Monthly Archives: May 2009

Buffett’s Eye on Google’s Moat

Some recent fussing over Google has followed from an unlikely source—the Berkshire Hathaway annual meeting. During a Sunday press conference, Charlie Munger quipped that “Google has a huge new moat. In fact I’ve probably never seen such a wide moat.”

Unfortunately, Charlie’s brevity and the reporters’ lack of curiosity leave the reader to surmise what he really means. Warren Buffett kindly filled a bit of the gap when he added that Google’s search-linked advertising is “incredible.”

At a basic level, their observations are hard to dispute. Any time a brand name enters our common lexicon, one can assume that their product has attained sufficient “share of mind” to command pricing power. Even the most ardent Yahoo-er would not be so uncouth as to “yahoo” the web for an answer.

As if seeking confirmation, many leapt to conclude that Buffett and Munger now find Google a great investment. Yet a wide moat does not a great investment make. And I can think of no better criteria for an investment than those which have served Buffett and Munger so well over the years, and which are annually reproduced in Berkshire’s annual reports. An investment must have: 1) demonstrated consistent earning power, 2) earn good returns on equity while employing little or no debt, 3) have honest and able management, 4) operate in simple businesses, and 5) be available at a fair price (somewhat below its intrinsic value, to provide a margin of safety).

Given these criteria, Google couldn’t pass as a viable investment for two reasons—it is too difficult (likely impossible) to forecast what the “search” market will look like in ten years, and Google’s equity currently sells at a premium price. One only needs to look back ten years ago to see a Google with no “share of mind.” For Buffett and Munger, Google’s moat—like Microsoft’s—is extremely wide, but its durability is unknowable.

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

Buffett’s Berkshire Letter for 1990

800px-warren_buffett_ku_visit1990 let Nelson Mandela once again greet the world. Saddam decided he wanted to know his Kuwaiti neighbors better. And over in Germany, Helmut Kohl was elected Chancellor in the first free election of a single, unified Germany since 1932. Over at 11 Wall Street, the S&P 500 entered the year near 360 and departed near 330.

At Berkshire, net worth was up by $362 million, or 7.3%. Since 1964, per-share book value has grown from $19.46 to $4,612.06, or at a rate of 23.2% compounded annually. Total after-tax earnings were down to $394.1 million from $447.5 million in 1989.

Of course, Chairman Buffett encourages shareholders to concentrate on Berkshire’s growth in intrinsic value, rather than merely its annual earnings. Given Berkshire’s reinsurance operations, annual earnings figures may look terrible in the short-term.  Given Berkshire’s large investments in publicly traded companies, its annual earnings understate Berkshire’s fair share.

For those interested in Berkshire’s earnings, Buffett notes that “the best way… is in terms of “look-through” results, calculated as follows: Take $250 million, which is roughly our share of the 1990 operating earnings retained by our investees; subtract $30 million, for the incremental taxes we would have owed had that $250 million been paid to us in dividends; and add the remainder, $220 million, to our reported operating earnings of $371 million. Thus our 1990 “look-through earnings” were about $590 million.” Ultimately Berkshire aims to grow look-through earnings at about 15% annually, and will do so without leverage—with nearly all major facilities owned, not leased—and with a bevy of businesses not known for spectacular economics: furniture retailing, candy, vacuum cleaners, and even steel warehousing.

As usual, Buffett briefly surveys Berkshire’s wholly-owned businesses, and two themes consistently emerge—either they have rock-bottom operating costs or monopolistic pricing power. At Borsheim’s, operating costs run about 18% of sales (which includes occupancy and buying costs, which other public companies include in “cost of goods sold”), compared to 40% at the typical competitor. At Nebraska Furniture Mart, operating costs ran 15% in 1990 against about 40% for Levitz, the country’s largest furniture retailer, and 25% for Circuit City Stores, the leading discount retailer of electronics and appliances.

At the Buffalo Evening News, unusual pricing power has generated consistently increasing advertising rates; yet, Buffett is quick to note that in recent years, advertising dollars have grown more slowly, as retailers that do little or no media advertising have gradually taken market share in certain merchandise categories. “As a consequence, advertising dollars are more widely dispersed and the pricing power of ad vendors has diminished.” Today, seventeen years later, we see the effects of this trend in many print and television media businesses; as media channels disperse and increase, advertising venues increase, slowly eroding the pricing power that newspapers and network TV stations previously enjoyed.

