1979 saw the Shah of Iran depart his homeland for Egypt, enabling Ayatollah Khomeini to return to Tehran after fifteen years of exile. Chrysler went begging to the U.S. government for $1.5 billion in loan guarantees. The S&P 500, like 1977 and 1978, spent the majority of the year trading within 10 points of 100.
Over at Kiewit Plaza in Omaha, Chairman Buffett reported operating earnings on shareholder capital of 18.6%. Though the tally fell short of the performances of 1977 and 78, the total approached within a few percentage points their best record. Buffett clearly describes the relevant metrics that shareholders should use to assess Berkshire’s annual performance—“we continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders’ equity with all securities valued at cost is the most appropriate way to measure any single year’s operating performance.” Over the longer term, owners should also assess the market value of its security investments. Speaking most generally, Buffett concludes that “the primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”
During 1979, worries about inflation permeated everyday discourse. With the consumer price index increasing more than 10% annually, mortgage rates seemed to have no ceiling, and hording necessities appeared the best “investment.” And Buffett noticed the new competition with his characteristic frankness—“if we should continue to achieve a 20% compounded gain… your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash… We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.” In an economy with double-digit annual inflation rates, even the best capital allocators struggle to tread water.
And all this from a man who had the pleasure of owning some great businesses, like See’s Candies and Illinois National Bank. How much more is the misery of the mediocre business operator. Far wiser to be in a very good businesses with solid long-term prospects, like insurance, which “tends to magnify, to an unusual degree, human managerial talent – or the lack of it,” than to acquire new textile mills in Waumbec. As Buffett sums, “both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.”
Lastly, Buffett concludes with some particularly useful comments about making bond investments. Observing that insurance competitors had given up one-year policies because of the inflationary environment, Buffett highlights the inconsistency expressed by their willingness to purchase long-term bonds. In short, “having decided that one year is too long a period for which to set a fixed price for insurance in an inflationary world, they then have turned around, taken the proceeds from the sale of that six-month policy, and sold the money at a fixed price for thirty or forty years.”
Inspired by Polonius, Buffett lays out what looks to be an absolute rule for bond investments: “neither a short-term borrower nor a long-term lender be.” For “even prior to this [inflationary] period, [Berkshire] never would buy thirty or forty-year bonds; instead we tried to concentrate in the straight bond area on shorter issues with sinking funds and on issues that seemed relatively undervalued because of bond market inefficiencies… Our unwillingness to fix a price now for a pound of See’s candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years.”
Here again we see Buffett’s reticence in projecting the earnings power for any business for any period longer than a decade. In his email conversation with Jeff Raikes of Microsoft, he insinuated that very few businesses are sufficiently predictable to submit to long-term forecasts about their earnings potential. And observers see this played out again and again in Buffett’s investments—in equities or fixed income. Berkshire will rarely give money away for longer than ten years, and it will rarely pay today for the discounted value of more than a decade’s earnings.*
Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.
* The one important and notable exception here is Coca Cola.
[This post continues our series on Warren Buffett’s letters to Berkshire Hathaway shareholders.]