Berkshire Hathaway (BRK-A), for those that do not know, is Warren Buffett’s gargantuan investing vehicle.  Book value for Berkshire has grown from $19 to $59,377 over the past 41 years at a rate of 21.5% compounded annually.  And Warren Buffett - the second richest man in the world - is now worth over $40 billion.

I only wish every annual report was as fun to read.  Warren Buffett is not only the world’s best investor, but he is also, I think, one of the finest writers.  This year’s letter to shareholders talked in detail about Berkshire’s various businesses and acquisitions:  Clayton Homes, Medical Protective Company, Forest River, Business Wire, Applied Underwriters, and MidAmerican Energy.  As usual, Mr. Buffett also elaborated on his insurance businesses – GEICO, General Re, and National Indemnity – and their successes and failures and how insurance works especially in regard to float and taking on risks like mega-catastrophes.

Executive compensation was another hot topic.  Mr. Buffett defended Gillette CEO Jim Kilts as having “earning every penny” of his large salary, but said extraordinary CEOs are a rare specie.  (Gillette was acquired this year by Proctor & Gamble.)  As an example, Mr. Buffett explains the problem compensating with fixed-price options.  There executives use earnings to repurchase shares to make themselves rich, instead of paying out dividends or improving the company (doing their job).  He also pokes fun at severance packages and how getting fired can be extremely lucrative for CEO’s:  “Today, in the executive suite, the all-too-prevalent rule is that nothing succeeds like failure.”

Like last year, Mr. Buffett voiced his concern about the U.S. trade imbalances.  However, a change in strategy, Berkshire reduced their position in currencies favoring equities whose prices are denominated in a variety of foreign currencies and that earn a large of their profits internationally.

Regarding investing, Mr. Buffett tells a parable illustrating how hedge funds are damaging the wealth of Americans.  With transaction costs, high management fees, and mediocre performance, investors are earning only 80% of what they should be making if they just left their investments alone.

On the subject of debt and risk, Mr. Buffett explains why Berkshire shuns debt: “…hundreds of thousands of investors have a large portion of their net worth in our stock (among them, it should be emphasized, a large number of our board and key managers) and a disaster for the company would be a disaster for them.”  Moreover, he goes on to say, “there are people who have been permanently injured to whom we owe insurance payments that stretch out for fifty years or more.  To these and other constituencies we have promised total security, whatever comes: financial panics, stock-exchange closures (an extended one occurred in 1914) or even domestic nuclear, chemical or biological attacks….Whatever occurs, though, Berkshire will have the net worth, the earnings streams and the liquidity to handle the problem with ease.”

Last but not least, Mr. Buffett discusses his succession.  Berkshire has three managers capable of being CEO, and the board of directors has unanimously agreed on one.  When the time comes – either Mr. Buffett’s death or his mental decay – the board will know what to do.  Berkshire Hathaway will be in good hands, Mr. Buffett reassures.  And what will happen with Mr. Buffett’s large fortune after his death?  In his own words: “Every share of Berkshire that I own is destined to go to philanthropies, and I want society to reap the maximum good from these gifts and bequests.”

Letter to Shareholders

Annual Report