Norfolk Southern Capex

I spent some time today with Norfolk Southern’s recently filed 2013 10-k.  With a $28 billion market cap and 6.7% trailing after-tax earnings yield, it bears a striking resemblance to that former target of Mr. Buffett’s “elephant gun“.

Now suitably reloaded, it doesn’t require much imagination to see how elegantly the Norfolk lines would fit with Burlington’s.

Of course, one should not let the imagination linger too long, for regulators have effectively preempted such a union, noting in 2001, that any future merger between Class 1 railroads would “bear a heavier burden to show that a major rail combination is consistent with the public interest.” (546)   Most simply, the STB merger policy “disfavors mergers that reduce competitive options for shippers absent substantial overriding public benefits.” (550)

So let us assume then that Mr. Buffett’s elephant gun is safely stowed.  The question remains–should we take aim, particularly since Mr. Buffett might be similarly inclined, but cannot?  After all, imitating or “cloning” has served many investors well.

Norfolk’s financial performance over the last three years has been strikingly consistent–revenue ton miles between $186 and $194 billion, freight train miles between 74.8 and 76.3 million, and revenue per ton mile between $0.0581 and $0.0595. (K5)  Those loads were good enough to produce $3.1-3.2 billion in net cash from operating activities in each of the last three years. (K46)

And where did the money go?  2011 saw $2.16 billion in capex, $576 million in dividends, and $2.05 billion spent repurchasing stock (extra debt was raised that year to fund the excess).  2012 saw $2.24B in capex, $624MM in dividends, and $1.29B spent on stock (again, extra debt was raised).  2013 saw $1.97 billion in capex, $637MM in dividends, and $627MM spent on stock.

So I guess that you can see the theme.  Norfolk’s business gushes cash at a remarkably consistent rate, but every year, nearly two-thirds of that cash is just as consistently reinvested in capex (i.e., track, railroad ties, locomotives, freight cars, etc.).  In itself, that fact is not necessarily bad, for reinvested cash may create opportunities for growth and productivity improvements in the future.  However, in the case of railroads (or at least, Norfolk), it just seems that desired future never arrives.

To be fair, cash flow from operations has grown at Norfolk over the last decade.  In 2004, cash flow from operations tallied $1.66 billion.  Recall that 2013 saw cash flow from operations of $3.08 billion.  So growth of $1.4B.  But to get there, Norfolk had to invest $13.32 billion over the last nine years, or roughly $1.5B every year.  So there was a return on all that capex, and not an indecent one.  After all, everyone knows that railroads are capital-intensive businesses, and a regulated “utility” of sorts.

Yet, it is a bit surprising to see free cash flow at Norfolk in 2005 at $1.08 billion, and to see it at $1.11B in 2013.  After all, it almost sounds like a boast when I see Mr. Buffett write: “We are not, however, resting on our laurels: [Burlington Northern] will spend about $4 billion on the railroad in 2013, roughly double its depreciation charge and more than any railroad has spent in a single year.” (2012 Letter to Shareholders)

Perhaps tomorrow will shine brighter on the railroads than today.  Then at last, the seeds of yesterday’s capex will fully blossom.  Until then, count me as too impatient or unimaginative, or worse.

Disclosure: I own shares of Berkshire Hathaway.

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MFC Industrial and IAT Reinsurance Settle

In the Friday evening news dump, there were some interesting tidbits, including, and with no particular relation to one another, a mine safety disclosure from Berkshire Hathaway, and a settlement agreement between MFC Industrial and IAT Reinsurance.

Peter Kellogg of IAT (who controls 33% of MFC’s shares) was ultimately elected to MFC’s Board after an interesting proxy fight this past December.  Friday’s settlement indicates that the MFC Board size will now increase from five to seven:

“On or prior to the date hereof, the Board has passed a resolution fixing the number of directors of the Company at seven (7), subject to the filing of the Notices of Dismissal of All Claims With Prejudice pursuant to Sections 8(a) and 8(b) hereof. The Company covenants that during the Term, the number of directors of the Company shall not be increased from seven directors unless such increase is approved by at least 6 of the 7 directors of the Company. The vacancy on the Board resulting from the increase in the number of directors of the Company to seven shall be filled within one hundred and twenty (120) days from the date hereof by a person who is qualified to act as a director of the Company and who is selected and approved by mutual written agreement of the Company and IAT.”

Mutual agreement on two names?  Mark me intrigued.

Disclosure: I own shares of Berkshire Hathaway and MFC Industrial.

Berkshire Buys Lubrizol

So Berkshire has announced its latest acquisition—Lubrizol (LZ).

In its latest 10-K, Lubrizol describes its primary business—lubricant additives (primarily for engine and driveline lubricants):

“We believe we are the market leader in lubricant additives, and we intend to remain the leader by continuing to invest in this business. Our Lubrizol Additives segment’s growth strategy is to continue to optimize our product mix while closely aligning production capacity with product demand. Challenging market forces and conditions continue to influence the Lubrizol Additives segment. A key factor is the low long-term global growth rate for this market, which we believe is in the range of approximately 1% to 2% per year.”

