Category Archives: Moat

Why Did Berkshire Stop Selling Moody’s?

[Warren Buffett recently entertained CNBC and its viewers in what now seems to have become an annual three hour session (transcript here).  Amid the inopportune interruptions and political meanderings, some interesting things emerged.  For one, the central reason why Berkshire has stopped selling Moody’s…]

“BECKY:  That’s one of many questions that have come in, but we also have questions that have come in about Moody’s. Achit in Arizona writes in, “In your FCIC interview, you spoke of the inherent advantages of a duopoly that Moody’s and S&P share. Why does Berkshire continue to reduce its interest in Moody’s? Is there too much headline risk” for you?

BUFFETT: Well, I think that duopoly is in somewhat more danger than it was simply because people are mad at the ratings agencies and the ratings agencies totally missed what was going on in the mortgage market and that was a huge, huge miss. I don’t think they were, you know–I think they were just wrong, like a lot of people were wrong about in thinking that housing prices couldn’t go down a lot, but they were rating agencies and they’ve gotten a lot of criticism for it and their business model is sensational when it’s a duopoly. I mean, I have no bargaining power. I’m going to see Moody’s in the week or I think or something about our ratings.

BECKY: Mm-hmm.

BUFFETT: And you know, I dress up and do everything I can to, you know, talk about my balance sheet. But they–they’re God in the ratings field and Standard & Poor’s, and I need their ratings. And if they tell me the bill is X, I pay that, and if they tell me the bill is X plus 10 percent, I pay that. You know, if Coca-Cola charges too much, you know, you may think about drinking Pepsi Cola, but in the rating agency business, you need those two. And if that–either people get so upset with them or whatever it may be, or Congress gets upset, that could disappear. It won’t disappear from natural reasons. I mean, it is a natural duopoly, just like–it’s a little different than Freddie and Fannie were, but they also had some specific advantage. Sometimes you find situations where you get a natural–well, you used to have that in the newspaper business. You had a natural monopoly in big cities. It wasn’t–it wasn’t illegal, it just worked out that way.

BECKY: Mm-hmm.

BUFFETT : And that’s what happened in ratings agencies. But it’s not as bullet-proof as it was. Although, I will say that…

BECKY: Does that explain why you’ve been selling?

BUFFETT: Well, we haven’t sold that aggressively.

BECKY: Mm-hmm.

BUFFETT: I mean, if you look at it during the course of 2010, we sold a very small amount of the–it looked to me that that threat was receding to some degree. But it’s different than it was five years ago…” [Emphasis added.]

[A couple years ago, I suggested that Moody’s Structured Products Group (SPG) would find it difficult to match past peak revenues ($873m in 2007).  In their latest 10-K, 2010 revenues from the Structured Finance Group appear down 5% v. 2009, to $291m.

In the meantime though, revenues from their Corporate Finance Group have held strong, and increased 38% YOY in 2010, to $564m.  Income before tax (for the whole company) was $714m in 2010, compared to $730m in 2008.  Despite a substantial revenue decline in their largest business line from 2008 to 2010, income before tax (for the company as a whole) has held relatively steady, even with a tarnished reputation.  So Berkshire will hold.]

Disclosure: none.

Buffett’s Berkshire Letter for 1991

1991 saw Scuds and Patriots battle over desert skies. Cracks became fissures, and the brittle Union of Soviet Socialist Republics finally dissolved. In the stock market, the S&P 500 launched from the gate—rising from 325 to 380 in the first quarter—only to chortle along for the remainder, and close with a two week sprint to 417. Including dividends, the 500 gained 30.5% for the year.

Over at Berkshire, net worth rose to $2.1 billion, or 39.6% YOY. In its most recent 27 years (i.e., since present management took over), per-share book value has grown from $19 to $6,437, or at a rate of 23.7% compounded annually. “Look-through earnings” declined from $602 million in 1990 to $516 million.