In the equity markets, Berkshire spent the year acquiring a large stake in Wells Fargo, the largest permitted without the approval of the Federal Reserve Board. Yet, Buffett notes that “the banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from… the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.”

Given the ever-present leverage dynamic of banks, Berkshire will never be interested in merely buying cheaply, for cheap banks will ever be in endless supply. Instead, “our only interest is in buying into well-managed banks at fair prices.” Here though Berkshire hit a home run, acquiring a well-managed bank at an unusually cheap price—a 10% interest for $290 million, “less than five times after-tax earnings, and less than three times pre-tax earnings.” Of course, bank stocks were unusually depressed in 1990, as “chaotic markets” followed the weekly disclosures of continuing losses in the industry; no less than 534 banks failed in 1989.

Yet the pessimism that accompanies dire conditions and exceedingly dire prospects provides pricing anomalies. The long-term investors should think of stock prices like food prices, for “knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It’s the seller of food who doesn’t like declining prices.)”

At Berkshire, this attitude guides their approach to the stock market; since “we will be buying businesses – or small parts of businesses… as long as I live (and longer, if Berkshire’s directors attend the seances I have scheduled)… declining prices for businesses benefit us, and rising prices hurt us… None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy… Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: “Most men would rather die than think. Many do.””

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

[Also, check out our other posts in our Berkshire Hathaway Letters Series.]

Seeking the Best Returns on Capital

For the investor with limited resources, success not only depends on how many rocks she turns over, but also the probability that those rocks reveal treasures.  Better to flip a hundred rocks at Sutter’s Mill than a million at the Hudson River.

Of course, one must mine the terrain that she commands.  Following Buffett’s advice, one should always begin within her circle of competence.  But when opportunity arises, how and where should the circle expand?

One useful place to begin are those industries with high returns on capital.*  Over at Prof. Damodaran’s homepage, his data shows that a handful of industries show consistent and significant advantages for invested dollars.  As of January 2009, the 34 publicly-traded businesses that provide educational services offered an average 47% return on capital.  More dismally, the 144 REITs returned an average of 8.5%.

Of course, broad macro considerations likely skew some of these data.  2008 was a year with an excess of housing supply–hence homebuilders and manufactured housing had fewer profitable avenues to deploy cash.  2008 also saw record prices for oil, and oil service companies received more and better bids for work than in past years.   Perhaps then their 20.5% ROC represents an interim high mark.

Unfortunately, going through these data ultimately reveals that my current competencies do not lie in today’s most profitable industries–educational services, computer peripherals (33% ROC), and tobacco (32.6%).  Looks like I need to enroll at Strayer, take up smoking, and study the engineering of peripherals.

* For Damodaran, return on capital is “estimated by dividing the after-tax operating income by the book value of invested capital. We use the cumulated values for both variables, for the sector, to estimate the sector ROC.”  Or, ROC = EBIT (1-tax rate) / (BV of Debt + BV of Equity-Cash).

Disclosure: None

Buffett’s Berkshire Letter for 1989

warrenbuffettcharlieroseIn 1989, the Wall fell. A VLCC tanker bled black. Hugo exacted a $7 billion tribute from South Carolina. In the stock market, the S&P 500 opened the year near 280, and despite a brief freefall in October, concluded its annual march near 360.

Over at Berkshire, net worth gained $1.515 billion, or 44.4%. That leaves the shareholder of 25 years with a per-share book value that has grown from $19.46 to $4,296.01, or at a rate of 23.8% compounded annually.

Berkshire’s wholly owned businesses—“the Sainted Seven Plus One”—turned in a record performance. The newest addition—jeweler Borsheim’s—brought significant sales growth, having doubled sales since moving to a new location four years earlier. Even better, their sales are highly profitable: “because of the huge volume it does at one location, the store can maintain an enormous selection across all price ranges. For the same reason, it can hold its expense ratio to about one-third that prevailing at jewelry stores offering comparable merchandise. The store’s tight control of expenses, accompanied by its unusual buying power, enable it to offer prices far lower than those of other jewelers. These prices, in turn, generate even more volume, and so the circle goes ’round and ’round.”  Mirroring strategies at its Omaha neighbor Nebraska Furniture Mart, Borsheim’s brings its customer the widest selection of goods under one roof, and at the lowest price. This combination turns inventory, keeps capital needs low, and enables even lower prices.

