Monthly Archives: April 2009

Buffett’s Berkshire Letter from 1985

800px-warren_buffett_ku_visit1985 saw violent earthquakes in Mexico City, a deadly cyclone and storm surge in Bangladesh, and rampant starvation in Ethopia. Planes it seems forgot how to fly. In the stock market, the S&P 500 opened the year near 165, bolted from the gate, and finished the year strong, near 210.

Over at Berkshire, their net worth gained $613.6 million, or 48.2%. Over twenty-one years, Buffett and Co. have now grown Berkshire’s book value from $19.46 to $1643.71, or 23.2% compounded annually. Following his habit of managing expectations, Buffett reminds his fellow owners that neither performance will be repeated again, particularly since he confesses that “we cannot find significantly-undervalued equities to purchase for our insurance company portfolios.” I think we all know where the market went from here.

The typical iconoclast, Buffett opens his letter with the suggestion that Berkshire’s stock may be overvalued. Perhaps I’m too green for not knowing better, but has any other CEO ever insinuated as much about his own company? In the past, with its shares trading at a discount to their intrinsic value, Berkshire’s buyers “could be certain that their personal investment experience would at least equal the financial experience of the business. But recently the discount has disappeared, and occasionally a modest premium has prevailed.” Watch out below, sub-23% returns are ahead.

The bulk of 1985’s gains ($338 million pre-tax out of a total of $488 million) derived from the buyout of Berkshire’s shares of General Foods, but these gains should not be used to assess the year’s performance. In a way, “security profits in a given year bear similarities to a college graduation ceremony in which the knowledge gained over four years is recognized on a day when nothing further is learned.” And in this case, the story began in 1980, when General Foods—a business with excellent economics and an able management—traded far below its intrinsic value. “Graduation day” found Philip Morris willing to pay full price.

Here lies an important lesson for investors trying to value insurance companies who carry substantial equity portfolios. Reported annual earnings do not usefully track the growth in the equities’ intrinsic value, for the accumulated gain in business value only shows up on the income sheet when the equity is sold. If the investors’ preferred holding period is “forever,” operating earnings will forever fail to capture true owner earnings.

Over at Berkshire’s mills, the looms went silent for the last time. Textiles, as Buffett came to recognize, operate in a commodity business, one which has to compete with cheap foreign labor. Even with Berkshire’s workers paid less than others in American industry, and even with reasonable union contracts, the returns were not sufficient to keep the lights on. Though Buffett wouldn’t “close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return… [he felt] it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with [the] first proposition, and Karl Marx would disagree with [the] second; the middle ground is the only position that [left Buffett] comfortable.”

Of course, defeat bluntly discloses important lessons. And here, Buffett observes that book value, by itself, has little value for determining a business’ intrinsic value or liquidation value. In winding down the mills, the equipment went to the auction block, equipment which “took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost [Berkshire] about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.” So how much did the sale yield? $163,122. “Allowing for necessary pre- and post-sale costs, [Berkshire’s] net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.” Liquidations do not always live up to their name.

Buffett the student though is not satisfied to take one lesson alone–moving quickly to discuss appropriate managerial compensation in light of this example.  Here, “the economic goodwill attributable to two paper routes in Buffalo – or a single See’s candy store – considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people. The power of this simple math is often ignored by companies to the detriment of their shareholders. Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in large part, by retained earnings—i.e., earnings withheld from owners.” If compensation derives primarily from ten-year, fixed-price options that totally ignore the fact that retained earnings automatically build value, one can imagine another Berkshire executive getting praise for growing a dying textile business by buying more efficient looms and assets. This, even though ever increasing piles of shareholder capital are squandered in low-return endeavors [for a Buffet-esque alternative, see Robert Moore’s compensation agreement with Western Sizzlin].

As the story goes, Buffett didn’t offer Ken Chace Berkshire shares or options for his excellent work managing the mills. However, he did offer to loan Chace whatever sum he wanted to purchase Berkshire shares. And perhaps now the reason is clear. “The rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I’ll be happy to accept a lottery ticket as a gift – but I’ll never buy one.)”

