March 1 2008: 12:45 PM EST
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Buffett: Don't bank on big returns

He chides investors who expect their portfolios to see double-digit growth, and says Berkshire's success has been so great that it is unlikely to see "outsized gains" in the future.

By Colin Barr, senior writer

Berkshire Hathaway CEO Warren Buffett.

Fortune -- Berkshire Hathaway had another excellent year in 2007, posting an 11% gain in net worth, CEO Warren Buffett said in Friday's annual report to shareholders. Berkshire has grown its per-share book value by a remarkable 21% annually since Buffett took the reins 44 years ago.

But as always, Buffett was quick to emphasize that past performance is no guarantee of future results. He predicts the Omaha-based company's insurance operations will be hit in coming years by narrowing profit margins and warned that gains at Berkshire - which operates businesses ranging from chocolatier See's Candy to private-plane timeshare company NetJets - will be constrained by the company's history of success.

"Berkshire's past record can't be duplicated or even approached," Buffett writes in the report, published Friday on the company's Web site at "Our base of assets and earnings is now far too large for us to make outsized gains in the future."

The comments come even as many of Berkshire's component companies turned in an impressive year. The company's insurance business turned in a $3 billion-plus underwriting profit for the second year in a row, thanks to another benign hurricane season.

"Our insurance business - the cornerstone of Berkshire - had an excellent year," Buffett writes in Berkshire's annual report. True, underwriting profits dropped to $3.37 billion last year from $3.84 billion in 2006 -- but then, that was a year in which Buffett said his insurance executives had "simply shot the lights out."

But, he adds, Berkshire investors shouldn't expect to see such robust insurance results in coming years. "The party is over," he says. "It's a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. Prices are down, and exposures inexorably rise." He warns that even if Berkshire avoids any major catastrophe claims, industry-wide profit margins could shrink by 4 percentage points. Obviously, he adds, results could be far worse if there's a big hurricane, earthquake or other major disaster.

Pension problems ahead

Natural disasters aren't the only worry on Buffett's mind. He is also concerned about the bill that will come due when U.S. companies are forced to tell shareholders they have been pumping up their earnings by under funding their pension plans.

Most big companies have been vastly overestimating the kind of returns their pension plans can realistically expect to earn, Buffett writes. He writes that a survey of S&P 500 companies with pension plans shows the companies on average expect their pension assets to earn an annual return of 8%. With more than a quarter of those assets invested in cash and bonds, Buffett writes, the implicit expected annual stock investment return is 9.2% - and that's after fees. "How realistic is this expectation?" Buffett asks.

Not very, he finds. He writes that the Dow Jones Industrial Average surged from 66 to 11,497 during the 20th century. That is a huge rise - yet it averages out to just 5.3% compounded annually, Buffett writes. What's more, were the DJIA to repeat that 5.3% average annual gain throughout the 21st century, its value on Dec. 31, 2099, would approach 2 million.

"It's amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands," he writes. "If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?"

If that scenario isn't outlandish enough, Buffett goes on to note that were stocks to return 10% annually throughout this century, the Dow would hit 24 million by year 2100. "If your adviser talks to you about double-digit returns from equities," he writes, "explain this math to him - not that it will faze him. ... Beware the glib helper who fills your head with fantasies while he fills his pockets with fees."

Buffett adds that the presence of "layers of consultants and high-priced managers," or "helpers," at financial advisers and mutual funds is another factor pulling down returns for individual investors as well as pension plans.

With all that in mind, why are companies making investment assumptions that could be vastly overstated? Buffett believes it's a case of CEOs manufacturing earnings growth now, at the expense of problems that will manifest themselves only later. Assuming higher returns means having to set aside less money now to build their pension funds. "What is no puzzle ... is why CEOs opt for a high investment assumption," he writes. "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."

Thinking ahead

Retirement doesn't appear to be a priority for the 77-year-old Buffett. In a discussion of a few investment opportunities that didn't work out as he planned, Buffett suggests he plans to continue to steer Berkshire for the foreseeable future. "To date, Dexter is the worst deal that I've made," he writes of Berkshire's 1993 purchase of the shoe company for $433 million in stock. "But I'll make more mistakes in the future - you can bet on that."

One mistake Berkshire won't make is failing to design a succession plan for Buffett, who is both CEO and investment chief. He told shareholders the company has for some time had three "outstanding internal candidates" lined up to succeed him as CEO. And following up on last year's announcement that Berkshire would seek an investment manager understudy for him, Buffett said the company has now identified four candidates who could succeed him.

"All manage substantial sums currently, and all have indicated a strong interest in coming to Berkshire if called," Buffett writes. "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."

Succession planning aside, it's clear Buffett has no plans to be anywhere but Berkshire if he can help it. But he jokes that he is gradually coming to see that even he has mortal limitations that can't be overcome.

"I've reluctantly discarded the notion of continuing to manage the portfolio after my death - abandoning my hope to give new meaning to the term 'thinking outside the box,'" he writes.

(A member of FORTUNE's staff, senior editor at large Carol Loomis, edits the chairman's letter in Berkshire's annual report.) To top of page

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