Buffett letter is hopeful, despite his worst year at Berkshire

— -- Billionaire Warren Buffett's Berkshire Hathaway brk.abrk.b posted its worst-ever year in 2008, a dramatic 62% decline in net income, showing how the global financial crisis is pressuring even the world's most experienced investors.

Hurt by big losses in Berkshire's stock portfolio as well as bets on derivatives, the company's net earnings for the year fell to $5.0 billion, which eroded the company's book value.

Book value, the difference between assets and liabilities, and the way Buffett prefers to track the company's performance, dropped 9.6%. Not only was that Berkshire's largest drop in history, it was also only the second time going back to 1965 that it fell.

Still, Buffett, nicknamed the Oracle of Omaha, remains one of the world's most successful investors. Buffett is head of Berkshire, a diversified company that operates businesses that sell everything from insurance to electric power and candy. Berkshire takes the cash from those businesses to invest.

Buffett's annual letter to Berkshire shareholders, released Saturday, reflects a year hurt by economic recession and falling investment prices. Investors have been awaiting the update, as shares of Berkshire Hathaway fell 31.8% in 2008 and have lost another 18.6% of their value so far in 2009. Berkshire's Class A stock closed Friday at $78,600 a share.

"It was a sober report, but it has to be in times like these," says Andy Kilpatrick, author of "Of Permanent Value: The Story of Warren Buffett."

Some key points from Buffett's letter to shareholders:

• He expects the U.S. economy to remain weak in 2009. Pointing to the tremendous strain on companies and state and local governments, Buffett says the economy is likely to "be in shambles throughout 2009 — and, for that matter, probably well beyond." He says business activity has fallen "at a pace I have never before witnessed." However, that doesn't necessarily indicate whether the stock market will rise or fall, he writes.

• He is concerned about the consequences of the federal government's moves to stabilize the financial system and the economy. "Economic medicine that was previously meted out by the cupful has recentlybeen dispensed by the barrel," he writes. But, he says, "Whatever the downsides may be, strong and immediate action by government was essential last year ifthe financial system was to avoid a total breakdown."

While major companies and industries have already become dependent on federal assistance, Buffett expects "mind-boggling requests" from cities and states to follow. Such actions may have "unwelcome aftereffects," including inflation. "He's pretty frank about the U.S. economy," says Jeff Matthews of hedge fund Ram Partners and author of "Pilgrimage to Warren Buffett's Omaha."

• He explained why the company owns derivative contracts, on which it booked some big losses. Buffett has long warned of the dangers of derivatives, which make bets on asset price movements. He says he bought some for Berkshire because the terms are favorable for the company, as cash is received upfront for the contracts and any potential liability wouldn't be due for a decade or longer in many cases.

Buffett also explains that accounting rules require the company to book losses on these instruments, even though they are not costing the company cash; they are actually generating cash. There is ample time for many of these derivatives to turn out winners, Kilpatrick says. "The conversation about derivatives was reassuring," he says.

However, for the first time, Buffett acknowledges the company may end up losing money on one set of derivatives connected with credit losses on high-yield debt, Matthews says.

• Buffett admitted some mistakes in 2008. He routinely uses his annual letter to point out his own errors. Some of last year's errors were surprising. For instance, Buffett bought a large amount of ConocoPhillips stock cop when oil prices were near their peak last year. The move cost Berkshire investors billions. "So far I have been dead wrong," Buffett says. He also spent $244 million for shares of two Irish banks he thought were cheap. The value of those investments has since fallen 89%.

The missteps were surprising, since Buffett is known for buying assets when they're cheap, Matthews says. "That was a very odd thing," he says. "Buffett always talks about his big mistakes, but he hadn't had any in a while."

There were bright spots, too. Berkshire's insurance and utility businesses performed well and were highly profitable. The struggles by other insurance and utility companies will likely allow Berkshire to expand and become even more profitable in those areas when the economy turns, Kilpatrick says.

"The energy and utility segments are expected to do very well this year," says John Reese, CEO of Validea Capital Management.

And despite its current woes, the nation has faced worse times, only to flourish later, he says: "Though the path has not been smooth, our economicsystem has worked extraordinarily well over time. It has unleashed human potential as no other system has, and itwill continue to do so. America?s best days lie ahead."