500 Letters: Stocks that pick you

1. 500 Letters: Stocks that pick you Dan Ferris November 18, 2013 Ritz-Carlton Millennia Singapore

2. What we did Mike Barrett and I read the S&P 500 shareholder letters.

3. What Mike was looking for Tell me something I canʼt easily figure out by reading the 10K. Write the letter as if youʼre talking directly to me, a long-term shareholder who truly wants to better understand the company. Make it original, authentic and substantive. I realize there are other stakeholders (employees, customers, suppliers), but youʼre starting the letter with “Dear Shareholder”, so fill it with information germane to my concerns and interests. Be candid, especially when things didnʼt go according to plan, and tell me how any problems are to be corrected. Show me youʼve got a plan and measurable expectations in place.

4. What I was looking for? I don’t know, but I knew I’d find it. And I did.

5. If you don’t know the trees you may be lost in the forest, but if you don’t know the stories you may be lost in life. ~ Siberian elder

6. What we found • 31 excellent letters • 48 above average letters • Lots of other stuff…

7. The S&P 500 letters taken as a whole is pure, certified, Grade-A, prime…

9. Two most frequently found types of bulls**t…

10. Type #1 was in almost every letter “Despite the economic paralysis created by the European debt crisis and the fiscal cliff in the U.S., UPS generated record adjusted earnings per share.” ~United Parcel Service (UPS) “We delivered another year of record sales and earnings, despite the challenges that faced the chemical industry.” ~FMC Corporation

11. More Type #1 examples 2012 was another standout year for Cabot. Despite a backdrop of macroeconomic uncertainty and depressed natural gas prices, new company records were set for production, proved reserves, revenues, cash flow from operations and discretionary cash flow. ~Cabot Oil & Gas (COG) "worldwide economic recovery remains uneven“ vs. “worldwide ultra-deep rig utilization remains near 100%” ~Diamond Offshore (DO) "extremely challenging market environment“ vs.“largest annual net subscriber gain in DTV history” ~DirecTV (DTV)

12. What they should have said “…we as a management team will not use market headwinds as an excuse...” ~Stanley Black & Decker (SWK) “We are a no-excuses company in a no-excuses industry” ~Travelers Cos (TRV) "While we are not impervious to tough economic conditions, great companies can grow and increase market share during economic downturns; and we believe Costco achieved just that in 2012.“ ~Costco (COST)

13. What they should have said There was a lot of hand-wringing last year among CEOs who cried “uncertainty” when faced with capital allocation decisions (despite many of their businesses having enjoyed record levels of both earnings and cash). At Berkshire, we didn’t share their fears, instead spending a record $9.8 billion on plant and equipment in 2012, about 88% of it in the United States. That’s 19% more than we spent in 2011, our previous high. Charlie and I love investing large sums in worthwhile projects, whatever the pundits are saying. We instead heed the words from Gary Allan’s new country song, “Every Storm Runs Out of Rain.” ~Berkshire Hathaway (BRKA, BRKB)

14. What they could have said Despite some dire predictions, the world did not end in 2012. The European Union did not unravel. The U.S. did not throw itself over the “fiscal cliff.” Certainly, we are all still adjusting to the more complicated economic environment of the past few years. But we continue to move forward, propelled by consumer demand—the most powerful financial driver in the world. ~Nielsen (NLSN)

15. What they should have said Now don’t get me wrong – we did not achieve all of this on our lonesome. We had some help from broader trends… Fortuity no doubt helped in the other aspects of our results as well. For example, while we are increasingly confident of the improvements in our International P&C business, it is still too early to tell just what percentage of its improved results is luck versus design. Good fortune is welcome in the risk business, but it takes time to sort it from intended results. And while uneven, pricing for risk continues to improve and was generally better across the industry in 2012 than in 2011. Though, regardless of the trends, by the end of 2012, overall it was clear that our own actions were part of the larger XL story. ~XL Capital (XL)

16. How stocks pick you Businesses with highly competent people who don’t make excuses are trying to pick you. Others that got this right: • TJX Companies (TJX) • Macy’s (M) • Disney (DIS) SWK, TRV, COST, BRKA/BRKB, NLSN, XL, TJX, M, DIS

