Buffett’s Berkshire Letter for 1984

1984 was a temperate year for the market indexers; after the S&P 500 opened the year near 165, it slipped through spring and early summer to bottom near 150 in July, only to rebound and close the year again near 165.

Over at Berkshire, net worth increased by $152.6 million, or $133 per share, which represented a gain of 13.6% on Berkshire’s 1984 book value of $1108.77. A “mediocre” performance, says Chairman Buffett.

All told, Buffett the teacher showed up with his lecture notes in 1984, and the business summary he provides gives the clearest insight yet into the way his mind understands and values businesses. If I had to recommend one letter that characterized his approach, this would be it.

Buffett opens by describing his approach to share repurchases; in short, “when companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.” Of course, outstanding businesses rarely sell below their intrinsic value, and Buffett would not encourage buybacks at any share price.  And 1984 saw some dear prices paid.

You see, in the Eighties, relatively cheap debt put companies under siege from “greenmailers,” who would buy large stakes in vulnerable companies and demand that their shares be repurchased by management if they wanted to keep their jobs without a risky fight. One of the best known greenmailers was T. Boone Pickens, who made stabs at Cities Service Company, Newmont Mining, and Diamond Shamrock, before getting his cash.

Regarding these hostile takeover “attempts,” Buffett minces no words, finding the greenmail share repurchase “odious and repugnant.” It is a “mugging,” in which entrenched management offers up its owners’ wallet to pacify the coercive extortionist. Management emerges unharmed, the mugger gets a fat payday, and the innocent shareholder “mutely funds the payoff.” An extreme counterexample to be sure, but illustrative of Buffett’s approach—only buyback shares when the price is right.

Though Buffett admits that general levels in the stock market make it difficult to find stocks that meet his quantitative and qualitative standards, business is excellent at Nebraska Furniture Mart (NFM). Compared to its reasonably efficient competitor Levitz, NFM’s operating expenses (payroll, occupancy, advertising, etc.) are about 16.5% of sales versus 35.6% at Levitz. These savings enable NFM to consistently widen its economic moat, by passing some savings on to customers and expanding its geographical reach far beyond the Omaha market.

How is this astounding efficiency possible? “All members of the family: (1) apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts; (2) define with extraordinary realism their area of special competence and act decisively on all matters within it; (3) ignore even the most enticing propositions failing outside of that area of special competence; and, (4) unfailingly behave in a high-grade manner with everyone they deal with.” Enthuasism, self-analysis, prudence, decision, ethics—certainly not a bad list of business virtues, if you have the visible exemplars that embody them.

Over at the Buffalo Evening News, profits were greater than expected. Though management deserves praise, moreso does the industry, for “the economics of a dominant newspaper are excellent, among the very best in the business world.” Misplaced vanity may encourage “owners… to believe that their wonderful profitability is achieved only because they unfailingly turn out a wonderful product.” However, third-rate papers produce the same or better profits, as long as it is dominant in its community. When a paper reaches the homes of a desired geographical area, advertisers will pay for access, and if that access is a monopoly, the capitalist’s prices are wonderfully high. Even a poor newspaper commands attention because of its “bulletin board value,” and so it remains “essential” for most citizens, and by extension, most advertisers.

Lastly, in 1984, Buffett give his shareholders a golden key to business valuation.  Discussing Berkshire’s purchase of $139 million Washington Public Power Supply Service (WPPSS) bonds, Buffett reveals that his approach for analyzing bond investments does not differ from that for equities. For example, he asks us to imagine the WPPSS bonds as a $139 million investment in an operating business, which earns $22.7 million after tax (i.e., the interest paid on the bonds), and whose earnings are annually available to us in cash. Would you invest in that business? Intuition suggests to follow the master, and you would be right, as Buffett observes that “we are unable to buy operating businesses with economics close to these. Only a relatively few businesses earn the 16.3% after tax on unleveraged capital that our WPPSS investment does and those businesses, when available for purchase, sell at large premiums to that capital. In the average negotiated business transaction, unleveraged corporate earnings of $22.7 million after-tax (equivalent to about $45 million pre-tax) might command a price of $250 – $300 million (or sometimes far more).”

So what’s Buffett’s “fair value” earnings multiple? Basically 11-13 times unlevered earnings, or 6x EBITDA. Here Buffett’s purchase of the WPPSS equates to buying an unlevered equity trading at 6x earnings. And so Buffett showed up with his largest truck.

Buffett acknowledges that such an approach to bond investing may be “unusual” and perhaps “a bit quirky.” However, this rule of thumb would have saved the “staggering errors” made by the bond purchasers of 1946, who bought 20-year AAA tax-exempt bonds trading at slightly below a 1% yield. Using Buffett’s framework, the buyer, in effect, “bought a ‘business’ that earned about 1% on ‘book value’… and paid 100 cents on the dollar for that abominable business.”

All told, I have left too much of 1984’s letter aside. Buffett also briefly discusses inflation, retaining cash in a business, and reserving in Berkshire’s insurance units. Also, he offers an analysis of See’s Candies and their insurance subsidiaries. If you’re in the mood for some thick, rich business analysis with a Midwestern wit, it’s the letter I most highly recommend.

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

Where have the Buybacks Gone?

A stock represents an ownership stake in a business. But why should that stake ever be worth anything? In the worst cases, imprudent management funnels future earnings back into unprofitable endeavors and overpriced acquisitions, and your stake could become worthless. In the best cases, prudent management deploys capital where it can provide productive returns—either by growing the business organically, making acquisitions, paying dividends, or repurchasing its outstanding stock.

In recessionary periods, attempts to grow a business organically often do not meet with immediate success. However, if a recession depresses the market value of your business, buying back temporarily cheap shares becomes an interesting—albeit fleeting—opportunity. The sharp market declines in the fourth quarter of 2008 created one such opportunity. Yet, as a S&P report recently revealed, members of its S&P 500 spent $48.1 billion in stock repurchases in the fourth quarter, a 66% decline from the $141.7 billion spent during the fourth quarter of 2007. This, despite the fact that cash levels stand at record highs.

So why the pause? Howard Silverblatt, Senior Index Analyst at Standard and Poor’s, attributes the cash conservation to uncertainty about future cash flows. And for a company like Alcoa, such uncertainty seems warranted, for the company recently came to the market with an equity offering at $5.25 per share. This, after spending 2007 buying back the same shares near $40.

These billion dollar mistakes should not be taken lightly. Of course, saying it sounds obvious, but little outrage seems present within Alcoa’s shareholder ranks. If such mistakes are repeated consistently enough, the shareholder will find herself left with a piece of paper destined for the toilet.

And so today’s recessionary times illustrate what may be the most important component of a business’ economic moat—rational capital management. When management directs capital to its most productive endeavors, one finds stagnant textile mills blossoming into global insurance empires. Yet, for most business managers, this discipline seems so rare that a Randian would be tempted to call it heroic; even wide moat businesses like Moody’s, with its long history of stock buybacks, seem to lose their best habits in uncertain times.

If only a select few can manage capital well in uncertain times, the investor must use these times to scout for demonstrations of rational management. As the S&P report shows, Exxon led the way in the fourth quarter, followed by Microsoft and Oracle; included also are such stalmarts as GIS, JNJ, PG, PM, and PEP.

To become a stock owner of a great business does not guarantee investing success; nor does buying a great business at a bargain price. No, investing success requires owning great businesses purchased at good prices whose capital consistently finds its highest and best use, especially in times of economic uncertainty.

Disclosure: No Position.