Berkshire 2006 Shareholder Letter - Cliff's Notes Version

This is the thirtieth in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2016. For all of the prior shareholder letters, see here.

The 2006 letter weighs in at 14,420 words, a 9.0% increase from 13,230 words the prior year. Berkshire's gain in net worth during 2006 was $16.9 billion, or 18.4% of beginning 2006 net worth.

$16,900,000,000

Just to comprehend the enormity of the Berkshire achievement, Buffett in 2006 generated over $46 million in net worth for Berkshire's shareholders every day, against a starting 1964 capital base of approximately $22 million in total (for the 1964 figures, see here). And this with total shares outstanding increasing from 1,138,000 to just 1,542,000 during the 42 year period, or 35% overall (a CAGR of 0.7%). This equates to a 1964 purchaser receiving back in 2006 a value equal to 1.5X his or her entire starting investment every day during the year, assuming that purchaser purchased shares at book value--in actuality, the 1964 deal was even better since Berkshire's shares were then trading at less than two-thirds of book value.

Granted, inflation probably cut the real purchasing power of this by 90%, but still, getting back around 1/8th of one's entire original investment in real purchasing power every single day is simply breathtaking, given that a"reasonable" real (i.e., after inflation) return on investment is considered to be approximately 5% per year. To put it another way, if a person had gone less than two months in 1964 substituting free water for the normal daily $0.25 bottle of Coke or Pepsi at lunch, he or she could have bought a share of Berkshire A stock that is now trading at $245,000. Unfortunately, finding today's incipient Berkshire is trying to locate a needle in a proverbial haystack, but that doesn't mean it isn't worth searching for (please forward any promising leads to yours truly by express email). It would sure beat finding a few 1964 Pepsi bottles.

NETJETS AND EMOTION-BASED INVESTING

One of the stranger purchases in Buffett's career has been that of NetJets. The company is in a capital-intensive industry notorious for kamikaze-style competition, namely the airline industry (albeit in this case being essentially a private, members-only airline). Granted, Buffett probably believed that size and scale could conquer some competitive problems, but he really should have learned to avoid anything to do with airplanes from his earlier USAir preferred near disaster in the mid-1990s (see, for example, the 1997 shareholder letter in this respect). In any event, one can surmise that Buffett likely fell in love with the company by being a highly satisfied customer, rather than from any zen-like adoration of its financial statements. Here is Buffett's description of the purchase from the 1998 shareholder letter...

I first heard about the NetJets® program...about four years ago from Frank Rooney, our manager at H.H. Brown. Frank had used and been delighted with the service and suggested that I meet Rich to investigate signing up for my family’s use. It took Rich about 15 minutes to sell me a quarter (200 hours annually) of a Hawker 1000. Since then, my family has learned firsthand — through flying 900 hours on 300 trips — what a friendly, efficient, and safe operation NetJets runs. Quite simply, they love this service. In fact, they quickly grew so enthusiastic that I did a testimonial ad for NetJets long before I knew there was any possibility of our purchasing the business. I did, however, ask Rich to give me a call if he ever got interested in selling. Luckily, he phoned me last May, and we quickly made a $725 million deal, paying equal amounts of cash and stock.

Fast forward to 2006, however, and NetJets had already begun to acquire the dreaded 'turnaround' label...

A much improved situation is emerging at NetJets, which sells and manages fractionally-owned aircraft. This company has never had a problem growing: Revenues from flight operations have increased 596% since our purchase in 1998. But profits had been erratic.

Our move to Europe, which began in 1996, was particularly expensive. After five years of operation there, we had acquired only 80 customers. And by mid-year 2006 our cumulative pre-tax loss had risen to $212 million. But European demand has now exploded, with a net of 589 customers having been added in 2005-2006. Under Mark Booth’s brilliant leadership, NetJets is now operating profitably in Europe, and we expect the positive trend to continue.

