Fairholme Stays the Course

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Smart investors have an edge

Berkshire response to SEC letter dated June 11, 2010

Buffett Montana Economic Summit

Warren Buffett on Phil Fisher

Buffett Article 3 Percent Solution

Credit “Dr. Dave” for bringing this to my attention so quickly.

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Conversation With Charlie Munger Sept. 2010

Buffett’sMrFixIt

I win. Li Lu is indeed one of the three Buffett successor candidates, as suggested earlier.

From Tiananmen Square to Possible Buffett Successor – WSJ

The Most Underrated Part of Warren Buffett’s Success

Source:

http://www.fool.com/investing/general/2010/07/19/the-most-underrated-part-of-warren-buffetts-succes.aspx

Mac Greer
July 19, 2010

Mac Greer: Roger, we recently spoke with Alice Schroeder and we asked her what she thought the most underrated and the most overrated aspects of Warren Buffett’s success were, so I want to put those same questions to you. First of all, what do you think the most underrated part of Buffett’s success is?

Roger Lowenstein: The most underrated part of his success would be his independence of character, his ability to just not do what everyone else is doing, to stand apart from it … just not to be affected by it and not swing at pitches he is not sure about. How many times have we heard he’s through? We heard that in the dot.com era and we heard it in the mortgage era again. Just bubble after bubble, he stands on the sidelines and lets other people take what seem to be easy gains until they come crashing down. It sounds easy in retrospect, but it just takes an awful lot of self-confidence.

Greer: And what do you think the most overrated part of his success is?

Lowenstein: The most overrated part of his success, his connections, the supposed advantages that some people say he has because of his connections. I don’t think he really is overrated. He started with essentially nothing. Just through picking stocks and then as he got bigger, picking companies, never taking options or quick ways to personal fortune. Geez, how can you say any of that is overrated?

Greer: When I asked Alice, she said the underrated piece was just how hard he works — people just don’t understand how hard he works at it.

Lowenstein: That’s good.

Greer: And in terms of overrated, she said that people attribute so much of his success to stock picking, but she really made the point that so much of his success came through choosing companies and businesses to buy and then really striking favorable deals and as she said, being “somewhat predatory.” So with all that in mind, given the fact that most individual investors can’t command those terms, we don’t have the leverage, of course, that Buffett has. What is the most important thing that every investor can learn from Buffett and apply?

Lowenstein: If you look at the stocks that made him, The Washington Post (NYSE: WPO) was selling at four times earnings; anybody could have bought it. Same thing, the ad companies, same thing Coca-Cola (NYSE: KO) back when he bought it in the eighties. Just on and on and on. He didn’t get a special deal on Burlington Northern recently. He didn’t get a special deal when he went into the insurance business, but he sure does have the insight, intelligence and the courage to not write insurance policies when the premiums are too low, which is essentially the mistake that AIG (NYSE: AIG) made.

I think you should learn from Buffett these simple lessons that he keeps talking about. Alice and me and other Buffett writers have written about — stick to stuff you know. If something is going up and other people are buying it, but you don’t understand it, let that go by and buy something you would be confident for holding for three, four, five years. Don’t buy on the basis of it’s going to go up tomorrow or someone else is going to take it off your hands, but that if you were buying the whole business at that price, you would be happy owning and operating that business, having put that amount of capital on a per-share basis in. You can’t go wrong doing that kind of stuff.

Greer: Roger, I was struck in terms of that “sticking to what you know.” Buffett doesn’t just apply that to investing, he also applies it to how he gives away his money, and it really struck me a few years back when he essentially said, “The Gates Foundation knows a lot more about how to best give away my money, so I am going to put them in charge of it.”

Lowenstein: That’s right. He had his career in investing. He shied away from the “own a little bit of 100 different stocks” approach. He said look, I am going to find a few where I can, where I really have an edge in terms of knowledge and in terms of insight, whatever, and go big in them. He wanted to do the same thing with his philanthropy. Instead of giving a little bit to a zillion causes, all of which probably are good and well meaning and so on, he wanted to say, where can [I put] my dollars now, and after I am gone, make a difference?

So he was lucky enough to have a friend, Bill Gates, who is a billionaire in his own right and philanthropist and he is younger and therefore has a life expectancy that he should be around for 20, 30 years longer than Buffett and is tackling a cause which is basically world health that Buffett believes in. So instead of trying to find 30 little Bill Gates just to replicate that, he said, bingo, I have got my man. He was willing to say, OK, there will be no Warren Buffett entity trolling around in Africa giving redounding glory to Warren Buffett, but the idea is maybe he can help more Africans and others in world health that way. So that is what he did.

Statement of Tony Nicely – GEICO

GEICO Fairness Opinion Material 1995

FORBES ON BUFFETT

1
HOW OMAHA BEATS WALL STREET
Forbes discovered Warren Buffett in 1969, and this early interview
introduced the iconic investor to a wide audience for the first time.

4
THE MONEY MEN
Look At All Those Beautiful, Scantily Clad Women Out There!

6
“YOU PAY A VERY HIGH PRICE IN THE STOCK MARKET FOR A CHEERY CONSENSUS”
What does Buffett think now? In this article written for
FORBES he puts it bluntly: Now is the time to buy.

8
WILL THE REAL WARREN BUFFETT PLEASE STAND UP?
Warren Buffett talks like a cracker- barrel Ben Graham,
but he invents sophisticated arbitrage strategies that keep
him way ahead of the smartest folks on Wall Street.

