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Stock Analyst Update

Buffett to Berkshire Shareholders: Mea Culpa

Buffett grades his 1999 performance and gives himself a D. He's also considering repurchasing Berkshire shares.

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It's a year Warren Buffett and Berkshire Hathaway (BRK.B) shareholders would just as soon forget.

“We had the worst absolute performance of my tenure,” Buffett wrote in Berkshire’s just-released annual report, “and, compared to the S&P, the worst relative performance as well.” The growth in Berkshire’s book value per share--the key measure Buffett uses to assess his company’s performance--grew less than 1% in 1999, compared with a 24% average annual increase over the past 35 years.

The culprit? Berkshire's core insurance business stunk in 1999. Berkshire's not alone. The entire insurance industry is struggling with lower premiums (the amount received from policy holders) and sagging stock prices. The property-insurance industry has shed 25% of its value over the past year, and the reinsurance industry has lost 32%. They're two of the worst-performing industries Morningstar tracks, and they're also the two in which Berkshire does the bulk of its business.

Berkshire's General Re subsidiary posted a big underwriting loss in 1999, meaning it didn't rake in enough premiums to cover losses. At Berkshire's other key insurance unit, auto-insurer Geico, Buffett and team are sacrificing current profits to invest heavily in marketing--despite a tough pricing environment for insurance companies. “We told you last year that underwriting margins for both Geico and the industry would fall in 1999, and they did. We make a similar prediction for 2000.”

But tough market or not, Buffett says he's happy to continue spending at Geico. “Personally, I think these expenditures are the best investment Berkshire can make," he writes. "Through its advertising, Geico is acquiring a direct relationship with a huge number of households that, on average, will send us $1,100 year after year. That makes us--among all companies, selling whatever kind of product--one of the country's leading direct merchandisers.” In fact, Geico will spend even more aggressively in 2000 than it did in 1999.

And even regarding General Re, Buffett is bullish. “General Re has the distribution, the underwriting skills, the culture, and--with Berkshire's backing--the financial clout to become the world’s most profitable reinsurance company.”

But insurance isn’t the only thing that went wrong in 1999. After all, Berkshire's stock price has dropped even more sharply--down 48% over the past year--than that of the average insurance company. That partly reflects how expensive the stock had been in the past. (The more expensive the stock, the harder it falls.) It also reflects the poor year Berkshire's big equity holdings had--stocks like Coca-Cola (KO), Gillette (G), and Walt Disney (DIS). As Buffett said in the report when discussing Berkshire's equity investments: "My grade in 1999 most assuredly is a D."

According to Buffett, these stocks aren't cheap enough to buy more of--he'd rather allocate capital to companies like Geico--but they're good enough companies to hold onto. Remember, too, that he'd be taking a huge capital-gains hit if he bailed out on any of these stocks. (They're still way above the prices at which Buffett originally bought them.) And as for the various smaller companies Berkshire owns outright, they continued to turn in good results. “Almost all of our manufacturing, retailing and service businesses had excellent results in 1999.”

So, if the underlying businesses still sport solid fundamentals, and Berkshire's stock price is in the doldrums, why not buy back shares? Buffett says he's thinking about it. “Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report.”

Don't be surprised if Buffett does take the plunge and buys back some Berkshire shares. (The A shares closed on Friday at $41,300 apiece.) Any way you cut it, Berkshire is cheap. Morningstar's Travis Pascavis did a back-of-the-envelope calculation of Berkshire's intrinsic value, and came up with a bit more than $2,000 per B share. The current share price of the B shares is $1,370.

If Buffett did buy back shares, it wouldn't be to boost Berkshire's share price. Rather, it would be because he thought Berkshire was a good long-term investment at its current price. But given the way the market scrutinizes his every action, expect a runup if he goes ahead with a buyback. (Just admitting in the annual report that he's seriously thinking about it could boost the stock on Monday.)

For investors, Berkshire's short-term troubles point to opportunity. If you're looking to diversify a portfolio away from the high-priced growth stocks that are driving the market, Berkshire deserves to be on the short list of possibilities.

Haywood Kelly, CFA has a position in the following securities mentioned above: BRK.B. Find out about Morningstar’s editorial policies.