Over in insurance, Berkshire capitalized on the year’s hurricane and earthquake catastrophes. Following Hugo’s September visit and the World Series quake, CAT insurance writers rechecked their books, and potential losses looked dangerously high. As Buffett recalls, “prices instantly became attractive, particularly for the reinsurance that CAT writers themselves buy. Just as instantly, Berkshire Hathaway offered to write up to $250 million of catastrophe coverage, advertising that proposition in trade publications. Though we did not write all the business we sought, we did in a busy ten days book a substantial amount.” Contrary to competitors who only write catastrophe coverage when they can lay off the risk via reinsurance, Berkshire’s approach “is to retain the business we write rather than lay it off. When rates carry an expectation of profit, we want to assume as much risk as is prudent. And in our case, that’s a lot.” Yet, their boldness is not mere bravado, for Buffett and Company have initially structured their owners’ expectations to withstand potentially violent swings in quarterly earnings. Profit opportunities–though rare–require both deep pockets and an owners’ mentality that accepts near-term risk (and possibly pain) for the sake of long-term profitability.

For the investor, Buffett offers lessons on taxes, preferred stock investments, zero coupon bonds, and leverage.

First, on taxes, Buffett observes a curious fact. While many personal finance advisers recommend careful adjustments of tax withholding rates, so as to not give the government an interest free loan, Buffett observes that the structure of capital gains taxes allows the investor to receive interest-free investing funds. That is, even though capital gains may accumulate year after year, the investor only needs to pay the requisite taxes when the investment is sold. Buffett muses: “imagine that Berkshire had only $1, which we put in a security that doubled by yearend and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000. The sole reason for this staggering difference in results would be the timing of tax payments. Interestingly, the government would gain from Scenario 2 in exactly the same 27:1 ratio as we – taking in taxes of $356,500 vs. $13,000 – though, admittedly, it would have to wait for its money.” Long story short, buy and hold investing carries a substantial tailwind benefit—capital gains taxes can be indefinitely deferred, and the gains can compound while the government waits.

Buffett’s second lesson is on preferred stocks. With stock market prices violating gravity, Buffett allocated significant portions of Berkshire’s capital into the preferred stocks of Salomon Brothers, USAir, Champion International, and Gillette. In each case though, conversion privileges came along for the ride, and Buffett wouldn’t have been a buyer without them, for “if [return of capital and dividends are] all we get… the result will be disappointing, because we will have given up flexibility and consequently will have missed some significant opportunities that are bound to present themselves during the decade. Under that scenario, we will have obtained only a preferred-stock yield during a period when the typical preferred stock will have held no appeal for us whatsoever. The only way Berkshire can achieve satisfactory results from its four preferred issues is to have the common stocks of the investee companies do well.” Though an attractive interest rate may turn some heads, compounding capital at 15% annually requires a larger share of equity participation.

Lesson three surveys zero-coupon bonds. Though a good investment banker could likely sell any product to many “sophisticated” buyers, “the blue ribbon for mischief-making should go to the zero-coupon issuer unable to make its interest payments on a current basis.” Buffett’s advice: “whenever an investment banker starts talking about EBDIT – or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures – zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures.” Though we shouldn’t blame an issuer for avoiding the encumbrance of a regular interest payment, perhaps a biannual “shackle” unsuspectingly serves to keep the bondholder on management’s mind.

The year’s fourth and final lesson takes up borrowed money again, this time from the borrower’s side. And in Berkshire’s case, they have only rarely been on that side. To some, “our consistently-conservative financial policies may appear to have been a mistake, but in my view were not. In retrospect, it is clear that significantly higher… leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default. We wouldn’t have liked those 99:1 odds – and never will.”

Of course, Buffett loves “mathematical expectation.” And the simple rule stands supreme—any compounding sequence multiplied by zero is zero. 99 years worth of stellar returns, capped by a year of default, is a zero. And practically speaking, any open debt represents an avenue for default. “A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds…” Borrow not, neither be beholden to any. Of such, even Poor Richard could be proud.