12
WARREN BUFFETT’S IDEA OF HEAVEN: “I DON’T HAVE TO WORK WITH PEOPLE I DON’T LIKE”
Warren Buffett this year moves to the top of The Forbes Four Hund red.
Herein he ex plains how he picks his uncannily successful investments and
reveals what he plans on doing with all that loot he has accumulated.

18
NOT-SO-SILENT PARTNER: MEET CHARLIE MUNGER,
Here’s the lawyer who converted Warren Buffett from an old – fashioned
Graham value investor to the ultimate buy-and-hold value strategist.

23
BUFFETT ON BRIDGE
As the Duke of Wellington trained on the playing fields of Eton,
Warren Buffett trains at the bridge table.

25
THREE LITTLE WORDS
Warren Buffett says he doesn’t think the market is overvalued,
yet he buys few stocks. Why ?

27
FLYING BUFFETT
Leading a revolt of the airline business traveler.

29
THE BERKSHIRE BUNCH
Chance meetings with an obscure young investment counselor
made a lot of people wildly rich. Without knowing it, they were
buying into the greatest compound-interest machine ever built.

33
A SON’S ADVICE TO HIS FATHER
Howard Buffett does not expect to inherit his dad’s place on
The Forbes 400, but he hardly seems bitter.

36 A WORD FROM A DOLLAR BEAR
Warren Buffett’s vote of no confidence in U.S. fiscal policies
is up to $20 billion .

Forbes on Buffett

Download original Letter

March 5, 1982

The Honorable John Dingell
U.S. House Building,
Rayburn House Building
Washington, D.C. 20515

Dear Mr. Dingell:

This letter is to comment upon the likely source for trading activity that will develop in any futures market involving stock indices. My background for this commentary is some thirty years of practice in various aspects of the investment business, including several years as a securities salesman. The last twenty-five years have been spent as a financial analyst, and I currently have the sole responsibility for an
equity portfolio that totals over $600 million. I am enclosing copies of several articles that relate to my experience in the investment field.

It is impossible to predict precisely what will develop in investment for speculative markets, and you should be wary of any who claim precision. I think the following represents a reasonable expectancy:

1. A role can be performed by the stock index future contract in aiding the risk-reducing efforts of the true investor. An investor may quite logically conclude that he can identify undervalued securities, but also conclude that he has no ability whatsoever to predict the short-term movements of the stock market:. This is the view I maintain in my own efforts in investment management. Such an investor may wish to “zero-out” market fluctuations and the continual shorting of a representative index offers him the chance to do just that. Presumably an investor with $10 million of undervalued equities and a constant short position of $10 million in the index will achieve the net rewards or penalties attributable solely to his skill in selection of specific securities, and have no worries that these results will be swamped – or even influenced by the fluctuations of the general market. Because there are costs involved-and because most investors believe that, over time long term, stock prices in general will advance – I think there are relatively few investment professionals who will operate in such a constantly hedged manner. But I also believe that it is a rational way to behave and that a few professionals who wish always to be “market neutral” in their attitude and behavior will do so.

2. As previously stated, I see a logical risk-reducing strategy that involves shorting the futures contract. I see no corresponding investment for hedging strategy whatsoever on the long side. By definition, therefore, a very maximum of 50% of the futures transactions can be entered into with the expectancy of risk reduction and not less than 50% (the long side) must act in a risk-accentuating or gambling manner.

3. The actual balance would be enormously different than this maximum 50/50 division between risk reducers and risk accentuates. The propensity to gamble is always increased by a large prize versus a small entry fee, no matter’ how poor the true odds may be. That’ s why Las Vegas casinos advertise big jackpots and why state lotteries headline big prizes. In securities, the unintelligent are seduced by the same approach in various ways, including: (a) “penny stocks”, which are “manufactured” by promoters precisely because they snare the gullible-creating dreams of enormous payoffs but with an actual group result of disaster, and (b) low margin requirements through which financial experience attributable to a large investment is achieved by committing a relatively small stake.

4. We have had many earlier experiences in our history in which the high total commitment/low down payment phenomenon has led to trouble. The most familiar, of course, is the stock market boom in the late 20′s that was accompanied and accentuated by 10% margins. Saner heads subsequently decided that there was nothing pro-social about such thin-margined speculation and that. rather than aiding capital markets, in the long run it hurt them. Accordingly, margin regulations were introduced and made a permanent part of the investing scene. The ability to speculate in stock indices with 10% down payments, of course, is simply a way around the margin requirements and will be immediately perceived as such by gamblers throughout the country.

Brokers, of course, favor new trading vehicles. Their enthusiasm tends to be in direct proportion to the amount of activity they expect. And the more the activity. the greater the cost to the public and the greater the amount of money that will be left behind by them to be spread among the brokerage industry. As each contract dies, the only business involved is that the loser pays the winner. Since the casino (the futures market and its supporting cast of brokers) gets paid a toll each time one of these transactions takes place. you can be sure that it will have a great interest in providing very large numbers of losers and winners. But it must be remembered that. for the players, it is the most clear sort of a “negative sum game”. Losses and gains cancel out before expenses; after expenses the net loss is substantial. In fact, unless such losses are quite substantial, the casino will terminate operations since the players’ net losses comprise the casino sole source of revenue. This “negative sum” aspect is in direct contrast to common stock investment generally, which has been a very substantial “positive sum game” over the years simply because the underlying companies, on balance, have earned substantial sums of’ money that eventually benefits their owners, the stockholders.

