It's a disclaimer found on countless mutual fund advertisements: "Past performance is not indicative of future results." Warren Buffett reminded Berkshire Hathaway investors of this caveat in his annual letter to shareholders, released Friday.
Following a table showing that the company's noninsurance businesses gained an average of 17.8 percent a year from 1965 through 2007, Buffett called the results "completely misleading in predicting future possibilities." He also wrote: "Berkshire's past record can't be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future."
Investors should also keep their expectations in check when it comes to the insurance industry, according to Buffett. Although Berkshire generated an impressive 20 percent gain in net income in 2007, fourth-quarter profits dropped 18 percent on weaker results in insurance and in businesses linked to housing. He warned that tough times are ahead for insurance businesses, which have benefited from two years without major disasters.
"That party is over," he wrote. "It's a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. Prices are down, and exposures inexorably rise. Even if the U.S. has its third consecutive catastrophe-light year, industry profit margins will probably shrink by 4 percentage points or so. If the winds roar or the earth trembles, results could be far worse. So be prepared for lower insurance earnings during the next few years." A few more forward-looking highlights from Buffett's letter to shareholders:
• Berkshire's lone currency position in 2007 was the Brazilian real. "Not long ago, swapping dollars for reals would have been unthinkable. After all, during the past century five versions of Brazilian currency have, in effect, turned into confetti," he wrote. But since 2002, it's the dollar that has plunged: Greenbacks lost half their value against the real between 2002 and the end of last year.
Meanwhile, Buffett's holdings of the real paid off with $100 million in pretax gains in 2007, according to the report. "At Berkshire, we will attempt to further increase our stream of direct and indirect foreign earnings," Buffett wrote. "Even if we are successful, however, our assets and earnings will always be concentrated in the U.S. Despite our country's many imperfections and unrelenting problems of one sort or another, America's rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever growing prosperity for its citizens."
• Corporate America's accounting is also on Buffett's mind. Most big companies make unrealistic assumptions in calculating how quickly their pension fund assets will grow, he writes, adding that companies in the S&P 500 with pension plans, on average, expect their pension assets to earn an 8 percent annual return. He writes that more than a quarter of those assets are invested in cash and bonds, which can be expected to earn no more than 5 percent. That implies, he writes, that the remaining stock-invested assets must earn 9.2 percent—and that's after fees have been deducted.
"How realistic is this expectation?" Buffett asks. He adds that during the 20th century, the Dow Jones industrial average gained an annualized 5.3 percent. "What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them report higher earnings. And if they are wrong, as I believe they are, the chickens won't come home to roost until long after they retire," Buffett wrote. "After decades of pushing the envelope—or worse—in its attempt to report the highest number possible for current earnings, Corporate America should ease up."
• As for who will eventually replace him as Berkshire's chief executive, Buffett, 77, remains coy. (Berkshire plans to split his job into three parts: chief executive officer, chief investment officer, and chairman.) He notes that there are three internal candidates for his job as chief executive: "The board knows exactly whom it would pick if I were to become unavailable, either because of death or diminishing abilities. And that would still leave the board with two backups," he writes. For the job of chief investment officer, Buffett says there are four possibilities: "All manage substantial sums currently, and all have indicated a strong interest in coming to Berkshire if called. The board knows the strengths of the four and would expect to hire one or more if the need arises. The candidates are young to middle-aged, well-to-do to rich, and all wish to work for Berkshire for reasons that go beyond compensation."