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

[Also, check out our other posts in our Berkshire Hathaway Letters Series.]

Reviewing Malcolm Gladwell’s Blink

Malcolm Gladwell's BlinkIs investing more art or science? Cash flow analysis and industry assessment submit to quantitative measures. Yet, economic moats and management’s rationality less so. The most successful investors use both quantitative and qualitative assessments to find undervalued businesses, though the former is certainly the standard route. For most, investing is primarily a science.

Ostensibly Malcolm Gladwell’s book Blink: The Power of Thinking without Thinking (Back Bay Books, 2005), is not a book about investing. Being interested in the human mind making judgments, Gladwell highlights situations in which rational, well-considered judgments are more inaccurate than reactive, non-reflective judgments. Peppered with memorable, illustrative anecdotes, Blink contrasts scientific rationality with the aesthetic, to see which more reliably guides us to make correct decisions (spoiler: it’s not an either/or).

It is our basic prejudice to think that lengthy, thoughtful, verbose defenses of our judgments are more likely to produce correct judgments than unexpressed, implicit ones. For example, Gladwell tells the story of the J. Paul Getty Museum’s $10 million acquisition of a sixth century BC marble kouros in the 1980s. Employing typical caution and prudence, the Museum solicited a handful of experts—geologist included—to assess the piece. “I’ve always considered scientific opinion more objective than esthetic judgments,” said Getty’s curator of antiquities Marion True. And the experts gave the green light; two days with a stereomicroscope confirmed the presence of calcite on the statue’s exterior—significant because dolomite can turn into calcite only over the course of hundreds of years.

Of course you may suspect how the story ends—the kouros was a fake. The museum though was not without warning, for no fewer than three additional experts had expressed their concern. Federico Zeri, an Italian art historian, found the sculpture’s fingernails odd. The first time Evelyn Harrison, a Greek sculpture expert, saw the kouros, she thought something was amiss. Thomas Hoving, former director of the Metropolitan Museum of Art in New York, met the statue and found it “fresh.” Not exactly the first impression that a sixth century BC statue should expect.

Long story short, time revealed the fraud. But Gladwell’s interesting observation is that the latter three experts all felt an “intuitive repulsion” when they first saw the kouros, and they were absolutely right. Inexpressible at the time, yes. But correct. What Gladwell ultimately aims to explore is whether our initial, “gut” reactions are reliable tools for making correct judgments.

As Gladwell observes, “when it comes to the task of understanding ourselves and our world, I think we pay too much attention to grand themes and too little to the particulars of fleeting moments.” (16) In those fleeting moments, a practiced and prepared expert can expose truth with unreflective judgments. In sum, people who are “very good at what they do… owe their success, at least in part, to the steps they have taken to shape and manage and educate their unconscious reactions.” (16)

Reading the book with an eye on investing produced two conclusions. First, quick judgments—even unexpressed—may incorporate sophisticated unconscious mental skills, such that an initial response to a prospective investment deserves one’s special attention.  Second, and I quote, “being able to act intelligently and instinctively in the moment is possible only after a long and rigorous course of education and experience.” (259) I guess I’d better get back to the 10-Ks…

Buffett’s Berkshire Letter for 1988

buffett1988 gave forth a heat wave in the United States that scorched corps and took many lives. Dan Quayle brought mirth and cheer to an otherwise dull election year. And the Iron Curtain finally began to reveal some tatters, as Estonia declares itself “sovereign.” In the stock market, the S&P 500 opened the year near 255, and seesawed whimsically up and down through the year, to close near 275.

Over at Berkshire, net worth increased $569 million, or 20.0%. Buffett reports that “over the last 24 years… our per-share book value has grown from $19.46 to $2,974.52, or at a rate of 23.0% compounded annually.”

The lessons for this year are more episodic than the past. After a brief explanation of accounting changes and some obligatory finger-wagging (“there are managers who actively use GAAP to deceive and defraud. They know that many investors and creditors accept GAAP results as gospel. So these charlatans interpret the rules “imaginatively” and record business transactions in ways that technically comply with GAAP but actually display an economic illusion to the world”), Buffett sum the results.