5. In my judgment. a very high percentage – probably at least 95% and more likely much higher – of the activity generated by these contracts will be strictly gambling in nature. You will have people wagering as to the short-term movements of the stock market and able to make fairly large wagers with fairly small sums. They will be encouraged to do so by brokers who will see rapid turnover of customers t capital – the best thing that can happen to a broker in terms of his immediate income. A great deal of money will be left behind by these 95% as the casino takes its bite from each transaction.

6. In the long run, gambling-dominated activities that are identified with traditional capital markets, and that leaves a very high percentage of those exposed to the activity burned, are not going to be good for capital markets. Even though people participating in such gambling activity are not investors and what they are buying really are not stocks, they still will feel that they have had a bad experience with the stock market. And after having been exposed to the worst face of capital markets, they understandably may, in the future, take a dim view of capital
markets generally. Certainly that has been the experience after previous waves of speculation. You might ask if the brokerage industry is not wise enough to look after its own long-term interests. History shows them to be myopic (witness the late 1960s); they often have been happiest when behavior was at its silliest. And many brokers are far more concerned with how much they gross this month than whether their clients – or, for that matter, the securities industry – prosper in
the long run.

We do not need more people gambling in non-essential instruments identified with the stock market in this country, nor brokers who encourage them to do so. What we need are investors and advisors who look at the long-term prospects for an enterprise and invest accordingly. We need the intelligent commitment of investment capital, not leveraged market wagers. The propensity to operate in the intelligent, pro-social sector of capital markets is deterred, not enhanced, by an active and exciting casino operating in somewhat the same arena, utilizing somewhat similar language and serviced by the same work force.

In addition, low-margined activity in stock-equivalents is inconsistent with expressed public policy as embodied in margin requirements. Although index futures have slight benefits to the investment professional wishing to “hedge out” the market. the net effect of high-volume futures markets in stock indices is likely to be overwhelmingly detrimental to the security-buying public and, therefore, in the long run to capital markets generally.

Sincerely,

Warren E. Buffett

WEB/gk

Enclosures

b cc enclosures-

Mr. Irwin Borowski
House Oversight Investigation Sub-Committee
233 Rayburn Office Building
Washington, D.C. 20515

Buffett & Paulson (Omaha Chamber of Commerce)

What Buffett really said about the SEC Goldman Sachs Investigation
(From the Berkshire Hathaway Shareholder’s Meeting 2010)

Buffett:
Abacus was made the subject of an SEC investigation.  There’s been misreporting, non-intentional obviously, but there has been a misreporting of the nature of the transaction, in the majority of the reports that I’ve read.  This will take a little time, but I think it’s an important subject.  I would like to go through that transaction first and then we’ll get to have further questions.

There were four losers, I will focus on two of them.  Goldman Sachs itself was a loser, but they didn’t intend on being a loser.  They intended to sell a portion of the transaction, but were unable to sell.  The main loser in terms of actual cash value was a very large bank in Europe by the name of ABN AMRO.  They subsequently became part of the Royal Bank of Scotland.

Why did they lose money?  They lost money because they, in effect, guaranteed the credit of another company ACA.  ABN was in the business of judging credits, deciding which credits they would accept themselves and which credits they would guarantee. In effect, they did something in the insurance world called fronting, which really means guaranteeing the transaction of another party.  We have done that many times at Berkshire, we get paid for it.  People may not want the credit of XYZ insurance company, but they say they’ll take a policy of XYZ company, if we (Berkshire) guarantee it.  Berkshire has been paid a lot of money over the years and Charlie you can remember years back in the 1970′s when we lost a lot of money because we guaranteed some not so honest people and we lost a lot of money, Lloyd’s of all things, but they found ways not to pay it.

So ABN agreed to guarantee about $900 million worth of credit for ACA.  That is in the SEC complaint that they received about 17 basis points, that is  17 hundredths of one percent.  They got it about $1,600,000 and the company they guaranteed went broke, so they had to pay the $900 million.  It is a little hard for me to get terribly sympathetic.

ACA was a bond insurer and they started out as a municipal bond insurer.  ACA, MBIA…all those companies started out insuring municipal bonds.  It was a big business insuring municipal bonds and then all of a sudden their margins started to get squeezed so instead of accepting lower profits they got into the business of insuring structured credits and other kinds of activities. I described their activities a couple years ago as being a little bit like Mae West who said, “I was like snow white, but I drifted.”  Almost all of these bond insurers drifted to make a little bit more money.

ACA did it, they all did it, and they got into trouble, every one of them.

Is there anything wrong with bond insurance? No, but you better know what you’re doing.  Interestingly enough, when these other guys got in trouble we (Berkshire Hathaway) got into the municipal bond insurance business and reassured things that were almost identical to what ACA and others had insured, the difference being we thought we knew a little bit more about what we were doing and we got paid better for what we were doing and we stayed away from things we didn’t understand.

Here’s something we did ensure to give you a better idea.  Let me describe a deal to you.

A large investment bank came to us a couple of years ago (Lehman Brothers).   At the time we were not insuring bonds regularly, but we were insuring the bonds of a local utility in Nebraska and insuring the bonds of the Methodist Hospital about six miles from here.  We made the agreement that if the Methodist Hospital could not pay the liabilities of its bonds that we would pay. The total issue was between $100 million $200 million.  Now a couple of years ago, Lehman came to us and asked us to take a look at this portfolio.

(Projection of a slide displayed of several states and related amounts to be insured.)

As you can see there’s $1.1 billion for Florida and only $200 million for the state of California…

Lehman asked us to insure the bonds of these states for the next 10 years and if any of these states don’t pay then we’d have to pay.  I looked at the list and we had to decide (a) whether we knew enough to insure them and (b) what premium to charge.  It was that simple.  We didn’t have to insure them, we could just say forget it, we don’t know enough to make the decision.   But we knew enough to make the decision and collected about $160 million to insure those bonds.

