Once again, Berkshire Hathaway’s Annual Meeting was a showcase for the best of corporate America featuring the guru of value investing, 81-year-old Warren Buffett, and his long-time partner and alter ego, 88-year-old Charlie Munger.  Five hours of answering questions from shareholders, financial analysts, and journalists, and they didn’t miss a beat.

Management succession was again a major topic of discussion, but in spite of Buffett’s recent announcement of prostate cancer, the topic did not seem to be the same level of concern as previously.  Buffett said that he “feels good,” he does not require hospitalization, he is undergoing very successful treatment, and he expects to live many more productive years.  Berkshire’s board has designated a CEO successor who was described at the meeting as an existing Berkshire executive immersed in the company’s value investment culture.  As with Buffett, the new CEO would also be Chief Risk Officer who will continue to avoid excess leverage and insurance risk.  Could it be Ajit Jain who has been with Berkshire since the 1980s and is in charge of Berkshire’s own highly successful reinsurance business?  If so, we would applaud his choice.  Buffett praised Jain’s ability to create value and manage risk.

Future designated Co-Chief Investment Officers Todd Combs and Ted Weschler were reported to be performing well with assets under their management increased by $1 billion to $2.75 billion each.  Emphasis was also placed on the quality of Berkshire’s outstanding subsidiary CEOs, who run their companies independently.

Concern about the US economy was much less than that expressed in annual meetings of the last few years.  US banks were described as now being “in fine shape” with most of their “abnormal losses taken,” their capital “buttressed,” and their liquidity “built.”  The Federal Reserve and Treasury Department were given high marks for their actions which benefitted the banks’ recovery.  Problems still needing to be addressed include the ongoing excessive US government fiscal deficits and the high US unemployment rate.  Buffett said that the deficit could be contained by reducing expenditures to 21% of GDP and increasing revenues to 19% for a 2% differential as opposed to the current 8.5%.  Munger estimated the future US long-term real economic growth rate (above inflation) at 1% annually, which would increase the income of each succeeding generation by 25%, although income distribution between the wealthy and the poor could pose a problem.

Less confidence was expressed for Europe.  The European Central Bank’s support of the European banking system by providing one trillion euros of liquidity has kept the European banks in business, but successful resolution of the 17 member European Union’s sovereign debt crisis will be difficult to achieve politically.

Most of the annual meeting was spent discussing Berkshire’s operating subsidiaries and their future.  Buffett considers Berkshire’s stock significantly undervalued, and so do we. Historically, Berkshire Hathaway has traded in the range of 1.5–1.7 times book value, which we think more accurately reflects its true value.  Buffett renewed last year’s pledge that the company would repurchase its shares should their price fall to 110% of book value and further said Berkshire would be willing to purchase “tens of billions of dollars” of Berkshire stock at that level.   On the subject of dividends, Buffett believes that he can reinvest earnings for greater value to shareholders, so there will be no dividends forthcoming from Berkshire.

Buffett said that Berkshire’s major operating subsidiaries are performing extremely well.  GEICO’s share of the automobile insurance market has increased from 2% in the 1990s to 10% today, and he projects continued growth in underwriting profits and reserves available for investment.  As a regulated electric utility, MidAmerican Energy has significant opportunity for profitable additional investment.  So does railroad Burlington Northern Santa Fe, whose transport of one ton for 500 miles requires only one gallon of diesel fuel.  While MidAmerican and Burlington Northern are in capital intensive industries, Berkshire is “happy with their 12% return on equity” for new investment.  Altogether, Berkshire owns 79 operating companies plus many investments in publically held enterprises, the five largest of which are The Coca-Cola Company, International Business Machines Corp., Wells Fargo & Company, American Express Company, and The Procter & Gamble Company.

In response to a question, here’s a list of investment don’ts from Buffett and Munger:

• Stay away from companies you don’t understand and can’t forecast long term;
• Avoid highly priced stocks and look for those selling at less than intrinsic value;
• Stay away from initial public offerings (seller has too great a timing advantage);
• Avoid big disasters.

Sounds simple, but the trick is to execute like Warren Buffett.

In this latest installment of our quarterly report, my colleagues and I share some observations on the market’s spectacular rise in the first quarter, offer our current outlook for the economy and markets in this election year, and discuss three of the securities we are currently buying: Microsoft Corporation (MSFT), PNC Financial Services Group (PNC), and National Grid PLC (NGG).

