Warren Buffett's 2011 letter: Dump bonds, buy shares

Warren Buffett's 2011 letter to Berkshire Hathaway shareholders has been released. His letters are an amazing collection of knowledge and experience – and this year's letter is no different.

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Warren Buffett's 2011 letter  to Berkshire Hathaway (NYSE: BRK-A, BRK-B) shareholders was released on the company's website overnight, Australian time.

As we reported  at the time, an extract of the letter had already been released on Fortune magazine's website, extolling the virtues of quality businesses and his preference to hold those businesses rather than investments in gold or bonds – a view we also hold here in Fooldom.

Why care? Well, other than being the preeminent investor of our time, and the third-richest man alive, Buffett's credentials are right there on the first page – Berkshire Hathaway's book value has grown at a touch under 20 per cent per year, on average, since 1965 – taking book value from US$19 to US$99,860 in the process.

Buy shares of businesses, not gold or cash

In short, Buffett outlined the continual devaluation of cash, in the face of inflation. In fact, as Buffett points out, the US Dollar has lost 86% of its value since 1965 – not against other currencies, but simply through the ravages of price inflation.

Similarly, Buffett decries an investment in gold. An inanimate object – "you can fondle [it], but it will not respond" – Buffett mentions the phenomenon of its popularity during times of panic, but neatly does away with the perceived logic of such a choice. For the value of all the gold in the world, Buffett outlines an alternative – all of the farmland in the US, plus 16 Exxon Mobils (NYSE: XOM), an oil producer which is the world's most profitable company, delivering profits of more than US$40 billion per year – with US$1 trillion left unspent.

The kicker is that the farmland and sixteen Exxon Mobils will produce both goods and profits this year and every year – the gold just sits there, and the speculator hopes someone will pay more for it in the years to come.

Yes, gold will become more popular when people are scared (as now), but when fear recedes, Buffett believes the longer-term compound return of gold will be 'far inferior' to top quality equities.

A successor to Buffett

Buffett and the Berkshire Hathaway Board have been notoriously secretive about who will succeed the 81 year-old as CEO when the time comes. In past years, the shareholder letters – and Buffett's public statements – have mentioned that there were a number of candidates for his role as CEO, without mentioning names.

While we still don't know who the Board is favouring to replace Buffett, this year's letter made clear that there is now a single preferred candidate, with a couple of back-up candidates, should they be required. Much guessing will follow as to who the candidate might be, but this is another step along the carefully planned road to a Berkshire without Buffett.

Business is improving

We've been saying for a while  that despite the endless stream of things we could be worried about, we should instead keep our eyes on the horizon. Yes, Europe is in a mess, and the US still has unemployment over 8%, but the future will look better than the past.

It is clear from the shareholder letter that Berkshire Hathaway's operating businesses – with revenues of some US$72.4 billion last year – are experiencing good growth. Revenues were up 10% (though that number is slightly overstated due to the inclusion of 3 months of sales of a recent purchase).

While Buffett doesn't separate out the housing-related businesses from those revenue numbers, he did provide a breakdown of the pre-tax earnings for the non-housing related companies. The growth of earnings from US$1.4 billion in 2009 to US$3.9b in 2010 and US$4.4b (excluding the acquisition) in 2011 is ample evidence that the US economy (outside housing) is back on its feet.

Insurance is strong

Berkshire Hathaway's insurance businesses – the real engine of the business have delivered nine consecutive years of underwriting profits – meaning the premiums received were less than the claims paid and the expenses of running the business – allowing Buffett and his team to invest the premiums for profit in the interim. While Buffett doesn't expect the pool of premiums – called 'float' – to grow significantly from here, US$70.5 billion is a nice, cost-free, cash pile to invest.

Foolish take-away

The theme of top quality, productive businesses as the best vehicle for building wealth is universal and timeless, but bears repeating.

The performance of the operating businesses underpins a sense of optimism and that the worst of the downturn is well and truly behind us – Berkshire's 5 largest operating subsidiaries delivered record profits in 2011.

In a world full of business and investment education options – many costing tens of thousands of dollars – it is hard to find a better education resource that Buffett's (free) annual letters, replete with examples of success and unambiguous apologies for mistakes made. Together, they represent an amazing collection of knowledge and experience – and this year's letter is no different.

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Scott Phillips Is The Motley Fool's feature columnist. Scott owns shares in Berkshire Hathaway. You can follow him on Twitter @TMFGilla. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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