17. Bulls**t type #2 examples In 2012, we produced a total return to shareholders of 41% compared to 16% for the S&P 500 overall. ~Gannett (GCI) Our most important achievement was another strong year of stock price appreciation with a 31 percent increase, even in the face of stiff headwinds due to low natural gas prices. In 2011, we were the #1 performing stock in the S&P 500 and in 2012 we were the #1 performing stock in our peer group. ~Cabot Oil & Gas (COG) “We delivered a total shareholder return of 37 per cent, a premium performance in the chemical industry.” ~FMC Corporation (FMC)

18. What they should have said We don’t control the stock market. If we did, we wouldn’t be half stupid enough to deliver more total shareholder return to you in any given year than our business actually produced. So we wouldn’t have rewarded you with a 37% return last year, like the stock market did. In fact, we doubt you’ll make 30+% a year long-term owning our shares, but we do believe we can produce an excellent total shareholder return, in excess of the broad market indices, over the long-term. ~Dan Ferris, CEO of Nothing Inc. (NINC)

19. What they should have said It’s our job to increase intrinsic business value – for which we use book value as a significantly understated proxy – at a faster rate than the market gains of the S&P. If we do so, Berkshire’s share price, though unpredictable from year to year, will itself outpace the S&P over time. If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund. ~Berkshire Hathaway (BRKA/BRKB)

21. Worst letters (since writing was invented) • Caterpillar (CAT) • United Health (UNH) • Monsanto (MON)

22. Caterpillar (CAT): No. 1 worst When faced with challenges, it’s how we respond that defines us. 2012 was full of challenges for the Caterpillar team, but our response to everything that was thrown at us was rock solid. Nowadays it seems there aren’t many things that are rock solid. The global marketplace is constantly shifting and economies around the world face uncertainty on a variety of fronts — fiscally, politically and socially. The world struggles to address concerns like energy, infrastructure, workforce readiness and how to compete in the global economy. And our customers also face challenges like never before. It’s hard to grasp anything solid, steady and reliable anymore. But that’s exactly what we try to be for our customers, stockholders, employees, dealers and suppliers. We live by our core values of Integrity, Excellence, Teamwork and Commitment. And as we do business in every corner of the globe, our values guide us to be fair and consistent. You know what to expect when you deal with Caterpillar.

23. Monsanto (MON): No. 2 worst We live in interesting times. As the world becomes smaller, it has become easier than ever to see the ways in which we are all interconnected—through our needs, our resources and our reliance on a healthy planet. These connections aren’t new. But they require a new mindset to appreciate how we can best preserve, nurture and expand them.

24. United Health (UNH): No. 3 worst The employees of UnitedHealthcare, Optum and UnitedHealth Group worked together in 2012 to meaningfully advance the long-term capabilities, value, performance and potential of this enterprise for sustained growth. This letter represents one of the few public opportunities to recognize their extraordinary efforts and I’m honored to do so here. Their commitment to consistent and ever-improving execution on behalf of those we serve across the diversity of our businesses truly makes a difference in people’s health and in their lives. As we move forward into 2013 and the next several years, we expect change will continue to characterize our national health care system.

25. The best of the 500 letters

26. Great letters tell you… • How they’ll spend excess cash they earn • How the business/industry works • How to measure success in the business • Insightful information

27. Great letters tell you… How they’ll spend the profits

28. How they’ll spend the profits #1 by a mile:Berkshire Hathaway (BRKA, BRKB) • Reinvest in their current businesses • Buy new businesses • Buy back stock

29. How they’ll spend the profits JPMorganChase (JPM):The one and only S&P 500 company that prioritizes dividend growth over reinvestment “Our fortress balance sheet, including our strong return on capital, provides us with excess capital to invest, and we always are thinking way ahead about the best ways to deploy it. As we have said in the past, after steadily increasing dividends, our favorite deployment is in growing our businesses. After investing in the growth of our businesses, we look at other ways to use the remaining excess capital. One use we consider is buying back stock – but only at a price we think is good for shareholders.”