Click here to go to the full report on our website.  Following are a few highlights:

- The S&P 500 index returned 12.6% in the first quarter after surging 11.8% in the fourth quarter of 2011.

- We are cautiously optimistic about the potential for further increases in stock prices, particularly for high-quality holdings, but we do expect the ride to get bumpier again and will not be surprised to see a correction after the market’s long and strong rebound from last September.  Bonds, however, are likely to disappoint.

- We expect continued slow recovery for the U.S. economy and further increases in corporate earnings through the year, although first quarter earnings are likely to be up only about 1%.

- Even after the stock market’s recent rally, we see more room for price appreciation as corporations continue to profit from pent-up demand both in the United States and abroad, particularly in emerging markets, and as price/earnings multiples rise to historical levels.

- Further support for higher stock prices should come from companies’ efforts to return cash to shareholders through dividend payments and share repurchases.

- We continue to prefer shares of high quality, well capitalized, multinational companies that pay dividends and trade at significant discounts to intrinsic value.

- We believe the bond market is close to a peak and offers too much risk in exchange for too little potential reward.  At 2.0%, the 10-Year Treasury’s yield is lower than the inflation rate, resulting in a negative real return, and bonds will suffer when the Fed eventually tightens the money supply.

- For income investments, we favor high yielding securities including master limited partnership units and preferred stocks, which yield 6% to 7%, as well as common stocks such as utilities, which offer yields of 4% and higher with the potential for further dividend increases.  We believe that these income investments will provide better overall returns than bonds and will prove far more resilient than low yielding bonds when we inevitably face rising inflation and interest rates.

- Primary risks to our cautiously optimistic outlook relate to China, Europe, the Middle East, and U.S. political issues.

As always, feel free to contact us if you have any questions or comments.  For more information, visit our website.

Jordan Smyth and the Edgemoor Investment Advisors Team

Two of the most successful long-term investors, Warren Buffett and Jeremy Grantham, just released their latest commentaries.  We carefully study their reports and believe all investors should do the same.

The headlines related to Buffett’s 2011 letter to Berkshire Hathaway shareholders emphasized succession plans, which are in place, and his admission of mistakes, including the purchase of bonds in an electric utility now suffering from low natural gas prices, resulting in a $1 billion plus loss – yes, he’s human.  Our favorite section, however, begins on page 17 and is titled, “The Basic Choices for Investors and the One We Strongly Prefer.”  Buffett sees three choices, as summarized in the following excerpts:

While Buffett, who famously encouraged investors to “buy American” in October 2008, is known for being bullish on stocks and the U.S. economy, Grantham has developed a reputation as a bear.  Grantham and his firm, GMO, which manages nearly $100 billion, correctly predicted in 2001 that U.S. equities would post the worst performance of eleven major asset classes over the following decade.  Actually, Grantham’s investing approach is very similar to Buffett’s, as is his current outlook in GMO’s latest quarterly letter (fourth quarter 2011).  His summary of recommendations on page 12 includes suggestions to overweight high quality U.S. equities and other global equities but “underweight as much as you dare long-term bonds, especially higher-grade sovereign bonds.”  In one of our favorite quotes, he makes a case for equities as the best hedge against inflation:

In general, I also much prefer to have stocks and other real assets in a longer-term approach than to have complicated hedges and options.  Murphy’s Law of complexity is powerful: things will go badly if they can and when you least need them to, but complex things will go bad first, and worst given half a chance, as we saw in the mortgage market a few years ago.  Keep it simple when you can.  And owning stocks is very simple indeed.

Words of wisdom from one of the best, and a reminder to all that a simple approach focused on fundamental valuation, combined with patience and discipline, can lead to solid long-term results.

A Motley Fool article from last fall, recently cited in DailyFinance, highlighted three misconceptions regarding the US economy:

1: Most of what Americans spend their money on is made in China.

2: We owe most of our debt to China.

3: We get most of our oil from the Middle East.

Whether or not you believe these to be true, click here to see how the author debunks these notions in an attempt to try to focus the debate over economic policy.

As those who have followed our investing approach know, preferred stocks have been mainstays of our income portfolios for many years.  In today’s environment of low interest rates, including a yield of 2% on the 10-Year Treasury, the much higher yields offered by preferred stocks are particularly attractive.

Fidelity recently published a detailed review of the benefits and risks of investing in preferreds.  Click here to read the article and learn more about these securities.

For more on our approach to income investing, click here.