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Dividend Stocks

Warren Buffett’s 2007 Annual Letter to Shareholders

Warren Buffett’s 2007 Annual Letter to Shareholders

by Floyd G. Brown, Advisory Panelist, Investment U
Monday, March 3, 2008: Issue #770

This year, value investors have been eagerly awaiting Warren Buffett’s 2007 annual letter to shareholders. Whether you hold shares in Berkshire Hathaway or not, this letter always features Buffett’s musings on investing, the market, and life.

His letters are also known for their pity prose and quotable Buffett-isms. The 2007 annual letter didn’t disappoint his fans. The most quoted line is:

“You only learn who has been swimming naked when the tide goes out – and what we are witnessing at some of our largest financial institutions is an ugly sight.”

But the quote that caught my eye as sage advice came much deeper in the letter on page 16. That’s where Buffett discusses put options sold by Berkshire and personally managed by him. Here is what he had to say…

An Excerpt from Warren Buffett’s 2007 Annual Letter to Shareholders

These two paragraphs below, an excerpt from Warren Buffett‘s 2007 annual letter to shareholders, explain why I am sanguine about financial stocks that have taken large write downs on derivatives in the past two quarters, and I consider many to be screaming buys:

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie [Munger] and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

Because of the peculiar accounting rules that require financial firms to mark down these securities to the market price, combined with the onerous penalties created by the overzealous Sarbanes-Oxley laws, this has caused most firms to mark many securities to unrealistically low levels.

I believe that in the coming two years, when the market for many of these securities based on mortgages and various high-yield bonds returns to a more normal level, we will see huge earnings gains by firms who have gone too far marking down these securities.

A Shopping List for Value Investors

The latest victim of the accounting rules has been AIG (NYSE: AIG).

Last week, AIG recorded the worst quarterly results in its history, dating back to 1919. This firm, which I believe is the best, most diversified insurance company in the world, explained huge derivative loses in its quarterly earnings release this way:

“Included in both the full year and fourth quarter 2007 net income (loss) and adjusted net income (loss) were charges of approximately $11.47 billion pretax ($7.46 billion after tax) and $11.12 billion pretax ($7.23 billion after tax), respectively, for a net unrealized market valuation loss related to the AIG Financial Products Corp. (AIGFP) super senior credit default swap portfolio. AIG continues to believe that the unrealized market valuation losses on this super senior credit default swap portfolio are not indicative of the losses AIGFP may realize over time.”

Financial firms are writing down everything in sight. And I would be surprised if much of this write down didn’t end up boosting earnings in future years. These write downs are not cash loses, because in many cases the firms are continuing to hold the bonds, contracts and other financial instruments. Many of the instruments are valued far below the cash stream they continue to provide.

Investors who can think like Buffett, and are not scared witless by the financial lightweights who write the business sections of most daily newspapers, will make a bundle.

Yes, there are financial firms that made massive mistakes in extending credit to unworthy borrowers. The market has punished these financial firms for lax lending standards and followed that up with pricing them for a recession.

When Stocks Are On Sale, Buyers Can’t Be Found

The wise investor knows that when stocks are on sale in America, buyers are nowhere to be found. But the brave investor who uses these discounts to acquire shares in quality companies will be well rewarded for that risk over time.

Maybe that’s why Buffett is buying stocks again. He has added to his equity positions in several key financial firms, including Wells Fargo (NYSE: WFC) and U.S. Bancorp (NYSE: USB). I rate these two firms, as well as AIG, as outstanding buys at this level. Plus, you get the benefit of dividends. All three pay them, and as the markets return to normal, each company will also provide large capital gains.

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