This gets to the crux of the SEC’s case against Golden.
Lehman came to us with this list, we didn’t create them, another party came to us.  From a buyers perspective there are about 4 possibilities to consider.

Lehman Brothers might:
(1) own these bonds and want protection against the credit
(2) they might be negative on the bond market and effectively be shorting these bonds.
(3) a customer of Lehman that owns these bonds may have wanted to buy protection against the credit.
(4) or a customer of Lehman might be negative on these bonds and wants to short them.

We don’t care what scenario exists.  It is our job to value the risk of these bonds
and to arrive at a proper premium.  If Ben Bernanke were on the other side of the trade it wouldn’t make any difference to me.  If I have to care about who’s on the other side of the trade I should not be in this business.

So, in effect, we did with these bonds exactly what ACA did with the bonds that were presented to them, but ACA was presented with a list of about 120 and they decided they’d insure about 50 of them, then went back and negotiated to insure 30 more.  So they insured only a handful of the total list, whereas we looked at the list and took the list and was totally the other guys list.

In the case of the Abacus transaction it was a negotiation. In the end the bonds that were included in the Abacus transaction all went south very quickly. That wasn’t so obvious that they would go south in 2007 as you can see by studying something like the ABX index, but the housing bubble started blowing up in 2007.  Now there could be problems in states we insured, there could be pension obligations or other problems and maybe the guy going short knows more about that than we do, but that’s our problem.   In the case of ACA they had teams of people looking at these bonds and at Berkshire we only had a couple people.  if I lose a lot of money on our transactions I’m not going to go to the other guy and say you took advantage of me.  If it’s John Paulson, I’m not going to complain.  No one forced me to enter into these contracts, we made the decision to do so.

I think the central part of the argument is that Paulson knew more about the bonds than the bond insurer did and my guess is that ACA employ more people than John Paulson.  In retrospect it just turned out to be dumb bond insurance.  I don’t see what difference it makes whether it was John Paulson on the other side of the deal or someone else.

I’d like to get Charlie’s comments from a legal perspective and I haven’t really spoken to him too much about this, charlie.

Munger:
My attitude is pretty simple.  This was a 3-2 decision by the SEC, under circumstances where they normally require unanimous consent.  if I would have voted, I would’ve been one of the two not the three who voted to move forward against Paulson.

Buffett:
I’ve heard something about the ACA deal claiming that investors were taken advantage of, but ACA was the parent company of the bond insurer that entered into the deal with Paulson.  ACA lost money because they were bond insurer.
—–

Responding to a question about Berkshire’s Investment in Goldman Sachs Preferreds.

Buffett:
Ironically the negative publicity to Goldman is probably in our best interest in certain ways, because we have $5 billion in preferred stock that pays us $500 million year.  Golden has the legal right to call these preferreds at 110% of par.  Anytime they want to send Berkshire 5.5 billion, they can, and we would turn around and put that money in some very short-term security, which would probably under today’s conditions yield something very small, so every day that Goldman does not call their preferred’s is beneficial to us.  Goldman pays us $15 every second, so as we sit here tick, tick, tick, tick… $50,000  We don’t want that to go away.  These ticks occur at night, on weekends…

We love the Goldman investment.

Advice to Goldman:
When some kind of transgression is found or alleged we go by the motto
(1) get it right
(2) get it fast
(3) get out
(4) get it over

But, get it right is number one.  If you don’t have your facts right you’re going to get killed.  I do not hold the allegations against Goldman as significant, but if it leads to something more serious, I’ll look at the situation at that time.

With respect to the Abacus situation I don’t see much of an argument.  We trade with Goldman but we don’t hire them as investment advisors.  We make our own decisions.  They could very well be selling short securities they sell us.  They don’t need to explain to us what their doing.  Their operating in a non-fiduciary capacity and we know that.

http://seekingalpha.com/article/203314-is-li-lu-going-to-be-buffett-s-successor

Charlie, please don’t hold this against me.

It appears to me very clear that the first in line for Warren Buffett’s position as Investment Officer is Li Lu.  Several years back I had the privilege to hear Li Lu speak, and he is no question, the real deal.

Li Lu was born in 1966 and was raised in China. He was one of the principle student leaders during the Tiananmen Demonstration in 1989, and was fortunate to escape to the United States later that year.

Li Lu attended Columbia University from 1990 to 1996 and received three degrees simultaneously: a B.A. in Economics from Columbia College, a J.D. from Columbia Law School, and a M.B.A. from Columbia Business School.  Shortly thereafter Li Lu began a career as a money manager.  Naturally, Li Lu is an avid student of both Warren Buffett and (especially) Charlie Munger.

With respect to Investment Manager succession, Munger provided a few very clear and important pieces of information recently, though not intending to explicitly do so.

It’s important to notice that both Berkshire Hathaway (BRK.A) and Li Lu own significant interests in BYD Company Limited (BYDDY.PK).

The first question is who found BYD first, Berkshire Hathaway or Li Lu?

BYD’s Report of the Directors, identifies Li Lu as a significant Shareholder in 2006.  (See http://www.bydit.com/userfiles/attachment/Circular_2006-12-18.pdf )

Prior to this year’s Berkshire Hathaway annual meeting in an interview with Becky Quick of CNBC on Friday April 30th, Charlie Munger says, “I have this young Chinese-American partner that found it (BYD) for us.”
(http://www.cnbc.com/id/15840232?video=1483877845&play=1%C2%A0; 17:25)

Additional information was provided during Berkshire Hathaway’s annual meeting.  When asked whether any of the managers on Buffett and Munger’s list employed the use of leverage, Buffett answered, “No.”  Charlie followed, “One of the managers returned over 200% last year, without any leverage at all.”  (Buffett did not appear very happy with this comment.)