Pre-tax operating income in 2010 was $1B, on $5.4B in revenues—both records for the company. At an estimated purchase price of $9.7B (which assumes $0.7 net long-term debt), Berkshire is paying 10x pre-tax OI. And almost 4x shareholder equity.

Lubrizol’s gross profit percentage for 2010 was 33.1%, which also appears to be an all-time high. (2008 marked the five year low, at 22.3%; 2006 saw 24.6%.)

Lubrizol has earned very good returns on shareholder capital (excluding special items) in recent years. Its average return on shareholder equity for 2010 was 34.4%, also an all-time high.

I will not extend the theme, but the drift is clear: this purchase price is not a bargain for Berkshire, given Lubrizol’s results over the last five years. Any margin of safety then must lie solely in expected (and highly likely, one would presume) future performance. At minimum, I would think, Berkshire must expect revenues and margins to remain close to their 2010 performance, for at least the majority of the next decade.

Berkshire was not willing to offer LZ shareholders the option of Berkshire stock (as in the Burlington deal), so that should indicate Buffett’s thoughts on each’s relative value.

Longer term, LZ’s future revenues and earnings may face risks—if, e.g., 1) improved engine design increases drain intervals, 2) new vehicle purchases slow and stagnant, or 3) input costs (particularly petroleum) increase faster than expected.

Clearly, I’m missing some important piece of this puzzle.

Disclosure: I hold shares of Berkshire Hathaway.

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 1992

In 1992, the United States watched its most successful third party candidate since Teddy Roosevelt garner nearly 20 million votes, or 18.9% of those cast. Bloomington, MN became home to an American temple, with its gargantuan coffers poised to receive the tribute of her mallrats. Over in the stock market, the somnolent S&P 500 opened the year near 417, made a few attempts to rise, but ultimately closed the year near 435.

Over at Berkshire, book value per value increased 20.3%, to $7745. Since Warren and Charlie took up textiles, book value has grown from $19 to $7,745, or at a rate of 23.6% compounded annually. Look through earnings came in at $604 million. Despite all of Warren’s warnings, Berkshire’s performance has consistently been able to outpace his stated goal—to grow intrinsic value at 15% per annum.*

On Acquisitions

In this year’s letter, Buffett bears all, as he discloses his most exhiliarating activity at Berkshire—“the acquisition of a business with excellent economic characteristics and a management that we like, trust and admire.” And Buffett knows he is not alone, for “in the past, [he’s] observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess. Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations. Initially, disappointing results only deepen their desire to round up new toads.”

What sets Buffett apart from other spirited suitors is his patience. And 1992 saw his patience rewarded, purchasing 82% of Central States Indemnity, “an insurer that makes monthly payments for credit-card holders who are unable themselves to pay because they have become disabled or unemployed.” A family owned business, Central States is based in Omaha and has annual premiums are about $90 million and profits about $10 million.

On Insurance

By 1992, the Berkshire shareholder is surely accustomed to hearing the Chairman warn that future returns will lag those of the past, primarily because its swelling capital base demands larger businesses to produce significant investment returns. In order to grow “look-through” earnings by 15%, or $100 million, Berkshire would likely have to lay out at least a billion. Yet, the amount of excellent businesses that could absorb such an investment is relatively small.

One viable candidate though is super-catastrophe insurance. Looking ahead, Buffett can see that Berkshire’s future earnings growth will increasingly depend on its insurance businesses, and as usual, he wants its shareholders to calibrate appropriate expectations beforehand. In short, super-cat insurance—though likely profitable over the long term—may produce abysmal results for any single year. Pricing in particular is difficult to determine, for “catastrophe insurers can’t simply extrapolate past experience. If there is truly “global warming,” for example, the odds [for potential losses] would shift, since tiny changes in atmospheric conditions can produce momentous changes in weather patterns.” Even worse, occasionally, the unthinkable happens. “Who would have guessed, for example, that a major earthquake could occur in Charleston, S.C.? (It struck in 1886, registered an estimated 6.6 on the Richter scale, and caused 60 deaths.) And who could have imagined that our country’s most serious quake would occur at New Madrid, Missouri, which suffered an estimated 8.7 shocker in 1812.”

“Furthermore, in recent years there has been a mushrooming of population and insured values in U.S. coastal areas that are particularly vulnerable to hurricanes, the number one creator of super-cats. A hurricane that caused x dollars of damage 20 years ago could easily cost 10x now.”

Pricing for the unexpected and adjusting for lifestyle changes represent two prongs of Berkshire’s strategy. The last—conservative accounting. “Rather than recording our super-cat premiums on a pro-rata basis over the life of a given policy, we defer recognition of revenue until a loss occurs or until the policy expires… because the likelihood of super-cats causing us losses is particularly great toward the end of the year. It is then that weather tends to kick up: Of the ten largest insured losses in U.S. history, nine occurred in the last half of the year. In addition, policies that are not triggered by a first event are unlikely, by their very terms, to cause us losses until late in the year.”