For Buffett, the goal of each investor should be to create a portfolio that will deliver the highest possible look-through earnings a decade from now. Successful investing requires the investor to think about long-term business prospects rather than short-term stock market prospects. It is crucial then that an investor competently distinguish companies with long-term “economic franchises” from mere businesses, those companies with wide moats from those with none.

An economic franchise “arises from a product or service that: 1) is needed or desired; 2) is thought by its customers to have no close substitute and; 3) is not subject to price regulation.” These conditions enable a company to “regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.”

A mere “business” earns exceptional profits “only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.”

In Berkshire’s stock portfolio in 1991, Coca Cola, Gillette, and Guinness PLC meet Buffett’s definition of an economic franchise. Only a few years prior, The Washington Post Company and Capital Cities/ABC would have also sat in this class. However, in recent years, “the economic strength of once-mighty media enterprises continues to erode as retailing patterns change and advertising and entertainment choices proliferate.” By 1991, newspaper, television, and magazine properties now resemble businesses more than franchises in their economic behavior. GEICO and Wells Fargo represent mere businesses, albeit ones which are some of lowest cost providers in their industry. Each has superior management—as Buffett often notes—but were mismanagement to arrive, costs could quickly escalate, and their moats erode.

Given Buffett’s lecture, one may be surprised to find that Berkshire acquired another “business” in 1991—H.H. Brown Company, a shoe manufacturer. Candor reigns, for “shoes are a tough business… and most manufacturers in the industry do poorly. The wide range of styles and sizes that producers offer causes inventories to be heavy; substantial capital is also tied up in receivables. In this kind of environment, only outstanding managers like Frank Rooney and the group developed by Mr. Heffernan can prosper.”

What distinguishes H.H. Brown’s management? For one, their compensation system is one of the most unusual Buffett has encountered: “key managers are paid an annual salary of $7,800, to which is added a designated percentage of the profits of the company after these are reduced by a charge for capital employed. These managers therefore truly stand in the shoes of owners.” Unlike most compensation schemes which are “long on carrots but short on sticks,” the system at Brown has served both the company and managers exceptionally well, for “managers eager to bet heavily on their abilities usually have plenty of ability to bet on.”

Ultimately, the best investments are those with favorable long-term economic characteristics, honest and able management, and a fair price. With H.H. Brown, Buffett shows that two out of three is sufficient to pass his tests.

In light of our contemporary economic environment—with new government equity stakes in highly competitive industries with questionable economics—Buffett offers a final and interesting coda. Recall that a few years back, Berkshire bought convertible preferred stock in a notoriously bad “business”—US Air. On Berkshire’s balance sheets, Buffett and Munger valued this stock at a significant discount to its par value, to reflect the risk that “the industry will remain unprofitable for virtually all participants in it, a risk that is far from negligible.”

1991 was a “decimating period” for airlines, as Midway, Pan Am and America West all entered bankruptcy. Continental and TWA followed some months later. And the risk to the entire industry was further heightened by the fact that “the courts have been encouraging bankrupt carriers to continue operating. These carriers can temporarily charge fares that are below the industry’s costs because the bankrupts don’t incur the capital costs faced by their solvent brethren and because they can fund their losses—and thereby stave off shutdown—by selling off assets. This burn-the-furniture-to-provide-firewood approach to fare-setting by bankrupt carriers contributes to the toppling of previously-marginal carriers, creating a domino effect that is perfectly designed to bring the industry to its knees.”

[If history serves as precedent, keep an eye out for GM and Chrysler promotions in the months and years ahead. And you really thought Ford could survive?]

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.]

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 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.]

Searching for Rational Management

Through the rambling course we’ve taken on this blog, we’ve highlighted a few businesses with wide economic moats. Some offer products that satisfy basic and enduring needs; others sell a commodity product—like insurance or suit liners—but with the lowest cost structure in the industry.  Elsewhere, we seen wide moat businesses with a network advantage that makes their service difficult to replicate—like Craigslist or eBay.

