The New York Times reports that Berkshire Hathaway Inc. (NYSE: BRK.A) Warren Buffett's annual letter includes some important observations about the state of the securities markets. The one I found most eye opening was that companies are using unrealistically high assumptions about pension fund returns to boost their reported earnings.
Here are three themes I found most interesting:
- 8% pension fund return assumptions. Buffett said that many companies assume their pension funds will earn 8% a year from investments, a return he deems unlikely given the low level of interest rates, but one that lets them report higher profits now. Buffett notes that by the time those managers need to lower those assumptions to be more realistic, they'll be long gone from their jobs -- along with their bonuses.
- Ending of Home Price Appreciation (HPA) exposes financial folly. Buffett coined a new acronym, HPA, to highlight a familiar point. People were willing to take on risky mortgages because they assumed that their houses would rise in value. He noted that "As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out - and what we are witnessing at some of our largest financial institutions is an ugly sight."
- Weak prospects for property/casualty insurance. Buffett also warned of lower profits ahead for the insurance industry, which has benefited from two years without major disasters. "That party is over. It's a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. Prices are down, and exposures inexorably rise."
The common theme in all of these comments is the important role that forecasts of the future play in accounting for the current performance of public companies. And it's not just an accounting issue -- Buffett also points out that people use rosy assumptions about the future to take on risks that they might shun if they had a more balanced crystal ball.
In my view, public companies should separate out future projections from their current condition. Unfortunately, accounting rules confuse the two. One way to deal with this would be to require companies to report on their current condition using cash basis accounting -- reporting to investors the cash that comes in and goes out. If they wanted to provide forecasts, companies could do that separately from reporting on their current financial condition.
Another alternative is that they could present to investors multiple scenarios. For example, a company that use an 8% return assumption for their pension fund could also present its earnings assuming that its return was 3% -- which happens to be about how much the S&P 500 rose in 2007.
Unfortunately, the article does not provide much insight into where Buffett sees investment opportunities. If he tipped the public off, he'd end up overpaying. But the decline in Berkshire's earnings -- to $2.95 billion, or $1,904 a share, from $3.58 billion, or $2,323, in 2006 -- suggests that it could be easier for him to show earnings growth in 2008 since he'll be starting from a lower base.
That is unless he has trouble offsetting weak insurance earnings with bigger winning bets. We'll see next year.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter
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