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Buffett’s Favorite Manager

In reading through Warren Buffett’s letter to Berkshire shareholders from 1985, he makes the bold claim that “ [the management of Capital Cities] is the best of any publicly-owned company in the country.” In Buffett’s mind are Tom Murphy and Dan Burke, and in Murphy’s case, he presided over Capital Cities’ growth from one television station to a $20 billion dollar company that ultimately merged with Disney in 1995. By Murphy’s estimation, his tenure returned $10000 to owners for every $1 originally invested; can one even imagine a 10,000 bagger today?

In 2000, Tom Murphy sat down with a Director of Media Development at Harvard Business School for this interview. Describing his start as slipping into “a little crapshoot up in Albany, New York,” largely thanks to a story told by Murphy’s father, Murphy came under the wing of an excellent mentor Frank Smith. After some initial struggles and some capital shortfalls, Capital Cities went on an almost unprecedented acquisition spree, ultimately taking it afield, into newspapers, cable, and radio.

If today’s investor is looking for the next Tom Murphy, what attributes should he seek? For one, Murphy encouraged and sustained a “barebones culture,” as CapCities’ early years provided meager capital. To keep operations “tight,” Murphy hired the smartest and most diligent he could find, not necessarily those with the most experience. And he gave his chosen few plenty of responsibility, so that he never had any more employees than necessary.

From the beginning, Murphy “always ran the company, for better or for worse, as if [he] owned 100 percent of it.” And the principle ran deep, as “we really thought about our stockholders. We ran the company to do the best job for our stockholders. We never ran it to get big. We ran it, if we could, to get our stockholders rich.”

Looking back though, Murphy attributes the majority of his success to being well placed at the beginning stages of a great and growing industry. As he notes, “there’s no substitute for being in good businesses, and there are not many of them. If you go into business, the most important thing is to do something you like. That’s the most important thing, but it’s even better if you can do that and pick a business that really has a future… Today, the cable business is a pretty good business. It’s probably better than the broadcast industry, although the broadcasting business has been pretty good in the past several decades too.”

Simple principles, to be sure, but difficult to argue with his results.

Searching for Rational Management

Through the rambling course we’ve taken on this blog, we’ve highlighted a few businesses with wide economic moats. Some offer products that satisfy basic and enduring needs; others sell a commodity product—like insurance or suit liners—but with the lowest cost structure in the industry.  Elsewhere, we seen wide moat businesses with a network advantage that makes their service difficult to replicate—like Craigslist or eBay.

However, I am increasingly persuaded that the caliber and experience of management is the most important criterion for determining the width of an economic moat. Given today’s rapid pace of innovation and competition, even the best businesses will require excellent strategic decision-making and creative problem-solving to survive and thrive. As we saw in Only the Paranoid Survive, competitive forces could have sunk Intel had Andrew Grove not boldly broken their old habits. If such crisis points arrive even more frequently for business managers of our future, a strong case can be made that strong management is the best tool for widening a business’ moat.

To say as much is largely uncontroversial. The real crux is: what are the characteristics of strong management, and what tools can an investor use to reliably find them? For Warren Buffett, strong management concentrates its focus on daily increasing a business’ intrinsic value. From an expense standpoint, that means using each retained dollar in projects that provide an adequate return. It means growing revenues, but only when the projected profits far exceed other available alternatives (which may include buying shares of competitors in the public markets). It means returning capital to shareholders—in the form of share buybacks or dividends—when adequate returns cannot be found internally. The rational manager repurchases shares only when its price resides far below its intrinsic value.

With recent stock market declines, I had hoped to use this opportunity to filter out those management teams who buy high and pause repurchases when prices fall.  But few management teams have taken advantage of the recent declines. And perhaps even more interesting, April saw insiders’ stock sales outnumber purchases by more than 8 to 1! Though some interpret these sales as tax related, call me unpersuaded.  For one, management insiders are often higher net worth individuals, a group that regularly files for tax extensions, so as to not pay until at least October. And second, tax losses are really most valuable when paired with offsetting gains. To justify the level of insider selling we’ve seen, the tax losses would have to be paired with some very long term capital gains, as anyone who has bought and held the market over the last decade would have few gains. Without such capital gains, such selling is excessive for the mere $3000 claim.