However, I am increasingly persuaded that the caliber and experience of management is the most important criterion for determining the width of an economic moat. Given today’s rapid pace of innovation and competition, even the best businesses will require excellent strategic decision-making and creative problem-solving to survive and thrive. As we saw in Only the Paranoid Survive, competitive forces could have sunk Intel had Andrew Grove not boldly broken their old habits. If such crisis points arrive even more frequently for business managers of our future, a strong case can be made that strong management is the best tool for widening a business’ moat.

To say as much is largely uncontroversial. The real crux is: what are the characteristics of strong management, and what tools can an investor use to reliably find them? For Warren Buffett, strong management concentrates its focus on daily increasing a business’ intrinsic value. From an expense standpoint, that means using each retained dollar in projects that provide an adequate return. It means growing revenues, but only when the projected profits far exceed other available alternatives (which may include buying shares of competitors in the public markets). It means returning capital to shareholders—in the form of share buybacks or dividends—when adequate returns cannot be found internally. The rational manager repurchases shares only when its price resides far below its intrinsic value.

With recent stock market declines, I had hoped to use this opportunity to filter out those management teams who buy high and pause repurchases when prices fall.  But few management teams have taken advantage of the recent declines. And perhaps even more interesting, April saw insiders’ stock sales outnumber purchases by more than 8 to 1! Though some interpret these sales as tax related, call me unpersuaded.  For one, management insiders are often higher net worth individuals, a group that regularly files for tax extensions, so as to not pay until at least October. And second, tax losses are really most valuable when paired with offsetting gains. To justify the level of insider selling we’ve seen, the tax losses would have to be paired with some very long term capital gains, as anyone who has bought and held the market over the last decade would have few gains. Without such capital gains, such selling is excessive for the mere $3000 claim.

Needless to say, I’ve been rather surprised by these findings (consider me naïve). Not only are many companies slowing their share repurchases, many managers seem to be tossing their ownership stakes aside. So the final question is—are they being rational or irrational? Today’s optimist believes that the stock market offers abundant bargains, and would chastise these crazed sellers for their depressive and irrational behavior. The pessimist though sees rationality in these insider sales, for what has fallen down can fall again, and again. Though I’d like to be an optimist, sitting on the other side of 8 to 1 odds can be a bit uncomfortable.

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

Buffett’s Berkshire Letter for 1983

warrenbuffettcharlierose1983 saw Israel, Lebanon, and the United States sign an agreement that called for Israel’s withdrawal from Lebanon. In Japan, the Nintendo Entertainment System hit the market for the first time. Bjorn Borg won his fifth straight Wimbledon title and announced his retirement. And in the world of crime, 6800 gold bars, worth 26 million British Pounds, were heisted from the Brinks Mat vault at Heathrow Airport. In the equity markets, the S&P 500 entered the year near 140, made a steady march higher until June, and then plateaued, to finish the year near 165.

Over at Berkshire, their book value increased from $737.43 per share to $975.83 per share, or by 32%. As Buffett observed last year, his favored metric for business assessment—return on shareholder equity—has become less useful for evaluating Berkshire now that the undistributed earnings of its common stock holdings have grown so large.

However, Buffett is quick to caution that Berkshire’s book value far understates its intrinsic business value, and it is the latter measurement that really counts. Whereas book value “is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings,” intrinsic business value “is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.” Though book value can serve as a shorthand proxy for economic value, better for the aspiring analyst to dig more deeply and discern Berkshire’s intrinsic value.

More than his past letters, Buffett reflects at length on the business moats that Berkshire’s subsidiaries currently enjoy. Over at the newly-acquired Nebraska Furniture Mart, their moat derives primarily from being the lowest cost provider—by far—and then passing on those savings to its customers. To keep costs lean is no small feat, and Buffett highlights, in particular, the purchasing acumen of Mrs. B and her son, Louie Blumkin, who is “widely regarded as the shrewdest buyer of furniture and appliances in the country.” As Buffett quips, “I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.”

