Berkshire Hathaway's 2004 Annual Report was posted on March 5, and the results were pretty much as expected. I felt that the fourth quarter would be good but probably not good enough to bring earnings for the whole year in up over last year. That is pretty much how the results came in, with 4th quarter up 40% over the same quarter in 2003, but with earnings for the full year at $7.3 billion, down 10% from 2003 because of lower investment gains. With characteristic self deprecation Buffett labeled his performance as "lackluster," but I see very little justification for this claim.

Berkshire is in full lock down, the hurricane shutters are up, everything loose has been tied down, and the patio furniture has been thrown in the pool. There was no rhetoric to this affect in the chairman's letter; Buffett is not going to wander about yelling that the sky falling. But if you read between the lines, and pick at the numbers a bit, you can get a pretty good idea how he feels about the market.

First there is Berkshire's huge pile of cash. A pile that has grown by $7.5 billion in the last year and now amounts to $43 billion. To this number you can add the $22 billion in bond holdings. As Charlie said at last year's WESCO meeting, they would prefer not to hold any bonds at all.

Then there is Buffett's bond trading. Berkshire's holdings of US government bonds have fallen from $8.8 billion three years ago to $1.6 billion at the end of 2004. In the same period, his holdings of foreign bonds have increased from $2.5 billion to $7.1 billion. These are actions that speak volumes about Buffett's mindset relative to domestic interest rates and FOREX markets. These foreign bonds are in addition to the $21.7 billion face values in foreign-currency forward contracts.

As of December 31, Berkshire still held $8.4 billion in corporate bonds. These are mostly what remains from the junk bonds that he purchased two years ago. These bonds currently are carrying $1.9 billion of unrealized gains. These unrealized gains are in addition to realized gains of $1.1 billion on the junk bonds that it sold in 2003 and another $730 million in gains on positions sold in 2004. All of this profit is in addition to the interest paid on the bonds, which in some cases has been as high as 20% of the price Berkshire paid for the bonds.

On page 17 of the chairman's letter is a table that makes me wonder about his complaints about his own "lackluster performance." In just the last two years Buffett has realized gains of $8.2 billion in his bond and FOREX trading. Add in another $1.9 billion of unrealized gains in the junk bonds he still holds, and maybe $200 to $300 per year in interest income, and it is apparent that the chairman has enriched shareholders by about $10.5 billion with his trading skills in two years. This definitely does not meet my definition of "lackluster performance."

Further evidence of Buffett's opinion on the current equity markets can be found on page 49, where there is a list of the asset mix for the company's pension plans. Cash held in the plans increased from 29% last year to 33% at the end of 2004. For the same period the allocation of assets to equities securities has declined from 27% to 12%. That's right, just 12% of the assets in Berkshire's pension accounts are in equities. I have not looked, but I doubt that there are many other pension plans in the country that are this bearish.

The tone of Buffett's chairman's letter was not all together positive, while he was not exactly talking the stock down. My impression is Buffett is happy with the stock price just about were it is, and that while there has been a lot of comment lately to the effect that Berkshire is selling substantially below intrinsic value, Buffett may not completely agree with this. Or, at least, he feels that market conditions are such that any substantial appreciation from this point will disappear as the market turns more bearish.

More than anything else, Berkshire is today a play for a down market, and in my opinion probably the best one around. Buffett is not in a contest, at this point, to outperform the S&P. He is focusing his attention on "rule number one," and trying to lower Berkshire's risk profile. Just as underperformance in 1999 led out-perfomance in the next three years, underperformance in 2004 may best be understood as we look back from four or five years in the future.

It was another good year for the insurance business which showed an underwriting profit of $1.5 billion even in the face of four hurricanes and a tsunami. The four Florida storms have generated claims of 1.2 billion so far. Indeed most CEOs would have been bragging about their performance by explaining that without one-time items of $1.7 billion, their earnings would have been $9 billion or up 11%.

When we see how difficult it has been for Berkshire to liquidate GenRe's derivatives operation, after three years in a benign market, they still have 2,890 contracts left, (as Warren says "Like Hell derivative trading is easy to enter but difficult to leave"), it is not hard to imagine Warren going to sleep at night with visions of sugarplums. (The telephone rings with the news that one of the big money center banks derivative portfolio has just blown up.)

It is impossible to forecast how or when Berkshire will eventually put its $65 billion in cash and bonds to work, but one thing is certain, the longer it takes, the bigger the cash pile will be.

Finally, the best news is that Berkshire is not paying a dividend. The best news for Berkshire shareholders that is—it may not be good news for the equity markets. If Buffett did not feel he would eventually be able to find a home for Berkshire's cash, and that this home would not return dollars at above market rates, he would start distributing the cash to shareholders. This was, I suspect his advice to Bill Gates.