Needless to say, I’ve been rather surprised by these findings (consider me naïve). Not only are many companies slowing their share repurchases, many managers seem to be tossing their ownership stakes aside. So the final question is—are they being rational or irrational? Today’s optimist believes that the stock market offers abundant bargains, and would chastise these crazed sellers for their depressive and irrational behavior. The pessimist though sees rationality in these insider sales, for what has fallen down can fall again, and again. Though I’d like to be an optimist, sitting on the other side of 8 to 1 odds can be a bit uncomfortable.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.

Buffett’s Berkshire Letter for 1984

buffett1984 was a temperate year for the market indexers; after the S&P 500 opened the year near 165, it slipped through spring and early summer to bottom near 150 in July, only to rebound and close the year again near 165.

Over at Berkshire, net worth increased by $152.6 million, or $133 per share, which represented a gain of 13.6% on Berkshire’s 1984 book value of $1108.77. A “mediocre” performance, says Chairman Buffett.

All told, Buffett the teacher showed up with his lecture notes in 1984, and the business summary he provides gives the clearest insight yet into the way his mind understands and values businesses. If I had to recommend one letter that characterized his approach, this would be it.

Buffett opens by describing his approach to share repurchases; in short, “when companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.” Of course, outstanding businesses rarely sell below their intrinsic value, and Buffett would not encourage buybacks at any share price.  And 1984 saw some dear prices paid.

You see, in the Eighties, relatively cheap debt put companies under siege from “greenmailers,” who would buy large stakes in vulnerable companies and demand that their shares be repurchased by management if they wanted to keep their jobs without a risky fight. One of the best known greenmailers was T. Boone Pickens, who made stabs at Cities Service Company, Newmont Mining, and Diamond Shamrock, before getting his cash.

Regarding these hostile takeover “attempts,” Buffett minces no words, finding the greenmail share repurchase “odious and repugnant.” It is a “mugging,” in which entrenched management offers up its owners’ wallet to pacify the coercive extortionist. Management emerges unharmed, the mugger gets a fat payday, and the innocent shareholder “mutely funds the payoff.” An extreme counterexample to be sure, but illustrative of Buffett’s approach—only buyback shares when the price is right.

Though Buffett admits that general levels in the stock market make it difficult to find stocks that meet his quantitative and qualitative standards, business is excellent at Nebraska Furniture Mart (NFM). Compared to its reasonably efficient competitor Levitz, NFM’s operating expenses (payroll, occupancy, advertising, etc.) are about 16.5% of sales versus 35.6% at Levitz. These savings enable NFM to consistently widen its economic moat, by passing some savings on to customers and expanding its geographical reach far beyond the Omaha market.

How is this astounding efficiency possible? “All members of the family: (1) apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts; (2) define with extraordinary realism their area of special competence and act decisively on all matters within it; (3) ignore even the most enticing propositions failing outside of that area of special competence; and, (4) unfailingly behave in a high-grade manner with everyone they deal with.” Enthuasism, self-analysis, prudence, decision, ethics—certainly not a bad list of business virtues, if you have the visible exemplars that embody them.

Over at the Buffalo Evening News, profits were greater than expected. Though management deserves praise, moreso does the industry, for “the economics of a dominant newspaper are excellent, among the very best in the business world.” Misplaced vanity may encourage “owners… to believe that their wonderful profitability is achieved only because they unfailingly turn out a wonderful product.” However, third-rate papers produce the same or better profits, as long as it is dominant in its community. When a paper reaches the homes of a desired geographical area, advertisers will pay for access, and if that access is a monopoly, the capitalist’s prices are wonderfully high. Even a poor newspaper commands attention because of its “bulletin board value,” and so it remains “essential” for most citizens, and by extension, most advertisers.