Over at Buffalo Evening News, business has finally blossomed. With its primary competitor gone, Buffalo is now a one-paper town, and fully enjoying the pricing power that such dominance commands. Even better, Buffalo Evening News commands more readers than most one-paper towns, and Buffett takes note, for “a paper’s penetration ratio [we believe] to be the best measure of the strength of its franchise. Papers with unusually high penetration in the geographical area that is of prime interest to major local retailers, and with relatively little circulation elsewhere, are exceptionally efficient buys for those retailers.” Lastly, Buffalo Evening News’ protective moat draws width from its superior news product. In 1983, the News’ “news hole” (i.e., its editorial material, not ads) “amounted to 50% of the newspaper’s content… Among papers that dominate their markets and that are of comparable or larger size, we know of only one whose news hole percentage exceeds that of the News.”

Berkshire’s third featured wide moat business is See’s Candies. Despite stagnant volume growth over the last five years (1979-1983), See’s has grown its sales over 50%, and more than doubled its operating profits, largely by pushing through consistent annual price increases. Though some of the volume stagnation may derive from See’s relatively high prices, See’s commands ample pricing power because its candy “is preferred by an enormous margin to that of any competitor. In fact, [Berkshire] believe[s] most lovers of chocolate prefer it to candy costing two or three times as much.” An excellent product, made with the highest quality ingredients, and delivered by cheerful, helpful personnel, is about as close to a successful retail formula that one will ever find coming from Buffett.

All told, Buffett’s descriptions of his best businesses’ economic moats may seem rather elementary. However, there is good reason to believe that simplicity here is the key to their sustained success. For many businesses, daily operations prolifically produce new and unforeseen problems, and managers’ minds must be constantly vigilant and rational to dispense solutions and move to the next. Without relatively simple competitive advantages, the plethora of daily problems may overwhelm attentions and distract focus. What the successful business needs is a singular principle to refocus their energies. For Nebraska Furniture Mart, that principle is to always buy merchandise more smartly than competitors. For Buffalo Evening News, their principle is maximizing the size of the news hole with competitive costs. At See’s, it is providing a premium product with pleasant service. In each case, the advantage seems so simple that it should be easily stolen. But when attacking a business with a wide moat, merely having the key is not enough to breech the castle.

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

Buffett’s Berkshire Letter for 1982

1982 saw guns ablaze at the Falkland Islands. Walt Disney World grew its empire by opening its second largest theme park—Epcot. Wayne Gretzky set the reigning record for the most goals scored during an NHL season, netting 92. And the S&P 500 started the year near 120, fell below 105 by mid-August, and rebounded to close the year near 140.

Over at Berkshirebuffett, “operating earnings of $31.5 million in 1982 amounted to only 9.8% of beginning equity capital (valuing securities at cost), down from 15.2% in 1981 and far below our recent high of 19.4% in 1978.” Buffett found three causes for the decline—first, “a significant deterioration in insurance underwriting results,” second, “a considerable expansion of equity capital without a corresponding growth in the businesses we operate directly,” and third, “a continually-enlarging commitment of our resources to investment in partially-owned, nonoperated businesses.”

As Buffett has mentioned in preceding years, return on equity capital should be the most significant metric for evaluating management performance. However, in Berkshire’s case, this metric has become less and less useful, as standard accounting practices fail to fully reflect Berkshire’s share of its equity holdings’ earnings. For example, Berkshire owned a significant stake of GEICO in 1982; however, rather than including Berkshire’s share of GEICO’ earnings ($23 million) with its earnings, accounting standards dictate that only distributed earnings (i.e., cash dividends) be noted (which were $3.5 million after tax). So long as GEICO retains some of its annual earnings for reinvestment, those earnings will not immediately show up on Berkshire’s annual report, even though their share of them is just as real as the assets on GEICO’s balance sheet. Over time, Buffett is confident that these retained earnings will become more fully reflected in the stock prices of their portfolio.

Despite low returns on equity capital, book value at Berkshire grew $208 million, thanks to an increasingly cheerful consensus in the stock market. Starting the year with a book value of $519 million, the levity lifted Berkshire’s net worth nearly 40%.