First, Buffett is quick to attribute Berkshire’s success to the stellar performances of its managers, who, like the Heldmans at Fechheimer and the Blumkins at Nebraska Furniture Mart (NFM), are able to deliver high returns on invested capital, despite being in industries without attractive economics. And in early 1989, Berkshire took this lesson back to the field and acquired Borsheim’s, a family-owned and operated jewelry store in Omaha. Like NFM, Borsheim’s offers “(1) single store operations featuring huge inventories that provide customers with an enormous selection across all price ranges, (2) daily attention to detail by top management, (3) rapid turnover, (4) shrewd buying, and (5) incredibly low expenses. The combination of the last three factors lets both stores offer everyday prices that no one in the country comes close to matching.”

In insurance, “the property-casualty insurance industry is not only subnormally profitable, it is subnormally popular.” What Buffett has in mind is California’s proposed Proposition 103, which would cap auto insurance rates in the state. Compared to the highly profitably breakfast cereal industry, profit margins and price increases in insurance dwarf. Yet, it is the auto insurance companies that receive complaints, while cereal lovers gobble their overpriced delectation without a peep; “when auto insurers raise prices by amounts that do not even match cost increases, customers are outraged. If you want to be loved, it’s clearly better to sell high-priced corn flakes than low-priced auto insurance.” Duly noted.

Perhaps most intriguing for the aspiring investor are Buffett’s concluding comments on his merger arbitrage strategy. The 1980s—with its ever decreasing interest rates and ever richer capital markets—saw wild growth in both friendly and unfriendly takeovers. So the merger arbitrageur “prospered mightily,” with Buffett no exception. For merger arbitrage situations, Buffett uses four questions: “(1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire – a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?”

Using the simple questions to provoke analysis, Berkshire’s arbitrage results have been impressive. Though selective—participating in only a few mergers per year—Buffett’s returns have proven far superior to merely holding unused cash in T-Bills. Yet, Buffett doesn’t try to get too obscure in his arbitrages, despite his consistent successes. Whereas some practitioners “buy into a great many deals perhaps 50 or more per year. With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks. This is not how Charlie nor I wish to spend our lives.”

Lastly, Buffett concludes with some brief shots at efficient market theory. Particularly in light of Berkshire’s arbitrage results, it is wholly incorrect to say that markets are always efficient. Frequently efficient, yes, but clearly not always. And the point is not merely academic, for “over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically-significant differential that might, conceivably, arouse one’s curiosity.” From a selfish point of view, Buffett should simply snap his trap, and “Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.” For “in any sort of a contest – financial, mental, or physical – it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.”

Assessing eBay’s First Quarter

logoebay_x451eBay filed its first quarter 10-Q at the end of April, and the stock price launched. With two highly lucrative toll-booth businesses—brokered sales and payment services (Paypal)—and an exceedingly low price (briefly selling below $10 per share earlier this year), it caught our attention earlier this year. Though we haven’t found the recent decline in eBay’s GMV (gross merchandise value) concerning, we do continue to worry about eBay’s capital allocation, its managerial compensation, and its emphasis on favoring high volume sellers (see our previous analysis of pretended problems, potential problems, and rejoinders).

Regarding capital allocation, eBay repurchased no shares in the first quarter, despite seeing its lowest share price since early 2001. And true to habit, eBay entered a definitive agreement to acquire Gmarket Inc. after the first quarter closed, in April.   Over the years, eBay’s management has clearly preferred acquisitions to share repurchases, and not all of the acquisitions have been prudent uses of capital (see e.g., their recent sale of Stumbleupon back to its founders for less than their purchase price). Though it is possible that Gmarket at 27x trailing earnings is a better investment than eBay’s own shares at 13x trailing earnings, the former clearly anticipates robust growth that may not materialize. In my view, buying Gmarket rather than eBay’s own shares is the riskier route.

Our second worry has been eBay’s managerial compensation. Despite sub-par performance in their core marketplace business in recent years, compensation has decidedly increased. And the first quarter confirms the trend. Year over year, stock-based compensation expense grew from $87.4 million to $113.8 million, or a 30% increase. This in a quarter in which both net income and free cash flow were down significantly YOY. Though one should acknowledge that stock-based compensation expense can be lumpy and not consistently spread across all quarters, the first glance does not offer a pretty picture. We’ll be keeping watch in the quarters to come.

