Buffett’s Berkshire letter for 1977

[Today we start a recurring series that will progress through some of Buffett’s Berkshire letters, gleaning what wisdom we can.]

1977 was the first year that saw the President Jimmy Carter, an immature Luke Skywalker, and a small start-up by the name of Apple Computer Inc. The S&P 500 spent the year oscillating within ten percentage points of 100.

For Berkshire, 1976 brought earnings of $16.07 million and a return on equity of 17.3%. 1977 proved even better, with earnings of $21.9 million and a return on equity of 19% (equity capital had increased 24% YOY). Record earnings, but that was not the chosen headline.

Buffett, teacher as he is, reminds us that record earnings, in themselves, should not please shareholders, for if earnings increase 5% YOY at the same time that equity capital has increased 10% YOY, the business has actually used owners’ capital less efficiently than the previous year. Anyone can return more with more, but for Buffett and the business owner, optimal management should return the most with the least—that is, provide the best return on equity.*

However, a few paragraphs later, Buffett admits that Berkshire will not always pursue optimal returns, particularly if that means dispensing with the textile workers in New Bedford and Manchester. You see, by 1977, it was clear to Buffett and observers that Berkshire’s textile operations were not capable of producing the same returns on equity that its other businesses could. Despite this realization, Buffett was still willing to retain some capital for investment in textiles. Why? First, “our mills in both New Bedford and Manchester are among the largest employers in each town, utilizing a labor force of high average age possessing relatively non-transferable skills. Our workers and unions have exhibited unusual understanding and effort in cooperating with management to achieve a cost structure and product mix which might allow us to maintain a viable operation.” And second, “management also has been energetic and straightforward in its approach to our textile problems.”

In spite of Buffett’s reputation as a capitalist, examples like this remind the investor that a myopic concentration on ROE is not a prerequisite for investing success. Pushing capital around is a wholly human endeavor, with its attendant harms and benefits. And some of the harms Buffett was unwilling to accept, at least in the short term.

Of course, Buffett made this decision with eyes wide open, and he concludes that in the textile business “even very good management probably can average only modest results. One of the lessons your management has learned—and, unfortunately, sometimes re-learned—is the importance of being in businesses where tailwinds prevail rather than headwinds.” Although Buffett does not prudently and hastily cast textiles aside, he cautions others against similar mistakes.

Finally, in this letter, Buffett offers some insight into the insurance business, concluding–most simply—that it does not have an economic moat. As he writes, “Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition.” In such businesses—where competitive products fail to differentiate—the only durable moat is offering the lowest price. Mr. Buffett, may I introduce you to Geico?

* Buffett acknowledges that equity on capital is best “except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values).” David Einhorn has made a similar point, which we observed here.

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

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‘Fooling Some of the People All of the Time’ Review

Over the last couple of days, I’ve buzzed through David Einhorn’s Fooling Some of the People All of the Time (Wiley, 2008), which describes Einhorn’s six year saga shorting Allied Capital. As Joel Greenblatt tells it in the foreword, this was a saga in which the good guys were dragged through the mud and the bad guys carted off millions. At least for a while.

The story begins with a bang in May of 2002 when David Einhorn, then a relatively unknown hedge fund manager, gives a speech at the Tomorrows Children’s Fund charity event in which he lays out his case for shorting Allied Capital. Word of the speech races from the event, and the next morning, Allied opens at $21, a 20% drop. As Einhorn recalls, “I did not for even a minute consider covering any of our short.” (55)

Of course, one can quickly look at the ticker to see how the story ends. But in between lay six years’ worth of accusations, name-calling, “pretexting,” and criminal charges, all from the ultimate loser’s side. Along the way, the reader sees into the state of regulatory oversight, contemporary business ethics, and corporate America. It is an interesting and highly detailed narrative that I would recommend to anyone interested in today’s equity markets.

Particularly interesting was Einhorn’s account of starting his Greenlight hedge fund with $900,000, over half of which came from his parents’ pockets. Even with an abundant contact list, he and his partner “soon realized that almost no one would invest with a couple of twenty-seven-year-olds with no track record.” (19) Yet, his early returns made up for his perceived inexperience, netting partners 3.1% in May of 1996, 6.9% in June, and 4.8% in July. After getting their first million dollar partner that August, money rapidly found its way to their door.

