10 pearls of wisdom from Warren Buffett’s 2012 letter to shareholders

Warren Buffett’s annual letter to shareholders is much anticipated by his followers around the world. If you are not an investor in his company Berkshire Hathaway, it’s a great way to keep up with his latest thinking and his long-held views.

Here are 10 pearls of wisdom from the letter.

The successor question has been answered, at least internally

Buffett is not naming names, but he has revealed that Berkshire Hathaway does have his replacement picked.

“Your board is equally enthusiastic about my successor as CEO, an individual to whom they have had a great deal of exposure and whose managerial and human qualities they admire. (We have two superb back-up candidates as well.) When a transfer of responsibility is required, it will be seamless, and Berkshire’s prospects will remain bright.

“With these assets, my successor will enjoy a running start. Do not, however, infer from this discussion that Charlie and I are going anywhere; we continue to be in excellent health, and we love what we do.”

Buffett’s still hungry for a big deal

Last year, Buffett warned his “elephant gun” was loaded looking for a big acquisition. That hasn’t changed.

“Over time, the businesses we currently own should increase their aggregate earnings, and we hope also to purchase some large operations that will give us a further boost. We now have eight subsidiaries that would each be included in the Fortune 500 were they stand-alone companies. That leaves only 492 to go. My task is clear, and I’m on the prowl.”

Buffett’s big bet remains on the US economy – and it’s already paying off

When Buffett bought railway group Burlington National in November 2009, he described it as an all-in bet on the US economy. And despite the fact the US looks weak, Buffett’s American businesses are performing well.

“Our major businesses did well last year. In fact, each of our five largest non-insurance companies – Burlington National, Iscar, Lubrizol, Marmon Group and MidAmerican Energy – delivered record operating earnings. In aggregate these businesses earned more than $9 billion pre-tax in 2011. Contrast that to seven years ago, when we owned only one of the five, MidAmerican, whose pre-tax earnings were $393 million. Unless the economy weakens in 2012, each of our fabulous five should again set a record, with aggregate earnings comfortably topping $10 billion.”

A one man economic stimulator

Buffett can’t keep the US economy going by himself, but it’s clear Berkshire is having a crack through the way it spends.

“In total, 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. About 95% of these outlays were made in the US, a fact that may surprise those who believe our country lacks investment opportunities. We welcome projects abroad, but expect the overwhelming majority of Berkshire’s future capital commitments to be in America. In 2012, these expenditures will again set a record.”

Berkshire Hathaway has its own “big four”

Forget the Australian banks, there is a new “big four” in town – Coca-Cola (Berkshire has a 8.8% stake), IBM (5.5% stake), Wells Fargo (7.6% stake) and American Express (13% stake). These are the rocks on which the company’s portfolio will be built.

“Had we owned our present positions throughout last year, our dividends from the “Big Four” would have been $862 million. That’s all that would have been reported in Berkshire’s income statement. Our share of this quartet’s earnings, however, would have been far greater: $3.3 billion.

“We expect the combined earnings of the four – and their dividends as well – to increase in 2012 and, for that matter, almost every year for a long time to come. A decade from now, our current holdings of the four companies might well account for earnings of $7 billion, of which $2 billion in dividends would come to us.”

Buffett was wrong on the housing market…

As usual, Buffett used his letter to fess up to some dud calls, including an investment in a Texas gas company which was “a major unforced error”. But his biggest dud call was on one of the key sectors in the US.

“Last year, I told you that “a housing recovery will probably begin within a year or so.” I was dead wrong.

…but hormones mean he’ll eventually be right

But he still contends housing will bounce back for a simple reason – hormones will eventually create new demand for housing

“That devastating supply/demand equation is now reversed: Every day we are creating more households than housing units. People may postpone hitching up during uncertain times, but eventually hormones take over.

“And while “doubling-up” may be the initial reaction of some during a recession, living with in-laws can quickly lose its allure.”

Why Buffett is slow to sell underperforming companies

Buffett admits that several companies in his manufacturing division are underperforming, and takes the blame for being the person who over-estimated their long-term prospects. But he won’t hear of dumping them because of what he says is a commitment he made.

“Berkshire’s newer shareholders may be puzzled over our decision to hold on to my mistakes. After all, their earnings can never be consequential to Berkshire’s valuation, and problem companies require more managerial time than winners. Any management consultant or Wall Street advisor would look at our laggards and say, “dump them”.

“That won’t happen… we have made – and continue to make – a commitment to the sellers of businesses we buy that we will retain those businesses through thick and thin. So far, the dollar cost of that commitment has not been substantial and may well be offset by the goodwill it builds among prospective sellers looking for the right permanent home for their treasured business and loyal associates. These owners know that what they get with us can’t be delivered by others and that our commitments will be good for many decades to come.”

Buffett’s betting on the banks

Buffett might have got his housing sector call wrong, but he’s more confident on the US banking sector, in which he invested heavily last year, buying $1 billion more of Wells Fargo stock. He’s also bullish on Bank of America.

“The banking industry is back on its feet, and Wells Fargo is prospering. Its earnings are strong, its assets solid and its capital at record levels. At Bank of America, some huge mistakes were made by prior management. Brian Moynihan has made excellent progress in cleaning these up, though the completion of that process will take a number of years. Concurrently, he is nurturing a huge and attractive underlying business that will endure long after today’s problems are forgotten. Our warrants to buy 700 million Bank of America shares will likely be of great value before they expire.”

How one of Berkshire’s subsidiaries bounced back from the Japanese tsunami

Berkshire’s cutting tool company Iscar (it owns 80%) bounced back from its own little disaster in 2011, when a company Iscar owns called Tungaloy suffered damage in the tsunami that hit Japan in early 2011.

“But you wouldn’t know that now: Tungaloy went on to set a sales record in 2011. I visited the Iwaki plant in November and was inspired by the dedication and enthusiasm of Tungaloy’s management, as well as its staff. They are a wonderful group and deserve your admiration and thanks.”