Lastly, in 1984, Buffett give his shareholders a golden key to business valuation.  Discussing Berkshire’s purchase of $139 million Washington Public Power Supply Service (WPPSS) bonds, Buffett reveals that his approach for analyzing bond investments does not differ from that for equities. For example, he asks us to imagine the WPPSS bonds as a $139 million investment in an operating business, which earns $22.7 million after tax (i.e., the interest paid on the bonds), and whose earnings are annually available to us in cash. Would you invest in that business? Intuition suggests to follow the master, and you would be right, as Buffett observes that “we are unable to buy operating businesses with economics close to these. Only a relatively few businesses earn the 16.3% after tax on unleveraged capital that our WPPSS investment does and those businesses, when available for purchase, sell at large premiums to that capital. In the average negotiated business transaction, unleveraged corporate earnings of $22.7 million after-tax (equivalent to about $45 million pre-tax) might command a price of $250 – $300 million (or sometimes far more).”

So what’s Buffett’s “fair value” earnings multiple? Basically 11-13 times unlevered earnings, or 6x EBITDA. Here Buffett’s purchase of the WPPSS equates to buying an unlevered equity trading at 6x earnings. And so Buffett showed up with his largest truck.

Buffett acknowledges that such an approach to bond investing may be “unusual” and perhaps “a bit quirky.” However, this rule of thumb would have saved the “staggering errors” made by the bond purchasers of 1946, who bought 20-year AAA tax-exempt bonds trading at slightly below a 1% yield. Using Buffett’s framework, the buyer, in effect, “bought a ‘business’ that earned about 1% on ‘book value’… and paid 100 cents on the dollar for that abominable business.”

All told, I have left too much of 1984’s letter aside. Buffett also briefly discusses inflation, retaining cash in a business, and reserving in Berkshire’s insurance units. Also, he offers an analysis of See’s Candies and their insurance subsidiaries. If you’re in the mood for some thick, rich business analysis with a Midwestern wit, it’s the letter I most highly recommend.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Rocky Mountain Chocolate Factory

rmcflogoLately I’ve been sleuthing for rational capital management. Impressed by FortuNet’s cash distribution, disappointed by Moody’s stagnant buyback plan, and annoyed by KSW’s passivity, it is clear to me that rational management can be found in unlikely places, and that even the most virtuous can settle into vice (which in this case is sloth—sitting lazily on shareholders’ cash).

Reader Sam highlighted Rocky Mountain Chocolate Factory (RMCF)—a franchiser and confectionary manufacturer with 334 stores (as of 2/29/08)—as an interesting wide moat business whose current market price resembles what Warren Buffett paid for See’s Candies, on a number of important metrics. And a quick glance at the recent 10-Ks and Qs depicts a management who has a habit of returning excess cash to shareholders—via dividends and share repurchases. In fact, on its $5.64 share price (as of 4/22/08), RMCF offers a 10 cent quarterly dividend, bringing the stock’s yield to over 7%.

Though the share repurchases seem to have stopped since February 2008 (filings reveal no share repurchases from March 2008-November 2008), management was an aggressive purchaser in better times. And their 10-K reveals their record:

“between January 9, 2008 and February 8, 2008, the Company repurchased 391,600 shares at an average price of $11.94. Between August 15, 2007 and August 28, 2007, the Company repurchased 16,000 shares at an average price of $15.96 per share. Between March 1, 2007 and May 15, 2007 the Company repurchased 76,335 shares at an average price of $13.12 per share. Between May 1, 2006 and February 28, 2007 the Company repurchased 253,141 shares at an average price of $12.94 per share. Between March 24, 2006 and April 28, 2006 the Company repurchased 74,249 shares at an average price of $14.90 per share. Between October 7, 2005 and February 3, 2006 the Company repurchased 185,429 Company shares at an average price of $14.6 3 per share. Between April 18 and April 20, 2005, the Company repurchased 18,529 Company shares at an average price of $13.28 per share.”

All told, that amounts to over 1 million repurchased shares in a three year period, or about 14% of outstanding shares.

Over that same period, RMCF also paid out significant quarterly dividends. Combined with its share repurchases, shareholders basically saw 100% of RMCF’s FCF returned to them.  Perhaps shareholders should rename them the Rocky Mountain Cash Factory.  In fact, it would be hard to ask for much more as an owner; one would only wish that the school that teaches such value creation would open its enrollment to a few more students.

Perhaps in future posts, we’ll look more carefully at RMCF’s financials, and do a comparison with Buffett’s purchase of See’s Candies. But trading less than 9x FCF, and with a management that has demonstrated sound capital management, it certainly warrants that closer look.

