Buffett's Annual Report: Big M&A, Promise, Concern (BRK-A, BRK-B, GE, GS, BAC, WFC)

Berkshire Hathaway Inc. (NYSE: BRK-B) has released its 2010 annual report.  While there are plenty of Buffett-isms in there for some mild financial entertainment, there are some clues that investors need to be aware of for what lies ahead.

The first issue we want to note is that if you go through Buffett’s most recent portfolio changes, he made more sales than in any recent quarter we have seen.  This raised loads of cash and now Buffett is looking for another “whale of a deal” or something like it.  While we would not expect another BNSF-sized deal, Bershire Hathaway’s cash and cash equivalents registered a whopping $38.2 billion at the end of 2010.  We want to address the 13% gain in the book value of $95,453 per share later.

Before bashing old Warren on derivatives like you have seen before, Berkshire Hathaway’s derivative gains registered $2.17 billion in the fourth quarter.  Buffett also unwound 8 contracts late in 2010 for a $222 million gain in the quarter.  This was just one factor that led to a total earnings gain of 43% to some $4.4 billion in fourth quarter profits.

If you want to know how the latest whale of a deal worked out in the Burlington Northern buyout, it is supposedly working even better than he expected.  Buffett claims that the earnings power is being boosted by almost 40% pre-tax and more than 30% after-tax.

Buffett sees a better business climate in 2011.  The question is whether or not he will overpay for his next megadeal  As far as dividends, we have no promise that Berkshire Hathaway will pay one.  Our belief is that Buffett will still focus on steady industries rather than riskier high-growth industries.

As the eternal optimist, Buffett argues that America’s best days are ahead.  He is still wary of borrowing money and on the earnings reported by some companies.  Buffett also noted that the performance of the past has little chance of being repeated due to the size of Berkshire now.

Investors have yet another year with no formal succession plan in place for Warren Buffett.  We all know that cannot go on forever.  The new portfolio manager Todd Combs is going to manage $1 to $3 billion in equity positions, without being limited solely to equities.

We want to go back to one thing here. The 13% in annual book value gains to $95,453, this lagged the S&P yet again.  With many components being less market oriented, some of this is no shock.  Buffett also noted in his letter, “some of our businesses are worth far more than their carrying value on our books.”  For instance, At GEICO alone Buffett noted that GEICO’s premium volume is $14.3 billion and growing, yet the goodwill of GEICO is carried as only $1.4 billion on the books.  Buffett said “the real value of GEICO’s economic goodwill” is about $14 billion.  The share price is $127,550.00 for the A-shares now, giving Buffett a hefty premium if you do not consider some of these book value anomalies.  Another part of the premium is because Berkshire Hathaway was added to many indexes and index-funds had to acquire large sums of A and B shares whether they wanted to or not.

A few things that investors need to consider about Berkshire Hathaway after 2011.  Both General Electric Co. (NYSE: GE) and Goldman Sachs Group Inc. (NYSE: GS) have every intention of paying off that 10% preferred investment that Buffett made during the market meltdown.  Buffett has exited Bank of America Corporation (NYSE: BAC) entirely and the Wells Fargo & Company (NYSE: WFC) stake is now a whopping total of more than 342 million shares.  If Wells Fargo is the same share count, that was worth $11.08 billion as of Friday’s close.

It would be very easy to just bash Buffett for underperforming the S&P 500 in book value growth again or for Berkshire Hathaway shares trading at such a large premium to book value.  Unfortunately, those ‘facts’ come with caveats and asterisks and are not necessarily representative of the full story.

We also wonder whether Buffett’s goal of growing book value faster than the S&P 500 is even fair, let alone possible.  Much of Berkshire’s empire is income oriented in stable business that just do not grow at nor can they ever grow at the same rate of say Apple Inc.  (NASDAQ:  AAPL).  Perhaps the biggest measurement will come from how Berkshire Hathaway does in the next market correction.  If it holds up better than the broad market then investors know they have a winner.  If it performs worse than the market in a downfall and lags in an upswing, then Berkshire Hathaway may be irrelevant.

JON C. OGG