Our third and last lingering worry—that favoring high volume sellers may alienate too many sellers—is difficult to assess from quarter to quarter. Over at eBay Strategies, Scot Wingo has highlighted some of the recent changes in eBay’s marketplace business. Early indications show that buyers appreciate the reliability of eBay’s largest and favored sellers, and buyers consistently show their preferences for free shipping. Though management’s push for ‘free shipping’ strikes me as nothing more than silly irrationality (i.e., sellers will just increase list prices to compensate), the data so far seems to confirm management’s side.

All told, I must say that I was disappointed with eBay’s capital allocation and stock compensation expense for the quarter. Though their actions fit seamlessly with their past, I had hoped that a $10 share would have been too tempting not to bite. Given these three worries, the unexpected comprehensive income loss of $27.7 million for the quarter, the broad macroeconomic picture, and the recent 70% run-up in eBay’s share price, we have closed our position and will now watch from the sidelines.

Disclosure: No Position.

Buffett’s Berkshire Letter for 1987

warren_buffett_ku_visit1987 was the year the stock market jumped off the cliff. We use the cliché rather flippantly, but perhaps no metaphor better captures a 20.4% single day drop in the S&P 500. Despite the theatrics, the S&P 500 essentially closed the year where it had started, at 247.

Over at Berkshire, net worth gained $464 million in 1987, or 19.5%. Since taking over, Buffett and Munger’s creation has grown book value per share from $19.46 to $2,477.47, or at a rate of 23.1% compounded annually. Unlike past letters, Buffett doesn’t manage down expectations of future returns; perhaps now he’s proven to himself his consistency.

One of the first items on this year’s agenda are the margins and return on equity (ROE) of Berkshire’s seven non-financial subsidiaries–Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See’s Candies, and World Book. In 1987, these seven combined to produce $180 million in EBIT while only employing $178 million in equity capital and virtually no debt. Thinking about it another way “if these seven business units had operated as a single company, their 1987 after-tax earnings would have been approximately $100 million – a return of about 57% on equity capital.” Indeed, quite impressive numbers, even for someone with Buffett’s standards.

How is it that Berkshire’s businesses require such meager portions of capital? As Buffett observes, “the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.” Stated simply, almost every business change requires capital. In a business or industry always in metamorphosis, substantial portions will be consistently consumed. Think here of the ravenous adolescent.

Since the mid-1970s, Buffett has clearly preferred businesses with small appetites, but is his preference generalizable? A Fortune study from 1987 thinks so, for they found “only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: during the decade, 24 of the 25 outperformed the S&P 500.” Where the pace of business and industry change is slow, capital can accumulate and moats develop.

After giving his annual briefing of Berkshire’s non-financial operations, Buffett gives his mind to analyzing their insurance businesses. Insurance, by and large, offers a commodity product, and the industry offers few barriers to entry. By penning a promise, virtually anyone can collect premiums. Like other commodity businesses, price will often be the primary determinant in the purchase decision.

Yet Buffett reminds his owners that “at Berkshire, we work to escape the industry’s commodity economics in two ways. First, we differentiate our product by our financial strength, which exceeds that of all others in the
industry. This strength, however, is limited in its usefulness. It means nothing in the personal insurance field: The buyer of an auto or homeowners policy is going to get his claim paid even if his insurer fails (as many have)… Periodically, however, buyers remember Ben Franklin’s observation that it is hard for an empty sack to stand upright and recognize their need to buy promises only from insurers that have enduring financial strength. It is then that we have a major competitive advantage.”

The second competitive advantage for Berkshire’s insurance business is their “total indifference to volume that we maintain. In 1989, we will be perfectly willing to write five times as much business as we write in 1988 – or only one-fifth as much. We hope, of course, that conditions will allow us large volume. But we cannot control market prices. If they are unsatisfactory, we will simply do very little business. No other major insurer acts with equal restraint.”

Lastly, Buffett’s 1987 assessment of CEOs’ capital allocation was particularly interesting, especially in light of our recent posts on assessing management [see here]. His basic observation is that “the heads of many companies are not skilled in capital allocation.” Yet, shareholders shouldn’t be surprised, for “most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.” The required new skill set “is not easily mastered,” but absolutely and overridingly critical for business success, for “after ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”

Of course, today’s technocratic mindset would encourage the CEO who lacks capital-allocation skills to run and hire some pristinely-dressed and well-connected management consultants or investment bankers. Unfortunately, “Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.”