Disclosure: I, or persons whose accounts I manage, own shares of Rocky Mountain Chocolate Factory at the time of this posting.

Buffett’s Berkshire Letter for 1983

warrenbuffettcharlierose1983 saw Israel, Lebanon, and the United States sign an agreement that called for Israel’s withdrawal from Lebanon. In Japan, the Nintendo Entertainment System hit the market for the first time. Bjorn Borg won his fifth straight Wimbledon title and announced his retirement. And in the world of crime, 6800 gold bars, worth 26 million British Pounds, were heisted from the Brinks Mat vault at Heathrow Airport. In the equity markets, the S&P 500 entered the year near 140, made a steady march higher until June, and then plateaued, to finish the year near 165.

Over at Berkshire, their book value increased from $737.43 per share to $975.83 per share, or by 32%. As Buffett observed last year, his favored metric for business assessment—return on shareholder equity—has become less useful for evaluating Berkshire now that the undistributed earnings of its common stock holdings have grown so large.

However, Buffett is quick to caution that Berkshire’s book value far understates its intrinsic business value, and it is the latter measurement that really counts. Whereas book value “is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings,” intrinsic business value “is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.” Though book value can serve as a shorthand proxy for economic value, better for the aspiring analyst to dig more deeply and discern Berkshire’s intrinsic value.

More than his past letters, Buffett reflects at length on the business moats that Berkshire’s subsidiaries currently enjoy. Over at the newly-acquired Nebraska Furniture Mart, their moat derives primarily from being the lowest cost provider—by far—and then passing on those savings to its customers. To keep costs lean is no small feat, and Buffett highlights, in particular, the purchasing acumen of Mrs. B and her son, Louie Blumkin, who is “widely regarded as the shrewdest buyer of furniture and appliances in the country.” As Buffett quips, “I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.”

Over at Buffalo Evening News, business has finally blossomed. With its primary competitor gone, Buffalo is now a one-paper town, and fully enjoying the pricing power that such dominance commands. Even better, Buffalo Evening News commands more readers than most one-paper towns, and Buffett takes note, for “a paper’s penetration ratio [we believe] to be the best measure of the strength of its franchise. Papers with unusually high penetration in the geographical area that is of prime interest to major local retailers, and with relatively little circulation elsewhere, are exceptionally efficient buys for those retailers.” Lastly, Buffalo Evening News’ protective moat draws width from its superior news product. In 1983, the News’ “news hole” (i.e., its editorial material, not ads) “amounted to 50% of the newspaper’s content… Among papers that dominate their markets and that are of comparable or larger size, we know of only one whose news hole percentage exceeds that of the News.”

Berkshire’s third featured wide moat business is See’s Candies. Despite stagnant volume growth over the last five years (1979-1983), See’s has grown its sales over 50%, and more than doubled its operating profits, largely by pushing through consistent annual price increases. Though some of the volume stagnation may derive from See’s relatively high prices, See’s commands ample pricing power because its candy “is preferred by an enormous margin to that of any competitor. In fact, [Berkshire] believe[s] most lovers of chocolate prefer it to candy costing two or three times as much.” An excellent product, made with the highest quality ingredients, and delivered by cheerful, helpful personnel, is about as close to a successful retail formula that one will ever find coming from Buffett.

All told, Buffett’s descriptions of his best businesses’ economic moats may seem rather elementary. However, there is good reason to believe that simplicity here is the key to their sustained success. For many businesses, daily operations prolifically produce new and unforeseen problems, and managers’ minds must be constantly vigilant and rational to dispense solutions and move to the next. Without relatively simple competitive advantages, the plethora of daily problems may overwhelm attentions and distract focus. What the successful business needs is a singular principle to refocus their energies. For Nebraska Furniture Mart, that principle is to always buy merchandise more smartly than competitors. For Buffalo Evening News, their principle is maximizing the size of the news hole with competitive costs. At See’s, it is providing a premium product with pleasant service. In each case, the advantage seems so simple that it should be easily stolen. But when attacking a business with a wide moat, merely having the key is not enough to breech the castle.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Rational Management at FortuNet

Truly rational capital management too rarely resides in the executive suites of publically traded businesses.  More often, a myopic focus fixes on growing the empire by acquiring more assets, all while ignoring the owners’ interests—the productive use of retained earnings.  Or, perhaps worse, abdicated vision instills an aura of lethargy.

