Warren Buffett Warns on Bond Shortcomings

"The board is enthusiastic about my successor as CEO," Buffett wrote, "an individual to whom they have had a great deal of exposure and whose managerial and human qualities they admire." Buffett also indicated that two back-up candidates had been selected as well. "When a transfer of responsibility is required, it will be seamless," he wrote.

Buffett also pointed to the recent hires of Todd Combs and Ted Weschler as investment managers. "Each will be handling a few billion dollars in 2012, but they have the brains, judgement and character to manage our entire portfolio when Charlie and I are no longer running Berkshire," Buffett wrote. He also indicated that Combs and Weschler will help the next CEO of Berkshire make acquisitions, implicitly suggesting that neither recent hire was on tap to succeed him as CEO. "They have excellent 'business minds' that grasp the economic forces likely to determine the future of a wide variety of businesses," Buffett wrote.

Operating Performance
Morningstar's equity analysts have dug into the firm's results separately, but here are a few highlights:

Growth in per-share book value (Buffett's preferred measure of performance) increased 4.6% in 2011 compared with 2.1% for the S&P 500 and down from 13% growth in 2010.

Berkshire's fourth-quarter net income of $3.048 billion ($1,846 per Class A share) was down from the $4.377 billion in net income ($2,656 per A share) in the fourth quarter of 2010, largely attributable to changes in the estimated value of Berkshire's investments and derivatives. (For more details see Berkshire's full Annual Report.)

Insurance operations reported a $107 million underwriting loss in the fourth quarter, compared with a profit of $414 million a year earlier, driven by Geico and Berkshire Hathaway Reinsurance Group, though Buffett reported an overall increase in "float" to $70 billion from $65.8 billion a year earlier.

Buffett reported that each of Berkshire's five largest non-insurance companies--BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy--delivered record operating earnings. Unless the economy weakens in 2012, Buffett wrote, each should again set a record, with aggregate earnings comfortably topping $10 billion.

The firm put a lot of money to work in capital expenditures. "Our entire string of operating companies spent $8.2 billion for property, plant and equipment in 2011, smashing our previous record by more than $2 billion. ... In 2012, these expenditures will again set a record," Buffett wrote. Given Berkshire's recent purchase of more capital-intensive businesses such as BNSF, this is perhaps not as surprising as it would initially seem.

Headwinds included a still-struggling housing market, which weigh on results at several Berkshire subsidiaries, including Clayton Homes, Acme Brick, Shaw (carpeting), and Johns Manville (insulation). Buffett admitted that his year-ago predictions for a housing recovery were premature, but "Housing will come back--you can be sure of that," he wrote. "Over time, the number of housing units necessarily matches the number of households (after allowing for a normal level of vacancies) ... At our current annual pace of 600,000 housing starts--considerably less than the number of new households being formed--buyers and renters are sopping up what's left of the old oversupply."

Berkshire's other manufacturing, retail, and service operations are tracking the economic recovery. Non-housing operations earned $1.8 billion in 2009, $3.9 billion in 2010, and $4.4 billion in 2011 (not including the contribution from the 2011 Lubrizol acquisition)--which, in Buffett's words, "illustrates the comeback of much of America from the devastation wrought by the 2008 financial panic."

'Bonds Should Come With a Warning Label'
Buffett has long included broader ruminations on the markets, economy and investing in his annual letters. This year, fans got a preview; Buffett released an adaptation from his annual letter in Fortune magazine earlier this month, laying out his case for stocks and slapping a warning label on fixed-income investments.

Buffett asserts that currency-based investments (including bonds, money market funds, and bank deposits), although widely considered "safe" due to their stable returns and low volatility, are actually dangerous to investors' wealth given that their current low yields will not likely keep up with inflation over time.

"The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability--the reasoned probability--of that investment causing its owner a loss of purchasing power over his contemplated holding period," Buffett wrote. "Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period."

Buffett's point of view on today's investing environment is shared by many other smart investors. For example, in a recent Bloomberg interview, BlackRock CEO Larry Fink recently asserted that being "100% in equities" was a pretty easy decision given the return prospects for stocks versus bonds. And in January, Morningstar's former director of equity research Pat Dorsey argued that the price investors are paying for "safe" assets is very, very high right now. "Even if you assume a pretty modest rate of inflation of say 3% over the next decade, Treasuries [and] high-grade corporates will not beat inflation," Dorsey said, "and you'll lose purchasing power."

But many investors seemingly haven't have got the memo yet, as Morningstar's fund flow data showed bond funds continuing to garner assets in January, while stock funds--and especially domestic equity growth funds--continued to suffer redemptions.

Despite investors' recent preference for bonds, current yields alone make it very hard to argue that fixed income could possibly enjoy the same kind of performance in the future that it has over the past 10 years. However, when considered at the portfolio level, and in the context of the everyday investor's objectives and needs, there is one important exception to this argument that can't be overlooked. Indeed, Buffett himself paused his thesis to note:

"Under today's conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety. At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be. Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum."

Although this was just a small point in Buffett's argument, it's a big deal for many investors--particularly those already retired--who need to run their households day to day and month to month just like Buffett needs to run his businesses.

The cost of holding these currency-based assets may be high (bonds may very well experience a real loss after inflation), but they still have a very important role--namely liquidity and stability in the short term. There is something worse than overpaying for "safe" assets that won't keep up with inflation, and that's having to liquidate more volatile assets at a deep discount in a down market because you needed cash for immediate expenses. As Buffett notes in his letter, volatility and risk are two different things--but they can intersect when your time horizon is short.

So, even though investors might have overdone their bond allocations, most will still need some exposure to these assets. The degree of that exposure, however, should be carefully weighed given today's low yields.

Putting Money to Work
A cornerstone of Buffett's argument is the nefarious effect of inflation on low-returning assets. But stocks in general may not always offer protection in a high-inflation environment. Buffett is looking for a specific type of company. Below, Morningstar analyst Drew Woodbury offers some more detail on where Buffett may be pointing his "elephant gun" next. (For more, see Drew's recent commentary on Buffett's Fortune article):

For investors concerned about inflation, Buffett recommends focusing on companies that do not require much capital reinvestment in order to maintain pricing power during inflationary periods. In general, we agree with him, holding a similar view here at Morningstar that investors should consider moaty stocks first, which tend to have the type of pricing power that Buffett mentions. In particular, he mentions IBM and Coca-Cola, whose securities are held in Berkshire's investment portfolio, as well as See's Candy, a company that is fully owned by the insurer, as examples of firms that benefit from some form of pricing power.

While his investment strategy does not change much with the times, as Buffett has always believed in looking for high-quality companies trading at discounts to their underlying value, he notes that his first choice would be to own these type of firms in their entirety. He is not, however, adverse to ownership "by way of holding sizable amounts of marketable stocks."

With few specifics about where Buffett may put money to work next, investors can only make educated guesses about his next move. We could look specifically to companies that require little capital reinvestment as likely targets. If the world is truly on the brink of a more inflationary period, it is left to be seen, though, whether or not Buffett would pass up more capital-heavy businesses--like MidAmerican and Burlington Northern--in favour of lower capital companies, or find value in both.