[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.