Of course I say as much knowing that I risk branding myself a crank. However, anomalies occasionally surface; when one catches glimpses of such glory, praise should abound. And today, the laurels should go to the Board and managers of FortuNet, Inc.

FortuNet, Inc. is a small, established manufacturer of multi-game and multi-player server-based gaming platforms, based out of Las Vegas, NV. With 50 employees, a market cap of $32.24 million, 11.04 million shares outstanding, and a price of $2.92, FortuNet is not going to turn many heads on the NASDAQ Global Market. Investors though would do well to take a look, since the company recently announced (and shareholders recently approved) that it will be paying a special cash dividend of $2.50 per share on May 4th, to shareholders of record on April 24th.

FortuNet had its IPO in January 2006, which brought net proceeds of $23.7 million. And since that offering, the company has struggled to find ways to put that capital to productive use. Some went to dividends, some to buybacks, but the end of fiscal year 2008 saw FortuNet’s bank accounts swollen with nearly $26.5 million in cash and short-term investments. This at a time when the market valued the entire company at less than $20 million. Of course, FortuNet is not the only microcap whose share price has been hammered in recent months; many—like KSW—have cash balances at their bank that exceed their market capitalization. However, unlike FortuNet, most of these companies are content to sit on their cash and count their pennies; or, even worse, dole it out on overpriced and impulsive acquisitions.

Since FortuNet’s announcement, its market price has soared from its lows. However, even at yesterday’s prices, the market effectively only values FortuNet’s business at about $4.64 million, or 42 cents per share ($2.92 less the upcoming dividend). And this for a business that earned 25 cents per share in 2008.

At these prices, I find FNET a compelling value, whose price and upcoming dividend offers a substantial margin of safety, particularly if the cash distribution is received in a tax-advantaged account (because the distribution may be taxed in a taxable account). After paying out the $27.6 million ($2.5 on 11.04 million shares) on May 4th, FNET will have a book value of about $16 million, or $1.45 per share. And it’s worth bearing in mind that FNET has shown positive FCF over each of the last six years (the only for which Morningstar data is available).

All told, I find FNET’s Board and management worthy of praise, for doing the right thing for its owners, even at the cost of reducing the amount of assets available for them to play with. It requires abundant honesty and candor to openly admit that productive uses for retained cash are too few and too risky. Human nature entices the powerful and capable to overestimate their abilities, and too often the result is irrational capital management. Kudos to FNET; may your fortune match your deeds.

Disclosure: I, or persons whose accounts I manage, own shares of FortuNet at the time of this writing.

Buffett’s Berkshire Letter for 1982

1982 saw guns ablaze at the Falkland Islands. Walt Disney World grew its empire by opening its second largest theme park—Epcot. Wayne Gretzky set the reigning record for the most goals scored during an NHL season, netting 92. And the S&P 500 started the year near 120, fell below 105 by mid-August, and rebounded to close the year near 140.

Over at Berkshirebuffett, “operating earnings of $31.5 million in 1982 amounted to only 9.8% of beginning equity capital (valuing securities at cost), down from 15.2% in 1981 and far below our recent high of 19.4% in 1978.” Buffett found three causes for the decline—first, “a significant deterioration in insurance underwriting results,” second, “a considerable expansion of equity capital without a corresponding growth in the businesses we operate directly,” and third, “a continually-enlarging commitment of our resources to investment in partially-owned, nonoperated businesses.”

As Buffett has mentioned in preceding years, return on equity capital should be the most significant metric for evaluating management performance. However, in Berkshire’s case, this metric has become less and less useful, as standard accounting practices fail to fully reflect Berkshire’s share of its equity holdings’ earnings. For example, Berkshire owned a significant stake of GEICO in 1982; however, rather than including Berkshire’s share of GEICO’ earnings ($23 million) with its earnings, accounting standards dictate that only distributed earnings (i.e., cash dividends) be noted (which were $3.5 million after tax). So long as GEICO retains some of its annual earnings for reinvestment, those earnings will not immediately show up on Berkshire’s annual report, even though their share of them is just as real as the assets on GEICO’s balance sheet. Over time, Buffett is confident that these retained earnings will become more fully reflected in the stock prices of their portfolio.

