In 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.]