As previously mentioned, Li Lu has a significant amount of his portfolio invested in BYD, which increased well over 200% last year.

The final and most compelling piece of information was documented today.  During the Wesco Financial annual shareholders meeting, Charlie openly identified Li Lu as an outstanding money manager, but did not elaborate to suggest he would replace Buffett.

Still not convinced?
Li Lu operates his partnership out of Pasadena California, which also happens to be home to Charlie Munger.  According to Thomson Financial, Li Lu’s partnership address is 301 East Colorado Blvd., Pasadena, CA 91101.  Wesco Financial Corporation (WSC) shares the same address, two floors below Li Lu.

BerkshireHathawayWEB

Download this document in a more reader friendly format.

**LINK**  Berkshire Hathaway’s Underlying Value  **LINK**

The same content is below, but somewhat harder to read.

Berkshire Hathaway Underlying Business Value

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You should begin by looking over these consolidated figures:

http://mattpauls.com/berkshire/Balsheet.pdf

http://mattpauls.com/berkshire/INCOMESTMENTa.pdf

http://mattpauls.com/berkshire/Cashflow.pdf

http://mattpauls.com/berkshire/ratios.pdf

Reported earnings and equity are significantly misrepresented.

Investment reports generally include basic financial data and financial ratios, both of which are almost always taken from consolidated financial statements. Much of the time, reasonable conclusions (though of varying quality) can be determined by use of consolidated data, however, this is not always the case. There are plenty of instances where consolidated information is, at times, misleading or otherwise altogether useless. Consolidated information which does not accurately represent a business’s underlying economics is bad information and conclusions drawn therefrom will be equally bad.

Berkshire’s consolidated presentation is not altogether useless. Over time, the annual compounded rate of return of either equity or book value will provide a rough benchmark with which investors may use to measure changes in the value of their respective holdings.To arrive at a reasonable estimate of Berkshire Hathaway’s underlying or intrinsic value, investors must look beyond consolidated figures.

The economics of an insurance business is quite different from a retail or service business. Consolidating these businesses for financial reporting purposes would not properly illustrate the value of each business unit considered separately. Similarly, Berkshire Hathaway on a consolidated basis does not provide a clear picture of what Berkshire is worth as separate business units.

An investor could easily look at berkshire’s numbers and be confused in two very different respects. Both reported earnings and equity are significantly misrepresented and have been for several years. For 2009, Berkshire Hathaway reported earnings of $8 billion, however more accurately earned roughly $5.7 billion, a difference of about $2.3 billion.

Necessary Adjustments

Berkshire Hathaway Adjustments

This is not intended to be a complete explanation of Berkshire Hathaway’s intrinsic value, rather, it is meant to provide a clearer understanding of complicating factors and how to adjust them sensibly. In the broader sense, there are two general complications the first of which is the holding company structure of Berkshire Hathaway and the second is related to required accounting standards, primarily with respect to derivative contracts. The organizational chart below provides a general overview of important items discussed.

Berkshire Organizational Chart

Overview

There are several potentially confusing adjustments that I make to Berkshire Hathaway which I will describe here in brief and describe in greater detail throughout the remaining discussion.

Berkshire’s investments represent a significant amount of Berkshire’s business value. As reported, investments are broken down into four categories: (i) cash and cash equivalents, (ii) fixed maturity investments, (iii) equities, and (iv) other investments all of which are held by Berkshire’s various insurance companies.

Other investments consist of preferreds, warrants, notes, and other convertible investments specifically interests in Wrigley’s, Goldman Sachs, General Electric, Swiss Re, and Dow Chemical. Also included within other investments are securities reported under the equity method i.e. Burlington Northern Santa Fe. Since the most recent annual filing, Berkshire subsequently acquired the remaining interest of Burlington Northern.

In 2011, Burlington Northern will be placed under “Utilities” for financial reporting purposes. To adjust the 2010 annual report for this, I transfer Berkshire’s 22.5% Burlington Northern holding to the utilities operating unit also adding thereto the $8 billion in cash earmarked by Berkshire Hathaway Inc. That is, a total of about $14.6 billion, $6.6 billion of which is deducted from other investments, leaving about $21 billion.

I do not treat Berkshire’s derivative liabilities as liabilities whatsoever. The primary reason for this is that I believe Buffett to have effectively hedged derivative contract exposures. That is, Buffett received $8.1 billion in derivative premiums (float) most of which came from equity put contracts which provided $5.9 billion. I suggest later that even under the worse case scenario, Buffett should break even on equity put contracts so long as he earns 10.4% annually over the contracts life.

I do not therefore treat Berkshire’s derivatives as liabilities and I either add back or deduct from earnings, respective derivative gains and losses.

Note, these adjustments ultimately do not play a significant role in Berkshire’s underlying value as we are here concerned. It does however add about $9 billion to equity of the finance and financial products business unit. There are other ways to reasonably adjust this, however with the same net effect.

