1985 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.