There is much more of interest here—comments on Mr. Market’s mania and depression, Buffett’s buy and hold philosophy, and inflation. But for the aspiring capitalist, the above themes are most important—buy simple businesses, in industries with little change, those with economic moats—if possible, and managed by skilled capital allocators. Oh, and be sure to pay the right price.

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

Candid Management and Widening Moats

[This article first featured on the DIV-Net on April 28, 2009]

Spring is the season for annual reports, and many executives use the occasion to spin a few tales about business in the year past. Though ostensibly these are letters from management to the boss—that is, the owners—far too many seem to take their storytelling lessons from the habits of evasive, guilty teenagers. On rare occasions one finds an honest, clear assessment of the year’s work, and such candor is impossible to miss. For the investor, the spring season is one for assessing the pen of management, in order to discern trustworthy and honest stewards of capital.

Of course, candor from management has almost become an endangered species in recent years. Rittenhouse Rankings Inc. has followed this trend with its annual CEO Candor Scores, and in 2007, found that in shareholder letters “confusing and misleading statements or “dangerous fog,” increased 66 percent… up from 39 percent five years ago.” Instead of providing an impartial and clear analysis of successes and failures, more and more executives speak their Orwellian language, using “words to describe ‘the truth we want to exist,’ rather than facts.” And the point here is not merely pedantic, for Rittenhouse Rankings argue that “high candor scores and rankings reveal high quality leadership, cohesive corporate cultures, more reliable accounting and superior financial performance.”

One CEO known for his candor is Wells Fargo’s John Stumpf.John Stumpf pic

In his most recent letter to shareholders, Stumpf makes good on his reputation. Though Wells Fargo acquired Wachovia in one of the largest banking acquisitions in the last year, Stumpf does not trumpet their size, for “where [Wells ranks] in asset size alone is meaningless to us… In fact, to our customers, bigness can be a barrier. I’ve yet to hear of a customer walking into one of our banks and saying, “I want to bank here because you’re so … big!”.”

For Stumpf, Wells’ annual success should be determined by two metrics—revenue v. expenses, and return on equity. Regarding the first, Wells’ revenue grew six percent in 2008, while expenses declined one percent—“the best such revenue/expense ratio among our large peers, and the one we consider the best long-term measure of a company’s efficiency.” And on the second, Wells’ return on equity was 4.79 cents for every dollar of shareholder equity, best among their peers for the year. By the numbers, Wells did more with less than the year before, and it had better returns on shareholder capital than peers. Even in a difficult macroeconomic environment, someone had to be the best. For the large American banks, 2008 was the year of Wells.

As an investor, Stumpf’s candor is refreshing, but his focus arguably more important. Rather than telling a lengthy and jargon-laden tale of Wells’ growth or enigmatic synergies, Stumpf reveals his concentration on managing his owners’ capital productively, and optimizing aspects of Wells’ business that he can control. Increasing the loan portfolio may not be a productive use of capital: only if it can be done at adequate margins, and without excessive expense. Rather than spinning a grand story of how our economy went wrong, Stumpf keeps his eye on his business and intelligent opportunities for growth in the year ahead. Though these two tasks need not be exclusive, experience shows that too many bankers love to indulge in forecasting and professoring.

In our assessment of economic moats, managerial ability, more than almost any other factor, directly correlates with the width of a business’ moat. Like Andrew Grove, the best managers are capable of rebuilding a protective moat with a new product, even as past competitive advantages deteriorate. Like Warren Buffett, the best managers are capable of redirecting the life blood for building moats—capital—to the best castles with the ablest builders. Like John Stumpf, the best managers are capable of concentrating their gaze on matters they can control, and each day use capital a little better than the day before.

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

Buffett’s Berkshire Letter for 1986

buffett1986 saw seven million people join hands in Hands Across America–a well-publicized, but unsuccessful attempt to raise $50 million to alleviate famine in Africa.  Later in the year, the Iran-Contra Affair features on the public page, revealing that the United States had sold weapons to Iran in exchange for the release of 7 American hostages held in Lebanon.  And the stock market had drawn its share of helium, with S&P soaring from its open near 165 to close the year near 210.