Derivative contracts not designated as a hedge, for example, sold European Style Equity Index Puts (receiving premiums up front) are accounted for by recording premiums as liabilities on the balance sheet. Changes in the fair value of these contracts are adjusted quarterly with changes reflected in the income statement as derivative gains or losses and correspondingly in the balance sheet account as an increase or decrease in derivative contract liabilities. The $8.1 Billion Berkshire initially received in premiums (“Derivative Float”) was initially recorded as a liability on the balance sheet and gains or losses in the “Fair-Value” of “Mark-to-Market” securities are either added or subtracted from earnings in the period of gain or loss, irrespective of actual economic gains or losses. In 2008, Berkshire’s mark-to-market changes in derivative values increased to $14.6 billion and as a consequence a pretax loss of $6.821 billion was recorded as negative revenue (expense) understating reported earnings. In 2009, Berkshire’s earnings were overstated, recording a pretax gain of $3.624 billion as derivative liabilities fell to $9.269 billion, however, this reduction included what appears to be a real derivative loss of $1.9 billion.

Berkshire’s Derivative liabilities are effectively hedged. Last year I tried to put the derivative contracts into proper context, restated below:

In December 1929 the Dow Jones Industrial Index was at about 370. In 1944, 15 years later, the index had fallen a total of 60% i.e. a 6% annual loss. In equivalent terms, Berkshire’s Equity puts would require payment of about $22 billion. To break even on this transaction Berkshire Hathaway would need to compound $5.9 billion at about 10%. Buffett’s track record is well above 15% over the last 50 years and his current investments are certain to outlive him-and I expect will exceed the break-even 10%.

[Amendments made in 2009 with respect to certain equity put contracts reduced the strike price by between 29% and 39% and reduced the related contract expiration dates by between 3.5 and 9.5 years. This effectively reduced the annual rate of compounding on these contracts to 8% in order to break even. The remaining contracts were unaltered and remain as they did in 2008.]

If markets are at par with the initial and amended strike prices over the next 14 years, Berkshire will not have made and will not be required to make any payment. Meaning, derivative float will explicitly become equity. In this case, the value of “Equity Put Float” will have definitely compounded well above 15% annually.

What is not discussed, is that these contracts are effectively hedged and the probability of having to actually pay anything is negligible. While Berkshire has the use of between $6 and $8 billion, the balance sheet has shown derivative liabilities of up to $14 billion.

These contracts, though technically, are liabilities should not be considered such insofar as a private investor is concerned. I adjust the income statement from period to period, by either reducing or increasing earnings by the corresponding amount of derivative gains or losses that result from a change in the contract’s fair value. I eliminate derivative liabilities altogether from the balance sheet, since I am of the impression that the contracts are effectively hedged.

That said, investors need to arrive at their own conclusions about the risks involved and may very well wish to keep some or all derivative liabilities on Berkshire’s Books.

Equity Put Contracts

Equity puts are very similar to selling insurance-the purchaser pays a premium and in return is protected from future loss. The loss in this case is a decline in the general stock market.

Berkshire sold puts and collected premiums of $5.9 billion up front, which Buffett invested. “Derivative premiums,” like insurance premiums, are invested until the contracts expire. These are European style contracts, meaning the seller (Berkshire) is liable only for losses that exist on the expiration date of the contract. The amended contracts have an average weighted expiration of 11.5 years. In the meantime Buffett gets the benefit of the use of this money.

Credit Default Swaps

High Yield Index

Last year I suggested that, of Buffett’s derivative book, these were the most likely to produce a loss. Indeed it appears as though this was the case for 2009 as Berkshire had to pay $1.9 billion in real losses. These contracts now account for approximately $1.1 billion of Buffett’s derivative float.

Individual Companies

Counter party risk exists to the extent the purchasers of these contracts are able to pay the full $4 billion premiums over the 5 year life of the contracts. Annually Berkshire receives $93 million for premiums on these contracts. Berkshire was initially liable for 42 corporations. Should any of these companies default on their loans, Berkshire is liable for the decline in the market value of the debt relative to the value of the debt specified in the CDS contract.

Tax Exempt (Muni) Bond Insurance Contracts

Last year I mistakenly reported that premiums for State/Muni contracts would be paid annually. Premiums were received upfront and therefore counter-party risk does not exist. These contracts are mostly second-to-pay contracts meaning Berkshire is liable to pay only what the first insurer cannot.

Berkshire received premiums of $595 million in 2008 on contracts extending as far as 40 years. Berkshire now have total “Derivative Float” of about $6.3 billion primarily from Equity Puts and Credit Default Insurance (high yield index).

Operating units

Berkshire is made up of several separate business units. I like to think of Berkshire in terms of the insurance business and the non-insurance business. Within the non-insurance business there are several subgroups: manufacturing, service, & retail; utilities & energy; and finance & financial products. Within the insurance business group there are two subgroups, the insurance business itself and the investment business.

It may seem a bit strange to separate these two as they are very much related, however, if we look at regulatory capital required for normal insurance operations we find that Berkshire has significant excess capital better treated separate from the insurance business. If we compare Buffett’s stated amount of float which is approximately $62 billion to cash, fixed income securities, and other investments it’s clear that equity investments are not required capital of the insurance business. Therefore I treat equities as separate from the insurance business.

Berkshire Operating Units

Insurance operation

The value of an insurance company comes from the amount of investable funds it generates. Investable funds can come from underwriting profits, from investment income, or from securities gains. In the simple sense, if insurance premiums are sufficient to cover the losses incurred over the insurable period, the insurer produces an underwriting profit. These profits may be added to surplus, which allows the insurer to write additional business. The amount of business an insurer can write is generally limited to 3 times the insurers surplus, Statutory Accounting Principle’s (SAP) definition for shareholders equity.

As stated above, the amount of business an insurer can write is dependent upon surplus. Investable funds are a combination of surplus and float.

