1980 saw an actor nominated for the Presidency of the United States. Children and adults, flocking to video arcade games, became seduced for the first time by Pac-Man. Art lost a lyricist outside The Dakota building in New York City. And the S&P 500 Index finally lurches free from its range-bound antics around 100, finishing the year over 135.
Over at Berkshire, “operating earnings improved to $41.9 million in 1980 from $36.0 million in 1979, but return on beginning equity capital (with securities valued at cost) fell to 17.8% from 18.6%.” Yet, Buffett quickly notes that accounting practices far understate Berkshire’s share of its common stocks’ earnings. For those businesses that Berkshire owns less than a 20% stake, only dividends show up on the earnings statement; since dividend payouts represent only a small fraction of their earnings power, much of Berkshire’s value as an owner doesn’t find its way onto its balance sheet. In fact, were Berkshire to sell all its equities and pour the proceeds into tax-free bonds, Berkshire’s reported earnings would nearly double, adding at least $30 million annually.
Nowhere is this discrepancy between reported earnings and “true” earnings more clear than GEICO. Berkshire’s stake cost them $47 million, but at GEICO’s current dividend rate, Berkshire only reported earnings from GEICO of a little over $3 million annually. But, given their ownership stake, Buffett estimates their share of GEICO’s earnings power to be “on the order of $20 million annually. Thus, undistributed earnings applicable to this holding alone may amount to 40% of total reported operating earnings of Berkshire.”
But shouldn’t Buffett want a greater share of GEICO’s earnings annually deposited into Berkshire’s coffers? Absolutely not. As Buffett observes, “we should emphasize that we feel as comfortable with GEICO management retaining an estimated $17 million of earnings applicable to our ownership as we would if that sum were in our own hands. In just the last two years GEICO, through repurchases of its own stock, has reduced the share equivalents it has outstanding from 34.2 million to 21.6 million, dramatically enhancing the interests of shareholders in a business that simply can’t be replicated. The owners could not have been better served.” Despite relatively difficult economic conditions, GEICO bought back more than a third of its shares. Compare that to others’ recent performance.
Much of Buffett’s remaining reflections cheerlead his various managers and eulogize his friend and banker Gene Abegg, past owner of Illinois National. At National Indemnity, business looks lighter with industry-wide premiums softer, but Buffett sounds content—“while volume was flat, underwriting margins relative to the industry were at an all-time high. We expect decreased volume from this operation in 1981. But its managers will hear no complaints from corporate headquarters, nor will employment or salaries suffer.”
Over in reinsurance, Buffett forecasts ominous clouds rising soon over the horizon. With “the magnetic lure of [reinsurance’s] cash-generating characteristics, currently enhanced by the presence of high interest rates… the reinsurance market [has transformed] into “amateur night”.”
All told, Buffett says little about competitive advantages at this, the dawn of the Eighties. Berkshire’s mills, a high capex and low margin business, has trimmed its workforce and idled some looms. Inflation, torturous demon of prudent capital allocation, slowly stripped Berkshire of some of its relative value as an investment vehicle. “In a world of 12% inflation a business earning 20% on equity (which very few manage consistently to do) and distributing it all to individuals in the 50% bracket is chewing up their real capital, not enhancing it.” For even the best businesses, with the best competitive advantages, consistently high inflation requires abundant managerial skill while at the same time crippling investors’ real returns.
Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.