Despite low returns on equity capital, book value at Berkshire grew $208 million, thanks to an increasingly cheerful consensus in the stock market. Starting the year with a book value of $519 million, the levity lifted Berkshire’s net worth nearly 40%.

Looking forward, Buffett foresees insurance underwriting results for 1983 to be no sight for the squeamish. For the industry, 1982 would seem bad enough, with Best estimating a combined industry ratio of 109.5; in short, that means that every dollar of insurance float cost $1.095, or a 9.5% annual rate. However, Buffett cautions that this relatively lousy results are a best case estimate, for in any given year, “it is possible for an insurer to show almost any profit number it wishes, particularly if it (1) writes “long-tail” business (coverage where current costs can be only estimated, because claim payments are long delayed), (2) has been adequately reserved in the past, or (3) is growing very rapidly.”

Looking over his competitors’ results, Buffett’s nose has caught some unpleasant whiffs, noting that “several large insurers opted in 1982 for obscure accounting and reserving maneuvers that masked significant deterioration in their underlying businesses.” Herein lies the wisdom—“In insurance, as elsewhere, the reaction of weak managements to weak operations is often weak accounting. (It’s difficult for an empty sack to stand upright.)”

The root of this temptation lies in the fact that insurance is a commodity business; its service amounts to a promise, and most purchasers take every insurer’s word to be that of the saint. Even worse, in insurance, barriers to entry are few; anyone with sufficient regulatory capital and a John Hancock can make a promise. Insurance then, unlike other commodity businesses, almost always operates “under the competitive sword of substantial overcapacity.” Only in those rare cases where there is a natural or financial megadisaster does capacity retreat; and until such an event, Buffett forecasts that the insurance industry will not be profitable.

Lastly, Buffett concludes with some reflections on issuing equity for acquisitions. Their golden rule is that they will not issue shares unless they receive as much intrinsic business value as they give. Of course, stated so simply, no rational business manager should reject it; but in practice, very many do, using a variety of odd rationalizations and linguistic high jinks.

To help the manager apply the golden rule, Buffett recommends thinking about one’s own stock as a currency. Every time that a business issues shares for an acquisition, it has to honestly ask whether it would be willing to sell its whole business for its implied worth. In other words, if I value my business at X, I should not use its shares as currency for any purchase that values those shares at less than X. As Buffett notes, “A cumulation of small managerial stupidities will produce a major stupidity – not a major triumph. (Las Vegas has been built upon the wealth transfers that occur when people engage in seemingly-small disadvantageous capital transactions.)”

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Pricing Power and Economic Moats

seescandieslogoWhat products do you use that you would be willing to pay double the current price? Food and energy, being necessities, would be likely candidates. Of course, doubled prices would likely change your consumption habits. How about discretionary items? Books, news subscriptions, your iPhone?

Yesterday we observed Warren Buffett describing the importance of investing in businesses that could raise their prices “rather easily without fear of significant loss of either market share or unit volume.” In 1981, consistently raising prices was a necessity for business survival, with the consumer price index increasing at 10% annually. For Buffett, inflation was a giant corporate tapeworm, which “preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.” In many ways, highly competitive environments often treat a business in the same way; as the competition spends capital to update its stores, you have to spend just as much to maintain your market share.

Excellent businesses then—those with wide economic moats—are able to survive difficult macroeconomic environments because their products carry pricing power. For Buffett, See’s Candies and Coca Cola wield this power; for See’s, Buffett has unfailingly increased prices on the day after Christmas.

These days, newspapers, magazines, and periodicals—faced with declining advertising revenues—are considering price increases. As The New York Times recently reported, the average Time subscriber only paid 58 cents per issue, and Newsweek readers paid 47 cents. True to its moniker, The Economist raised its price per issue to $6.99 last year, all while seeing its subscriptions rise 60% since 2004.