30. How they’ll spend the profits We remain committed to ensuring we have a balanced and flexible capital allocation plan over the long term, in which roughly two-thirds of our free cash flow will be deployed to acquisitions, with a minimum of one-third returned to shareholders in the form of dividends and share repurchases. ~Stanley Black & Decker (SWK)

31. How they’ll spend the profits We believe strong organic growth provides the highest return and is in our shareholders’ best long-term interest. Our second priority is paying long-term, stable and growing dividends to our shareholders. ~BB&T Corp (BBT)

32. How they’ll spend the profits “Our external growth has never been programmed, formulaic or linear, i.e. we do not budget acquisition activity. Each year, we mine our deal flow for opportunities and, as such, our acquisition volume is lumpy.” ~Vornado Realty Trust (VNO)

33. How they’ll spend the profits "We remain committed to improving our return to shareholders and, in 2012, increased our targeted level of annual return to at least 50% of free cash flow, up from our prior target of 25% to 40%. During 2012, we returned more than $1.3 billion to shareholders in the form of dividends and share buybacks, marking the second year in a row that we returned over 70% of our free cash flow to shareholders." and this:  "Our plans call for further dividend increases, and we anticipate that our dividend payout ratio will rise significantly over the next few years. ~Covidien (COV)

34. How they won’t spend the profits "A compelling dividend offers investors a predictable annual return while enforcing capital discipline within the company.“ ~ConocoPhillips (COP)

35. How they won’t spend the profits What we try to avoid are companies with material obsolescence risk, companies whose business models we simply don’t understand, and companies that can be damaged beyond redemption by management that does not keep current with industry trends. In some industries — we are thinking of fashion, entertainment and technology as examples — inattention at the wrong moment, or a single bad decision by senior leadership, can be fatal. ~Loews (L) BRKA, SWK, BBT, COP, COV, L

36. Great letters tell you… About the business/industry

37. About the business/industry We operate under a specific, deliberate business plan which we think at the present time is the best way to increase shareholder value. We do not do discovery research… Since we do not do basic research, meaning we do not create new molecules, we look for molecules created and tested to some degree by others. And then we do the heavy lifting that results in products approved for marketing. ~Forest Laboratories (FRX), best pharma letter by far

38. About the business/industry In summary, Charlie and I hope to build per-share intrinsic value by (1) improving the earning power of our many subsidiaries; (2) further increasing their earnings through bolt-on acquisitions; (3) participating in the growth of our investees; (4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and (5) making an occasional large acquisition. We will also try to maximize results for you by rarely, if ever, issuing Berkshire shares… ~Berkshire Hathaway (BRKA/BRKB)

39. About the business/industry Our business has been built with local stores as the focal point. Some may feel this isn’t the most efficient model in today’s world, but we strongly believe the closer we are to our customer, the better we can understand their needs and help them improve their business. We also believe in vertical integration throughout our organization. Our teams work hard to develop solutions and systems ‘in-house’ whenever possible – from designing our own computer systems, to operating our own trucking fleet, to utilizing our own engineers to design our warehouse systems. We believe this approach not only makes us more profitable but also more responsive and flexible. ~Fastenal (FAST)

40. About the business/industry Approximately ten years ago, we made a monumental shift in our company’s investment strategy away from two- and three-story walk-up garden apartment properties with surface parking in suburban locations across the 50 largest cities in the country, towards higher density, urban properties in a handful of gateway cities in the northeast and West coast… We also wanted to invest where the construction of new housing would likely continue to be constrained, such that demand would exceed the supply of all forms of housing. ~Equity Residential (EQR)

41. About the business/industry Underwriting, or the art and science of taking risk, is a hallmark of our company – it defines our culture and is embedded in our ethos. We take risk for a living and so insist on making a profit when we do so. Together with a thoughtful, well-balanced mix of businesses, this underwriting discipline has served us well through all economic conditions and all stages of the commercial P&C pricing cycle. We have earned a cumulative underwriting profit since we were founded in 1985 and have outperformed the industry over any period of time. ~ACE Ltd (ACE)