“The bottom-line effect of our accounting procedure for super-cats is this: Large losses may be reported in any quarter of the year, but significant profits will only be reported in the fourth quarter.”

On Buying General Dynamics

Of course, all the work in writing reinsurance could be for naught if the capital it provides were not profitably deployed. In common stocks, Berkshire acquired a large new position in General Dynamics. Initially Buffett purchased the shares to take advantage of an arbitrage opportunity (General Dynamics was repurchasing 30% of its shares via a Dutch tender), but the more he uncovered about the business and the CEO Bill Anders, the more impressed he was: “Bill had a clearly articulated and rational strategy; he had been focused and imbued with a sense of urgency in carrying it out; and the results were truly remarkable.”

So Buffett dropped the thoughts of arbitrage and “decided that Berkshire should become a long-term investor with Bill. We were helped in gaining a large position by the fact that a tender greatly swells the volume of trading in a stock. In a one-month period, we were able to purchase 14% of the General Dynamics shares that remained outstanding after the tender was completed.” [NB–In less than two years, Mr. Market re-appraised Berkshire’s stake at more than four times its 1992 price.]

On Buying Growth or Value

As always, Buffett uses his annual letter as a lectern to dispense his investing lesson for the day. And 1992 saw him distill wisdom from contemporary financial jargon. To both his fellow investment professionals who pursue “value” stocks, and those seeking “growth,” Buffett notes that John Burr Williams, some 50 years ago, set forth the proper equation of value, as “the value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” Stated so, it is clear that investing—no matter one’s emphasis—will be most successful insofar as one can determine future cash flows and the remaining life of a given asset.

Growth “is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” And what is investing except the seeking of value sufficient to justify the price paid? “Value investing” then is redundant.

Yet, “whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.”

The investor then should not settle comfortably in this jargon, for growth projections can soar to the moon, and discounted assets can still be priced too dear. Focus on cash flows, while keeping in mind, that “the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.”

On Health Care Liabilities

Even among smart and hard-working stock analysts, one can find negligent disregard for off-balance sheet liabilities—pensions, health care benefits, SIVs, etc. One only needs to look to today’s Washington to see the difficulties of reserving money for tomorrow’s health care.

Thinking as an insurer, Buffett notes that “no CEO would have dreamed of going to his board with the proposition that his company become an insurer of uncapped post-retirement health benefits that other corporations chose to install. A CEO didn’t need to be a medical expert to know that lengthening life expectancies and soaring health costs would guarantee an insurer a financial battering from such a business.” Given the rate and cost of health care innovations, population demographics, and the United States’ love for perceptions of egalitarianism, it is indubitable that health care costs relative to GDP will be much higher than they are today. To insure against this eventuality would require more chutzpah than any insurer would care to muster.

Yet, “many a manager blithely committed his own company to a self-insurance plan embodying precisely the same promises – and thereby doomed his shareholders to suffer the inevitable consequences. In health-care, open-ended promises have created open-ended liabilities that in a few cases loom so large as to threaten the global competitiveness of major American industries.”

And Buffett is not afraid to place blame, for “the reason for this reckless behavior was that accounting rules did not, for so long, require the booking of post-retirement health costs as they were incurred. Instead, the rules allowed cash-basis accounting, which vastly understated the liabilities that were building up. In effect, the attitude of both managements and their accountants toward these liabilities was “out-of-sight, out-of-mind.”

“Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles: “How many legs does a dog have if you call his tail a leg?” The answer: “Four, because calling a tail a leg does not make it a leg.” It behooves managers to remember that Abe’s right even if an auditor is willing to certify that the tail is a leg.”

Conclusion

All told, 1992 was a year with much to say. Beyond these lessons, Buffett highlights the advantages of purchasing securities in the secondary market (rather than initial offerings), the lack of correlation between high corporate overhead and business performance, and the true cost of stock options. And last but not least, learn from Mr. Buffett’s mistake; be not too incautious with your 89 year old employees. Some, like Mrs. B., just may rekindle the fire to compete. At 99, Buffett finally got her signature on a non-compete.

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

* Of course, growth in book value and intrinsic value often diverge significantly, and in extreme cases, show no correlation. In assessing Buffett’s performance in 1992, we feel comfortable taking him at his word: that Berkshire’s book value is a useful, albeit conservative, proxy for valuing the business.

[In more recent years, this same assessment would look increasingly foolish, as one of the largest components of Berkshire’s intrinsic value today is the value of its insurance float, which has grown significantly, relative to Berkshire’s book value, since 1992. In 1992, Berkshire had 2.3 billion in float vs. about 7.5 billion in equity; in 2008, it was 58 billion in float vs. 109 billion.]

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 Berkshire Letter for 1990

1990 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.]

Buffett’s Berkshire Letter for 1989

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.]

Buffett’s Berkshire Letter for 1988

1988 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.”

Buffett’s Berkshire Letter for 1987

1987 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.