The amount of float depends upon the amount of business written. The amount of business written depends upon the amount of surplus. The amount of surplus depends upon underwriting profit or loss, investment income from interest and dividends, and/or capital gains on investments. The underwriting of insurance policies and the investment of surplus and float are separate operations.

Berkshire Hathaway has, on average, earned underwriting profits. Float at the end of 2009 was $62 billion, up $4 billion from last year. For several reasons not discussed here, most insurers earn underwriting losses. These losses must be made up for with interest income and securities gains. If this does not happen,surplus declines and the amount of business written must also decline.

If a privately owned insurance company owns very attractive securities, but consistently writes at an underwriting loss, then the owner’s equity interest will decline either via liquidating investments or by raising new capital. The key here is that it’s critically important to earn underwriting profit. Berkshire Hathaway’s insurers clearly do this quite well.

It is important to recognize that Berkshire Hathaway’s insurance business holds cash, fixed income securities, and equity securities. Berkshire Hathaway has about $144 billion in cash & cash equivalents, fixed maturity investments, and Equity investments all of which are held within various insurance businesses, primarily by National Indemnity, Columbia Insurance Company, GEICO, GenRe, National Fire and Marine Insurance Company, and Berkshire Hathaway Assurance Company. As of December 31, 2009, $8 billion of this $144 billion was earmarked for the Burlington Northern Santa Fe acquisition and is deducted from the cash account below. Cash and cash equivalents, fixed income securities, and other investments clearly support potential normal insurance underwriting losses, meaning these investments are required for the normal operation of the insurance business, whereas, equity securities are not.

This is very important and a fundamental component of value which must be considered separately.

Other investments consist of warrants, preferreds, notes, and similar investment securities-itemized on the following page. Though Burlington Northern Santa Fe is included within other assets (above,) I transfer the $6.6 billion equity securities held by Berkshire to the utilities business for valuation purposes.

OTHER INVESTMENTS – A wonderful lesson in parsimony. If professional investors spent more time thinking, they might recognize a fallacy in the underlying logic that prevents them from holding cash, namely the excuse, “Our investors don’t pay us to do nothing. We have to be fully invested.” The fundamental job of a professional money manager is, or at least should be, to decide when and where to invest. For some reason investors often forget the when. (This has everything to to with knowledge of underlying business value and I am in no way talking about market timing so please don’t confuse the two.) Attractive investments are not always attractively priced. When sensible investments aren’t readily available, the facts and sound logic are clearly telling you to hold cash, and by the way, so too was Warren Buffett. Berkshire Hathaway had more than $40 billion in cash leading up to 2007. As the financial crisis unfolded, Buffett put to work as much as could be invested without overextending the insurance business. Many of these investments are itemized under the line item, Other Investments. Buffett’s other investments were private placements, made at a time of corporate desperation (mid-2008 to mid-2009). Not only did Buffett have the luxury of where and when to invest, he also determined the specific terms under which he invested. (Necessity never made a good bargain.)

2008 – Initial Purchases

Wrigley’s

Berkshire bought $4.4 billion fixed income notes yielding 11.5% due 2018 and $2.2 billion cumulative preferred stock which convert into Wrigley’s equity. The preferreds also pay a 5% dividend annually.

Goldman Sachs

Berkshire invested $5 billion in Goldman Sachs preferred stock yielding 10%, however attached thereto, Berkshire also received warrants convertible into 43 million shares of Goldman Sachs equity.

General Electric

Berkshire invested $3 billion in GE, on terms nearly identical to the Goldman deal.

2009 – Additions

Wrigley’s

In addition to Securities purchased in 2008, Berkshire added $1 billion in fixed notes due 2013 & 2014.

SwissRe

Berkshire bought a $2.7 billion fixed income security yielding 12% forever until converted or called (under favorable terms).

Dow Chemical

Finally, Berkshire Invested $3 billion in Dow Chemical convertible preferreds yielding 8.5%.

Berkshire’s insurance float is roughly $62 billion and is largely supported with $32.3 billion fixed maturity securities and $21.2 billion fixed income securities, listed under line item “Other Investments” (less equity in BNSF,) the sum of which comes to $53.5 billion. Berkshire Hathaway’s insurance units also hold a combined $18.6 billion in cash and cash equivalents. Naturally a portion of this cash is available for equity investment to which I arbitrarily assign $8 billion, leaving $10.6 billion with the insurers for the normal course of business. Income earned on fixed investments and cash generated by non-utility subsidiaries contribute to the cash account available for investing operations.

The above steps are useful only to the extent that investors can reasonably estimate how much capital from total investments is required for normal insurance operations, the amount which support float funds. In Berkshire’s case, the value of float (the truly important value in insurance,) commands an economic value in excess of its carrying amount. Meaning, residual capital not required for normal insurance operations should be treated separately for valuation purposes.

The value of float is not easily calculated and will vary from investor to investor, however, I am of the opinion that Berkshire’s float is conservatively worth $78 billion.

Equities

As mentioned above, equities are not an essential part of Berkshire’s insurance regulatory capital. We can therefore separate equity securities from the insurance operation. Equities are itemized below with few exceptions-one of which is BYD. With respect to this discussion, equities are valued at market as of December 31, 2009 ($56,289,000,000).

Insurance business value

Non-insurance operations

Non-Insurance Operating Businesses

On the low end of the valuation range, Berkshire’s non-insurance operating businesses are worth their adjusted net worth.

Pre-merger (BNSF) net worth was roughly equal to $56,000,000,000. Post-merger (BNSF) net worth is roughly, $75,000,000,000.