At our house over the last few months, we have been surprised to find—instead of subscription notices—cancellation notices from publishers. With declining advertising revenues, these periodicals were forced to close their doors for good. And I recall thinking—why didn’t they raise their prices? Because I would have easily paid twice what I had been.

For many goods and services, tight economic times trigger the tightening of budgets. However, even during such times, the most desired goods and services will still command a premium and increasing price. For the investor, these are the wide moat businesses that should find a home in one’s portfolio, at an attractive price.

So, is The Economist for sale?

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway.

Buffett’s Berkshire Letter for 1981

800px-warren_buffett_ku_visit1981 was the year of assassination attempts. It saw the United States President take a bullet—the first and only to survive such an assassination. The same was true for Pope John Paul II, who was shot and nearly killed by Mehmet Agca at St. Peter’s Square in Rome on May 13th. On a lighter note, Simon and Garfunkel performed a free concert in Central Park for nearly half a million people. And the S&P 500 Index opened the year near 138, traded all the way down to 112 in September, and closed the year near 122.

Over at Berkshire, “operating earnings of $39.7 million in 1981 amounted to 15.2% of beginning equity capital (valuing securities at cost) compared to 17.8% in 1980.” Much of the gain in Berkshire’s net worth—about $124 million, or 31% of 1981’s gain—came from the market’s increasing price for Geico. Of course, as Buffett observed in 1980, Berkshire’s share of its stock holdings’ undistributed earnings constitutes a substantial component of its future value, even though they do not immediately find their way into Berkshire’s balance sheet or income statement.

Buffett’s first lesson this year regards overpaying for acquisitions. Unlike most managers, Buffett’s rationality tempers the animal spirits that cause some to substantially overpay for controlled acquisitions. Though the value of uncontrolled acquisitions does not always feature prominently on a balance sheet, their pricing is subject to the whims of the manic-depressive Mr. Market; thus they can be acquired at bargain prices. For the manager willing to cede control, the economic choice is clear, and Buffett faithfully inhabits his designated role. Thus, not only does Berkshire acquire shares of uncontrolled businesses at substantial discounts in the stock market, but their quality is typically better than average. As Buffett notes, “in aggregate, our non-controlled business interests have more favorable underlying economic characteristics than our controlled businesses. That’s understandable; the area of choice has been far wider. Small portions of exceptionally good businesses are usually available in the securities markets at reasonable prices. But such businesses are available for purchase in their entirety only rarely, and then almost always at high prices.”

Of course, the standard practice among capital allocators is to buy 100% of T at 2X per share rather than 10% of T at X per share. And the reasons are manifold—though all equally detrimental to shareholder returns. Whether it be poorly channeled animal spirits, a myopic focus on size and revenues, or excessive confidence in one’s own managerial ability, each is equivalent to “investors [bankrolling] princesses who wish to pay double for the right to kiss the toad… We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses—even after their corporate backyards are knee-deep in unresponsive toads.”

Buffett’s second big lesson for 1981 is that stock investors must attend to the relative attractiveness of other asset classes, particularly in those highly inflationary times. In an environment with tax-free yields of 14%, a business returning 14% on invested capital will be a relatively unattractive investment, particularly if it retains some earnings, and its shareholder must pay tax on any dividends or capital gains. Buffett concludes that “with interest rates on passive investments at late 1981 levels, a typical American business is no longer worth one hundred cents on the dollar to owners who are individuals… Of course, some high-return businesses still remain attractive, even under present conditions. But American equity capital, in aggregate, produces no value-added for individual investors.”

This may strike one as a startling claim from the world’s best investor, but it clearly illumines Buffett’s mental flexibility and his ability to assess values in new and uncharted environs. In a highly inflationary environment, it is critical to invest in excellent businesses, defined as having two characteristics: “1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.”

Though Berkshire’s 21% long-term return still provides a modest margin over tax-free bonds after the capital gain tax rate, Buffett is careful to warn that such may not endure indefinitely. “It would be a bit humiliating to have our corporate value-added turn negative. But it can happen here as it has elsewhere, either from events outside anyone’s control or from poor relative adaptation on our part.”

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.