Our U.S. operation also had a good year in 2006, which led to worldwide pre-tax earnings of $143 million at NetJets last year. We made this profit even though we suffered a loss of $19 million in the first quarter.

Credit Rich Santulli, along with Mark, for this turnaround. Rich, like many of our managers, has no financial need to work. But you’d never know it. He’s absolutely tireless – monitoring operations, making sales, and traveling the globe to constantly widen the already-enormous lead that NetJets enjoys over its competitors. Today, the value of the fleet we manage is far greater than that managed by our three largest competitors combined.

There’s a reason NetJets is the runaway leader: It offers the ultimate in safety and service. At Berkshire, and at a number of our subsidiaries, NetJets aircraft are an indispensable business tool. I also have a contract for personal use with NetJets and so do members of my family and most Berkshire directors. (None of us, I should add, gets a discount.) Once you’ve flown NetJets, returning to commercial flights is like going back to holding hands.

So much for the turnaround, though--during the financial crisis the situation at NetJets got so bad that Buffett had to parachute David Sokol in to try to save the company. The following is from an August 2010 Fortune story on the topic...

Last summer Buffett handed Sokol perhaps the biggest assignment of his career: turning around NetJets. The fractional-ownership jet company last year lost $711 million before taxes -- not the kind of performance that warms Buffett's heart. Today the company is profitable, and Fortune got a rare, exclusive view of how Sokol did it. In mid-August 2009, NetJets was losing money and customers. Founder and CEO Rich Santulli drafted a letter of resignation, and Buffett accepted it. The situation was painful for both men. Buffett liked Santulli as a friend, and in the 2003 Berkshire annual report he had described him as "an extraordinary CEO."An ex-Goldman Sachs banker, Santulli had created the fractional jet ownership industry in 1986; by 2009, NetJets had 842 aircraft, 3,500 pilots, and revenue of $3.1 billion. Santulli, who signed a non-disparagement agreement, chose not to comment for this article.

Santulli came up with the notion of fractional ownership when he noticed that most owners used their jets only a couple hundred hours a year. Why not split the heavy cost of ownership, he thought, and at the same time avoid the hassles of hiring pilots and maintaining the plane? Today a NetJets customer typically buys a one-eighth share of a jet for, say, five years. He also pays around $5,000 an hour for operations. Because NetJets has a huge fleet, it can guarantee an owner a plane -- not necessarily his own but an identical model -- with only four hours' notice.

Buffett and his family, and many Berkshire executives, have long been happy NetJets customers. Buffett is so fond of the company he likes to peddle the service to Berkshire shareholders at his annual meetings, where he sometimes puts jets on display. In his 2001 report, Buffett, whose company also owns Fruit of the Loom, wrote, "If you buy a fraction of a plane, we might even throw in a three-pack of briefs or boxers." Yet since Buffett bought NetJets from the entrepreneur in 1998 for $725 million, it has not come close to earning back Berkshire's investment.

The fractional-jet business is like running an airline, only exponentially more complicated. Imagine having to fly a customer to a destination on four hours' notice. Not only does the jet need to be available, but the pilots, flight attendants, maintenance crew, and catering services all have to be at the right place at the right time. NetJets spends $100 million a year alone on pilot training. Headquarters in Columbus has its own staff of meteorologists to track weather that might delay flights.

And NetJets' well-heeled customers are used to getting what they want. One G-5 owner drank his coffee only out of a white Styrofoam cup, and crews would have to scramble to find the cups and put them next to his seat. A NetJets pilot recalls flying a passenger from Denver to L.A. for a haircut, and then returning him to Denver. The passenger was a poodle. The flights cost $32,000.

