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Stock Strategist

A Banner 2006 for Berkshire Hathaway

Our take on the firm's year-end results and shareholder letter.

On Thursday,  Berkshire Hathaway (BRK.B) reported that its book value per share increased by 18.4% during 2006, primarily thanks to stellar underwriting profitability across all of its insurance operations. We'd expected solid underwriting results, but this still bested our forecast, and we plan to raise our fair value estimate.

The underwriting results were driven by auto-insurer GEICO, which achieved a pleasing 88.11% combined ratio last year, while still growing its top line by almost 10%. Given that the U.S. auto insurance industry has over $165 billion of annual premium, and since GEICO has only around 7% of the market, there is ample room for the firm to profitably grow.

While we had expected solid results from Berkshire's reinsurance businesses, thanks primarily to a tranquil Atlantic hurricane season, both the Berkshire Hathaway Re and General Re subsidiaries exceeded our optimistic forecast. We think these impressive results demonstrate the value reinsurance buyers place on Berkshire's financial security, and the high prices they're willing to pay for it.

Berkshire's operating businesses also performed well, posting a 25% return on tangible equity, in aggregate, in 2006. NetJets, in particular, made a nice turnaround, posting earnings growth of 23%. Absent from the release, though, were Berkshire's views on potential future acquisitions. That said, given Berkshire's purchase of Israel-based Iscar Metalworking last year, we suspect it's actively looking for large firms (foreign or domestic) that present unique ownership challenges only a partner like Berkshire can meet. In the meantime, though, cash--now amounting to $43.7 billion--continues to pile up on the balance sheet.

In his annual shareholder letter, also released Thursday, Berkshire CEO Warren Buffett gave additional insight into the succession issue, indicating that he plans to hire a new investment officer to take the reins when he eventually steps aside. We think this is prudent, given that Lou Simpson, who currently runs the equity portfolio at GEICO and was probably next in line, is only six years younger than Buffett. We suspect this new hire will be relatively young (so that he can have a long career at Berkshire), and most likely somewhat unknown, given the way that Buffett hired Simpson in 1979. What's more, we suspect that Buffett may have already identified this person, since we don't believe that he would conduct a "public auction" for the individual who is to eventually replace him, given that he repeatedly states that he never participates in auctions of businesses, either.

Second, Buffett announced that  Yahoo  CFO Susan Decker will be joining Berkshire's board in May. Next to existing board member Bill Gates, this marks the second "technology" executive elected to the board. Buffett has long said that investing in technology firms is an area outside his circle of competence, and we think that by adding these types of executives, he's slowly building Berkshire's institutional knowledge of the sector. Thus, this move has the potential to increase Berkshire's universe of possible acquisitions.

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