1981 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.