Most useful was Einhorn’s brief descriptions of his earliest investments. Successful investors (particularly Buffett) are often asked where they would be investing with a small, million dollar portfolio, and here Einhorn gives a glimpse into the opportunities that these inquiring investors most covet. In 1997, Greenlight pushed money into insurance company demutualizations, spin-offs, Pinnacle Systems, and some short sales, like Boston Chicken and Samsonite. Boston Chicken bombed because its accounting practices “enabled it to recognize up-front revenue and profit when franchisees opened restaurants. Boston Chicken financed the openings and up-front fees and earned interest on loans to the franchisees. The underlying restaurants were not profitable enough to support the payments to the parent.” (25) In 1998, Greenlight’s short target was Computer Learning Centers, a for-profit education company; in 1999, Seitel, which had a multi-client library of seismic data used to find hydrocarbons.

All told, I thoroughly enjoyed it, and I was reminded what good research really looks like.

David Einhorn and Return on Equity

Here at Wide Moat Investing our primary task is to pinpoint the characteristics that separate good businesses from the great. So far, we’ve highlighted some qualitative characteristics that may not yield well to quantitative assessment (e.g., Coke has no “taste memory” and appeals to a basic, enduring preference). Yet, many investors begin their search for great businesses by using a handful of quantitative metrics. Margins are often important, for as we observed in our analyses of eBay and Microsoft, high gross margins may signal a business with significant competitive advantages.

Another important quantitative metric for many investors is return on equity (ROE).  For example, Francis Chou looks for excellent companies with a 15% ROE sustained over 10 years or more.*

David Einhorn, President of Greenlight Capital and hedge fund manager, addressed the topic of ROE in his November 2006 talk at the Value Investing Congress. There Einhorn argued that ROE is only a meaningful metric for capital-intensive businesses—like traditional manufacturing companies, distribution companies, most financial institutions, and retailers (4). For businesses that are not capital intensive—whose profits derive primarily from intellectual capital or human resources (e.g., pharmaceutical companies, software companies, etc.)—it is “irrelevant to worry about ROE” (4). Why? Because businesses that are not capital intensive do not generate substantial returns from retained earnings or capital expenditures. For example, if you are an insurance agent, you will bring in much more business and profit by getting on the phone and meeting more potential clients, rather than tripling your office space, or adding that new water feature to the atrium, or buying that highly efficient “document station.” In short, it’s not the “equity” which provides the retums, but the people, the brand, or the proprietary product—things which don’t show up on the balance sheet. ROE then is insignificant. For the most part.

You see, Einhorn observes, and experience confirms, that most non capital intensive businesses have an irresistible urge to direct excess returns back into the business that doesn’t need them, or to acquire businesses that do (i.e., capital-intensive businesses). And so the investment bank, which generates fees upon fees, largely due to its personal relationships with clients and its perceived brand, starts to pour excess capital into lending, trading, hedging, and gambling. Seemingly all of a sudden you have that old investment bank now asking its government for tens of billions of dollars, and it intensely needs the capital!

For Einhorn, the best explanation for such capital (mis)allocations is that such businesses are being run for their employees rather than their shareholders, employees running them just well enough to achieve a respectable 15% ROE, and sure enough, the shareholders’ respect keeps coming.

All told, we find Einhorn quite perceptive on these points. And we find his distinction between capital-intensive businesses and the rest to be crucial. For those numerous investors who use ROE to filter the castles from the shacks, they may be missing valuable investing opportunities. The lesson for the castle lover is clear—while the signs of some moats lurk on the balance sheet, not all do. Quantitative metrics will not uncover them all.

*[In the original post, I said “Joel Greenblatt’s Magic Formula screens for companies with the highest ROE and lowest earnings multiples (i.e., P/E).”  This was sloppy writing.  Greenblatt’s Magic Formula screens for high returns on capital (EBIT/net working capital+fixed assets).  ROE can give misleading numbers for companies with high debt or cash levels.]