By August of last year the financial meltdown had taken its toll on NetJets. Some top executives no longer wanted to be seen climbing onto a $50 million Gulfstream. (Those Detroit CEOs flying on private jets to the congressional bailout hearings didn't help.) Others couldn't afford it. The NetJets contract guarantees buying back an owner's share at a fair market price. Squeezed Wall Street titans couldn't sell their houses, their art, or their horses, but they did have a guarantee that Berkshire would buy back their jets. Owners started selling shares back at a level that was unprecedented. One NetJets executive there at the time says, "We were looking into the precipice. The charts looked like the Superman roller coaster at Six Flags." NetJets was left holding on its books a large number of unsold aircraft worth, in some cases, 40% less than had been paid for them.

As the situation worsened, Sokol replaced Santulli as CEO. When he had flown to NetJets' Columbus headquarters in early August to check things out, Sokol discovered two major problems with the company. First, it had bought too many new planes, causing its debt to skyrocket. Second, NetJets management, according to Sokol, was too informally organized to be effective. Sokol began handing out copies of his management book. Before long he realized that fixing NetJets was going to be far harder than he had imagined.

Indeed, as recently as November 2015 the problems at NetJets were still continuing, according to a bizjourals.com article...

NetJets Inc. has withdrawn some orders for aircraft purchases, forcing the company to pay cancellation fees and sending its profit tumbling, parent company Berkshire Hathaway Inc. said in its quarterly financial report.

Earnings for Columbus-based NetJets plunged 37 percent in the third quarter from a year earlier, and were down 7 percent through the first nine months of 2015, Berkshire (BRK.A) said.

While the company returned to profitability post-recession, it hit more turbulence as contract negotiations dragged on with pilots and flight attendants and it parted ways with CEO Jordan Hansell.

In 2015 Buffett also fired NetJets' CEO and installed someone new in the office. Suffice it to say, NetJets has been a rare lemon in Berkshire's portfolio since its acquisition nearing 20 years ago, despite occasional periods of profitability. It has possibly even operated at a loss over the entire period, let alone earning its cost of capital. Let this all be a lesson on the dangers of investing with one's heart rather than one's head, especially in capital intensive industries with ruthless economic competition and potential union problems, such as the airline industry. Ironically, in the 2006 letter Buffett quotes a friend saying to him that “If you want to get a reputation as a good businessman, be sure to get into a good business“--perhaps Buffett should have connected that statement with his discussion of NetJets later on in the letter. Or, to use employ another familiar expression, “If you find yourself in a hole, the first task is to stop digging.“

EXCORIATING “2-AND-20“ HEDGE FUNDERS

Buffett is decidedly not a fan of hedge funds, as witnessed as recently as just a few days ago at the Berkshire annual meeting. In the 2006 letter he takes another rhetorical whack at the seemingly perpetually-dwindling reputation of the 2-and-20 crew...

In last year’s report I allegorically described the Gotrocks family – a clan that owned all of

America’s businesses and that counterproductively attempted to increase its investment returns by paying ever-greater commissions and fees to “helpers.” Sad to say, the “family” continued its self-destructive ways in 2006.

In part the family persists in this folly because it harbors unrealistic expectations about obtainable returns. Sometimes these delusions are self-serving. For example, private pension plans can temporarily overstate their earnings, and public pension plans can defer the need for increased taxes, by using investment assumptions that are likely to be out of reach. Actuaries and auditors go along with these tactics, and it can be decades before the chickens come home to roost (at which point the CEO or public official who misled the world is apt to be gone).

Meanwhile, Wall Street’s Pied Pipers of Performance will have encouraged the futile hopes of the family. The hapless Gotrocks will be assured that they all can achieve above-average investment performance – but only by paying ever-higher fees. Call this promise the adult version of Lake Woebegon.

In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive this bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee.

The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these “hyper-helpers.” Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.

CONCLUSION

For the record, in 2006 Berkshire's stock rose 24%, beating the S&P 500 by 8%, the Cardinals beat the Tigers 4-1 in the World Series, the Colts beat the Bears 29-17 in Super Bowl XLI and on November 2nd this painting was sold for $140 million (I think I'd rather have the cash, personally). Next up, 2007, the year 'subprime' became a dirty word.