42. About the business/industry My Macy’s is our formula for localization – in merchandising, in marketing and in shopping experience. Even after our three consecutive years of phenomenal success in bringing localization to life, no other retailer has anything like My Macy’s. It is our sustainable competitive advantage. No one has copied it. No one is likely to copy it because of the investment required in infrastructure, systems and talent… If enough customers want a particular item in a particular Macy’s location, we will be relentless in making that happen. ~Macy’s (M) FRX, BRKA/BRKB, FAST, EQR, ACE, M

43. Great letters tell you… How to measure success

44. How to measure success Our goal is to grow free cash flow per share on a consistent, sustainable basis. Free cash flow is the funds remaining after paying expenses, maintenance capital expenditures and, for our commercial properties, tenant improvements and broker commissions, as well as preferred shareholder dividends. It represents the cash available to pay common dividends, invest in additional income generating properties or retain for future use. I frequently refer to this as “grocery money” as it is real cash like you spend at the grocery store. Since we now pay out a significant portion of our earnings in dividends, we manage for the occasional “great recession” or serious capital market dislocation. Why do we use free cash flow on a per share basis? What owners should care about is how much each share they own is increasing in value, not the size of the domain being managed. Frequently, in corporate America, management teams focus on total revenues, total assets or market value, especially relative to public competitors. While these are interesting metrics, they rarely have anything to do with value per share. ~Public Storage (PSA)

45. How to measure success It’s our job to increase intrinsic business value – for which we use book value as a significantly understated proxy – at a faster rate than the market gains of the S&P. If we do so, Berkshire’s share price, though unpredictable from year to year, will itself outpace the S&P over time. If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund. Charlie and I believe the gain in Berkshire’s intrinsic value will over time likely surpass the S&P returns by a small margin. We’re confident of that because we have some outstanding businesses, a cadre of terrific operating managers and a shareholder-oriented culture. Our relative performance, however, is almost certain to be better when the market is down or flat. In years when the market is particularly strong, expect us to fall short. ~Berkshire Hathaway (BRKA)

46. How to measure success “The five-year goals are as follows: • Grow earnings per share 9-11 percent per year, on average • Grow organic sales 4-6 percent per year, on average • Maintain return on invested capital above 20 percent • Free cash flow conversion of 100 percent” ~3M Co. (MMM)

47. How to measure success With the integration efforts around the Stanley Black & Decker merger essentially complete and far exceeding expectations, we are taking the experience gained from our successful acquisition/integration program and applying those best practices to drive organic growth initiatives in our most promising markets and improve return on capital employed (ROCE) and cash flow return on investment (CFROI). ~Stanley Black & Decker (SWK)

48. How to measure success We finished the year with an all-in Return on Equity (ROE) of 6.2%. This is a far better result than our 0.9% 2011 ROE, but make no mistake, is not a result with which we are satisfied. Our ROE target, as we have stated since the implementation of this strategy, is for double-digit returns. ~XL Capital (XL)

49. How to measure success Vornado’s Funds from Operations Adjusted for Comparability (an apples-to-apples comparison of our continuing business, eliminating certain one-timers) for the year ended December 31, 2012 was $964.1 million, $5.17 per diluted share, compared to $939.3 million, $4.90 per diluted share for the year ended December 31, 2011. Total Funds from Operations (apples-to-apples plus one-timers) for the year ended December 31, 2012 was $818.6 million, $4.39 per diluted share, compared to $1,231.0 million, $6.42 per diluted share, for the year ended December 31, 2011. ~Vornado Realty Trust (VNO)

50. How to measure success We feel that it’s important to have clear performance standards. Without them, goals become moving targets and bull’s-eyes can be painted wherever the arrow lands. The Board of Directors and I measure our financial performance by looking at revenue growth and operational performance of our businesses and the individuals that run them. Overall, our company’s progress in 2012 was very good, as we met revenue and earnings-per-share (EPS) expectations, and had exceptionally strong performance for the year. We had double digit operating income growth of 10.9 percent year over year. Our basic earnings per share was $1.30, an increase of 13.1 percent year over year. Total revenues were $1.9 billion, up 3.4 percent. ~Total Systems (TSS) PSA, BRKA/BRKB, MMM, SWK, XL, VNO, TSS