Looking forward, Buffett foresees insurance underwriting results for 1983 to be no sight for the squeamish. For the industry, 1982 would seem bad enough, with Best estimating a combined industry ratio of 109.5; in short, that means that every dollar of insurance float cost $1.095, or a 9.5% annual rate. However, Buffett cautions that this relatively lousy results are a best case estimate, for in any given year, “it is possible for an insurer to show almost any profit number it wishes, particularly if it (1) writes “long-tail” business (coverage where current costs can be only estimated, because claim payments are long delayed), (2) has been adequately reserved in the past, or (3) is growing very rapidly.”

Looking over his competitors’ results, Buffett’s nose has caught some unpleasant whiffs, noting that “several large insurers opted in 1982 for obscure accounting and reserving maneuvers that masked significant deterioration in their underlying businesses.” Herein lies the wisdom—“In insurance, as elsewhere, the reaction of weak managements to weak operations is often weak accounting. (It’s difficult for an empty sack to stand upright.)”

The root of this temptation lies in the fact that insurance is a commodity business; its service amounts to a promise, and most purchasers take every insurer’s word to be that of the saint. Even worse, in insurance, barriers to entry are few; anyone with sufficient regulatory capital and a John Hancock can make a promise. Insurance then, unlike other commodity businesses, almost always operates “under the competitive sword of substantial overcapacity.” Only in those rare cases where there is a natural or financial megadisaster does capacity retreat; and until such an event, Buffett forecasts that the insurance industry will not be profitable.

Lastly, Buffett concludes with some reflections on issuing equity for acquisitions. Their golden rule is that they will not issue shares unless they receive as much intrinsic business value as they give. Of course, stated so simply, no rational business manager should reject it; but in practice, very many do, using a variety of odd rationalizations and linguistic high jinks.

To help the manager apply the golden rule, Buffett recommends thinking about one’s own stock as a currency. Every time that a business issues shares for an acquisition, it has to honestly ask whether it would be willing to sell its whole business for its implied worth. In other words, if I value my business at X, I should not use its shares as currency for any purchase that values those shares at less than X. As Buffett notes, “A cumulation of small managerial stupidities will produce a major stupidity – not a major triumph. (Las Vegas has been built upon the wealth transfers that occur when people engage in seemingly-small disadvantageous capital transactions.)”

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

Pricing Power and Economic Moats

seescandieslogoWhat products do you use that you would be willing to pay double the current price? Food and energy, being necessities, would be likely candidates. Of course, doubled prices would likely change your consumption habits. How about discretionary items? Books, news subscriptions, your iPhone?

Yesterday we observed Warren Buffett describing the importance of investing in businesses that could raise their prices “rather easily without fear of significant loss of either market share or unit volume.” In 1981, consistently raising prices was a necessity for business survival, with the consumer price index increasing at 10% annually. For Buffett, inflation was a giant corporate tapeworm, which “preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.” In many ways, highly competitive environments often treat a business in the same way; as the competition spends capital to update its stores, you have to spend just as much to maintain your market share.

Excellent businesses then—those with wide economic moats—are able to survive difficult macroeconomic environments because their products carry pricing power. For Buffett, See’s Candies and Coca Cola wield this power; for See’s, Buffett has unfailingly increased prices on the day after Christmas.

These days, newspapers, magazines, and periodicals—faced with declining advertising revenues—are considering price increases. As The New York Times recently reported, the average Time subscriber only paid 58 cents per issue, and Newsweek readers paid 47 cents. True to its moniker, The Economist raised its price per issue to $6.99 last year, all while seeing its subscriptions rise 60% since 2004.

At our house over the last few months, we have been surprised to find—instead of subscription notices—cancellation notices from publishers. With declining advertising revenues, these periodicals were forced to close their doors for good. And I recall thinking—why didn’t they raise their prices? Because I would have easily paid twice what I had been.

For many goods and services, tight economic times trigger the tightening of budgets. However, even during such times, the most desired goods and services will still command a premium and increasing price. For the investor, these are the wide moat businesses that should find a home in one’s portfolio, at an attractive price.

So, is The Economist for sale?

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway.