Buffett’s Berkshire Letter from 1978

1978 saw Menachem Begin and Anwar Sadat sign the Camp David Accords between Israel and Egypt. Resorts International (now Resorts Hotel and Casino Atlantic City) became the first casino on the East Coast. And Norman Rockwell took this year to be his last.

Over at Berkshire Hathaway, Warren and Company generated operating earnings on shareholder equity (exclusive of capital gains) of 19.4%–within a fraction of their 1972 record. Mr. Buffett of course dallied with his typical modesty, attributing the gains to his operating managers and a “bonanza period for the insurance industry.”

In this year, Berkshire breaks out each of their four business lines for special scrutiny—textiles, insurance, banking, and retailing.

As in 1977, textiles returned meager capital, given the cost of past investment; with $17 million invested, $1.3 million returned. Buffett sounds a bit exasperated as he recounts management’s attempts to improve the business: “obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc.” Yet, suit liners are difficult to differentiate, and too many are willing to produce them. And so, “the textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage.”

In insurance, the “bonanza period” from 1976-1978 generated an abundance of float for Buffett to put to work, but not all was bliss. Over at National Indemnity, they had been struggling with losses in their California Worker’s Compensation division. Frank DeNardo was tasked with finding a solution in the spring of 1978, and the solution he found was writing 75% fewer policies. For those looking for a lesson in insurance underwriting, take this case study as your first lesson. When business is soft and premiums low, follow DeNardo and write fewer policies. Of course, the required discipline is extremely rare; how many insurance companies do you know that are willing to tolerate 25% of last year’s business volume? I suspect none.

Lastly, Buffett gives his shareholders insight into how he conceives of equity investments. By year’s end 1978, Berkshire Hathaway’s insurance companies held nearly one million shares of SAFECO, another publically traded insurance giant. To some, this purchase may seem odd; why not just compete with SAFECO straight up and steal their market share?

As Buffett notes, “SAFECO is a much better insurance operation than our own…, is better than one we could develop and, similarly, is far better than any in which we might negotiate purchase of a controlling interest. Yet our purchase of SAFECO was made at substantially under book value. We paid less than 100 cents on the dollar for the best company in the business, when far more than 100 cents on the dollar is being paid for mediocre companies in corporate transactions. And there is no way to start a new operation – with necessarily uncertain prospects – at less than 100 cents on the dollar. Of course, with a minor interest we do not have the right to direct or even influence management policies of SAFECO. But why should we wish to do this? The record would indicate that they do a better job of managing their operations than we could do ourselves. While there may be less excitement and prestige in sitting back and letting others do the work, we think that is all one loses by accepting a passive participation in excellent management. Because, quite clearly, if one controlled a company run as well as SAFECO, the proper policy also would be to sit back and let management do its job.”

I would contend that such a statement is unprecedented in the recent history of American capitalism. Have you ever heard a manager say that a competitor provides a superior product, and that it is a more prudent use of capital to buy the competitor’s company in the stock market than to spend capital in an attempt to unseat them? To be this impartial and rational is remarkable, and sets a high bar for others to follow. One over which very few can jump.

In closing, I leave you one more Buffettism worth a smirk–“Our experience has been that the manager of an already high-cost operation frequently is uncommonly resourceful in finding new ways to add to overhead, while the manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors.” So remember, being “resourceful” is not necessarily a compliment.

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

[This post continues our series on Warren Buffett’s letters to Berkshire Hathaway shareholders.  Part I is here.]

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