Over at Berkshire, net worth increased by $492.5 million, or 26.1%, and for those keeping score (be assured the Chairman is), that signifies an increase of 10,600% over 22 years, from $19.46 to $2,073.06 per share.

The good news for Berkshire’s owners is that they own a grove of money trees; the bad news is the fruit of their grove has not found fertile ground to grow tomorrow’s trees.  In the stock market, where Buffett and Munger had previously found abundant fertile ground, the terrain now looks sterile and barren. The best available alternative in 1986 then was to pay off debt and stockpile cash. Though “neither is a fate worse than death, they do not inspire us to do handsprings either. If we were to draw blanks for a few years in our capital-allocation endeavors, Berkshire’s rate of growth would slow significantly.”

After some obligatory back-slapping and “atta-boys” for Berkshire’s managers, Buffett talks the business. At Buffalo Evening News, they have attained both the highest weekday and Sunday penetration rates (near 83% on Sunday) of the top 50 papers in the country. At Nebraska Furniture Mart, net sales increased 10.2% to $132 million, and the only logical explanation for their success is “that the marketing territory of NFM’s one-and-only store continues to widen because of its ever-growing reputation for rock-bottom everyday prices and the broadest of selections.” At See’s Candies, their “one-of-a-kind product ‘personality’” derives from “a combination of [their] candy’s delicious taste and moderate price, the company’s total control of the distribution process, and the exceptional service provided by store employees.” More than any other metric, See’s manager Chuck Huggins “measures his success by the satisfaction of our customers, and his attitude permeates the organization.”

The big news of the year are Berkshire’s acquisitions of Scott Fetzer (which includes World Book and Kirby) and Fechheimer, a uniform manufacturing and distribution business. In the case of Fechheimer, its Chairman Bob Heldman had concluded that their company fit Buffett’s criteria for desired acquisitions: “1) large purchases (at least $10 million of after-tax earnings), 2) demonstrated consistent earning power, 3) businesses earning good returns on equity while employing little or no debt, 4) management in place, 5) simple businesses, and 6) an offering price.”

And Heldman was right. As Buffett recounts, “Fechheimer is exactly the sort of business we like to buy. Its economic record is superb; its managers are talented, high-grade, and love what they do; and the Heldman family wanted to continue its financial interest in partnership with us… the circumstances of this acquisition were similar to those prevailing in our purchase of Nebraska Furniture Mart: most of the shares were held by people who wished to employ funds elsewhere; family members who enjoyed running their business wanted to continue both as owners and managers; several generations of the family were active in the business, providing management for as far as the eye can see; and the managing family wanted a purchaser who would not re-sell, regardless of price, and who would let the business be run in the future as it had been in the past.” For those curious, Fechheimer earned $8.4 million pre-tax in 1986, and the purchase price valued the entire business at 6.5x pre-tax earnings.

Lastly, over at the insurance businesses, prices have firmed and premiums boomed, likely making Berkshire “the fastest growing company among the country’s top 100 insurers.” Not only that, but the cost of their insurance float fell, with Berkshire’s combined ratio falling from 111 in 1985 to 103 in 1986.

Despite Berkshire’s performance, they were no match for their partially-owned competitor GEICO. Under the leadership of GEICO’s Chairman Bill Snyder and with the investing acumen of Lou Simpson, GEICO’s moat grew considerably. As Buffett observes, “the difference between GEICO’s costs and those of its competitors is a kind of moat that protects a valuable and much-sought-after business castle. No one understands this moat-around-the-castle concept better than Bill Snyder, Chairman of GEICO. He continually widens the moat by driving down costs still more, thereby defending and strengthening the economic franchise. Between 1985 and 1986, GEICO’s total expense ratio dropped from 24.1% to the 23.5% mentioned earlier and, under Bill’s leadership, the ratio is almost certain to drop further.”

All told, the businesses performed well in ’86, but the stock markets offered few bargains. As a temporary home for Berkshire’s growing piles of cash, Buffett begrudgingly took some positions in merger arbitrage, for “common stocks, of course, are the most fun. When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value – stocks sometimes provide grand-slam home runs. But we currently find no equities that come close to meeting our tests.”

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

[Also, check out our other posts in our Berkshire Hathaway Letters Series.]