Although, currently suffering from the global economic downturn, I am still of the opinion that Berkshire Hathaway’s non-insurance operating businesses command a liberal premium over basic net worth.

Estimated value of Berkshire Hathaway’s non-insurance operating units sold in private transactions:

BNSF 100% consolidated
$88,000,000,000

BNSF is very capital intensive, why did Berkshire Hathaway buy Burlington Northern? There is literally no close substitute to railroad transportation, a service that is also both needed and desired. Were the industry not subject to price regulation, we would be talking about an economic franchise, but we would also be talking about a clear monopoly subject to anti-trust law. Instead, we have a utility business and as is the case with utility companies, railroads are effectively a regulated monopoly. As the cost of goods increases over time Burlington will pass along their capital costs to customers. However as the cost of oil increases with inflation, the relative attractiveness of rail transport will also increase, but without proportional cost increases. The extremely high fixed costs and similarly high initial investment or replacement costs are gigantic barriers to entry. Utility and railroad businesses alike, have fairly calculable future earning streams, which makes the use of leverage both reasonable and smart.

How much is Burlington Northern worth? Debating whether or not Buffett paid a reasonable price seems to me ridiculous. However, I had calculated BNSF before mention of the merger and as it turns out he appears to have paid what I thought to be his maximum price. (This is also supported by comments made by Buffett about the use of Berkshire Hathaway shares in the acquisition.)

(It is important to recognize that Berkshire Hathaway is enormous in size, limiting the universe of opportunities within which Buffett can invest meaningful amounts of shareholder capital. As the universe gets smaller, so too must overall investment returns, the consequence of an ever- growing huge amount of capital. Berkshire owner expectations should be significantly lower over the next 20 years. That is not to discount Berkshire altogether-owner partners should also expect to earn quite reasonable rates of return over the same period. )

In terms of replacement cost, I’m certain BNSF is worth considerably more than $34 billion. Moreover, I find it hard to believe that anyone wanting to enter this business could acquire enough (connected) real estate to build an equivalent network of roads. The cost would certainly be well in excess of $34 billion. The merger must be considered as a truly long-term investment. Sometime in the future, say 50 years hence, Burlington may very well be a 20% return business. Today it is somewhere between 13% and 15%. It has some, but not excessive leverage.

Though I consider this very much a speculative comment, I am also of the impression that the merger will benefit the utilities operation directly. Mid-American produces significant amounts of its energy production via coal. The Powder River Basin provides 40% of all coal used in the U.S. for electrical power generation. Significant coal bed methane deposits are also located in the Powder River Basin. The Powder River Basin consists of 18 coal mines, from which, 30 states receive approximately 400 million tons of coal every year. According to the U.S. Energy Information Administration, coal from Powder River Basin is significantly less expensive than coal extracted elsewhere in the U.S. selling, for instance, 1/6 the price of Central Appalachian coal. The majority of coal moved from Powder River Basin must first travel 103 miles on a BNSF-Union Pacific jointly owned line. Though partially owned by Union Pacific, the line is primarily owned, and fully operated by, BNSF. There are now a total of four tracks jointly used in the basin by BNSF and UP. Approximately 65 unit trains (115 cars) leave daily, laden with coal.

INSERT TEARSHEET

INSERT COAL IMAGE

Utilities and BNSF

Significant transportation contracts between Mid- American and Burlington Northern expire within 2 years. The new, generally long term contracts, would almost certainly include rate increases chargeable to Mid-American. Given the heavily regulated nature of both of these industries, I am uncertain whether favorable terms are allowable between affiliate companies, however I think it’s fair to assume some benefit will trickle down to the parent company.

The Merger

As of December 31, 2009, Berkshire Hathaway had acquired 76,800,000 shares (22.5%) of Burlington Northern through market share purchases. The weighted cost of these share purchases was approximately $6.6 billion. BNSF shareholders agreed to sell the remaining 77.5% of BNSF to Berkshire Hathaway in a cash and stock deal. The reported value of the transaction was valued at $26.4 billion, or $100 per share, thereby valuing Burlington Northern at approximately $34 billion.

Berkshire acquired the remaining 77.5% of BNSF not already owned. Were this consideration paid strictly with cash, there would be nothing further to discuss, but Berkshire used cash and stock. Meaning, stock, in effect, was used as currency. The underlying value of stock- currency (unlike cash-currency,) may be quite a bit different from its traded market value; generally the important value as far as the seller is concerned. Berkshire Hathaway’s stock-currency traded for about $180 billion at the time of offer. Shares issued in conjunction with the merger amount to approximately 6% of Berkshire Hathaway. That is, 30% of BNSF’s total shares (or 39.9% of BNSF’s shares not already owned) were acquired in exchange for 6% of Berkshire Hathaway’s stock-currency,

when Berkshire was selling for $180 billion. Based upon conservative estimates at the time of offer, Berkshire’s intrinsic value was, roughly $200 billion. The stock- currency used in the transaction adjusted for underlying value, suggests that the total cost of the deal was understated by roughly $1.4 billion. If reference is made to the cost as provided within the merger proxy, adjustment should be made to the value of stock purchased at market, before merger. This number was adjusted up from cost to market which inflated this portion of the acquisition cost, however the increase will come through the income statement in the first quarter. There are many ways to treat this. I take the actual cost to berkshire and add thereto, the cost of undervalued stock-currency.

Analysis of Multiples at Offer Price. Goldman Sachs calculated and compared various financial multiples and ratios for BNSF based on information that it obtained from BNSF management and estimates from the Institutional Brokers Estimate System (“IBES”):

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