "people familiar with the matter," the Journal reported that Buffett purchased "several hundred millions dollars" of both Finova and Conseco debt.

"Well, not that familiar," Buffett quips regarding the Journal's sources. "True, we had purchased bonds and bank debt of Finova -- though the report was wildly inaccurate as to the amount. But to this day neither Berkshire nor I have ever bought a share of stock or a bond of Conseco."

Buffett also says Berkshire "established 15% positions in several midsized companies," although he does not reveal specifics, suggesting that all of the positions were under $1 billion. In SEC filings, Berkshire indicated that it recently established positions in H&R Block HRB, Sealed Air SEE and Mueller Industries MLI.

A Solid Year for Operating Businesses

According to Buffett, Berkshire's book value increased 6.5%, outpacing the S&P 500 by nearly 16%. "Over the past 36 years, per-share book value has grown from $19 to $40,442, a gain of 23.6% compounded annually," he wrote.

That average annual gain bested the S&P by an average of nearly 12%. Buffett notes the year-over-year gains may remain small but will add up over time. "Charlie [Munger, Berkshire's vice-chairman] and I continue to aim at increasing Berkshire's book value at a rate that, over time, will modestly exceed the gain from owning the S&P 500," he wrote. "[A] small annual advantage in our favor can, if sustained, produce anything-but-small long-term advantage."

As we noted Friday, the major contributor to Berkshire's growth is its stable of operating companies. Buffett says the shift in focus has been profitable. "Lately the most promising 'bushes' have been negotiated transactions for entire businesses and that pleases us," he wrote, again invoking Aesop. "Many people assume that marketable securities are Berkshire's first choice when allocating capital, but that's not true."

Last year, Berkshire completed two acquisitions started in 1999 and initiated six. Combined, those eight companies accounted for nearly $13 billion in sales. Berkshire funded the purchases with 97% cash and only 3% in Berkshire stock. "We incurred no debt in making these purchases, and our shares outstanding have increased only one-third of 1%," He notes. "Better yet, we remain awash in liquid assets and are both eager and ready for even larger acquisitions."

What kind of businesses is Buffett courting? In typical Buffett style they are mundane businesses with one common theme: They make money. "We have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint," he wrote, noting the thrill of such purchases. "Try to control your excitement." A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons.

And his strategy isn't likely to change anytime soon. If anything, the past year has added more ammunition to his anti-tech stance, although Berkshire operating companies such as Geico, Borsheim's and his home furnishings units have embraced technology and the New Economy to leverage traditional sales.

"At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises," he wrote, alluding to technology companies. "We're not smart enough to do that and we know it. I'm the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores."

Two factors helped push the acquisition pace last year: a sense by business owners that a cooling economy would prompt slowdowns in their businesses, and a lack of speculative -- or junk bond -- financing that pushed valuations down. Buffett acknowledged that many of the businesses bought by Berkshire last year may experience slower sales this year, but said he isn't concerned. "The declines make no difference to us, given we expect all of our businesses to now and then have ups and downs."

Buffett suggested Berkshire's most significant acquisition last year was Shaw Industries, a Georgia-based carpet manufacturer. With annual sales of about $4 billion, Shaw is second only to Berkshire's insurance business. Quipped Buffett: "Now, if people walk all over us, we don't mind."

The insurance business presented challenges in 2000. "Policyholder growth at Geico slowed to a halt as the year progressed," Buffett said. Still, things are looking up. Ajit Jain, Buffett's reinsurance guru, landed a reinsurance policy with a $2.4 billion premium from a British company. He also revealed that the company wrote a disability policy for the Texas Rangers on Alex Rodriguez, or A-Rod, a policy Buffett said "probably also set a record for disability insurance." The Rangers are paying a record $252 million to their new shortstop in hopes he can lead them to the World Series.

Absent from the letter is Buffett's view on Berkshire's potentially expanding role in the electric power business. In 1999, Berkshire acquired Mid-American Energy, an electric utility and independent power producer. Last year Buffett indicated that Berkshire might "make additional commitments" in the field. Buffett's letter mentioned the Mid-American purchase, but is surprisingly quiet about the business.

For more on the Buffett's views of the market bubble, the future of equities, Reg FD and CEO shenanigans, click here.