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.]

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Buffett’s Berkshire Letter for 1986

1986 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.]

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 Berkshire, “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.

Buffett’s Berkshire Letter for 1980

1980 saw an actor nominated for the Presidency of the United States. Children and adults, flocking to video arcade games, became seduced for the first time by Pac-Man. Art lost a lyricist outside The Dakota building in New York City. And the S&P 500 Index finally lurches free from its range-bound antics around 100, finishing the year over 135.

Over at Berkshire, “operating earnings improved to $41.9 million in 1980 from $36.0 million in 1979, but return on beginning equity capital (with securities valued at cost) fell to 17.8% from 18.6%.” Yet, Buffett quickly notes that accounting practices far understate Berkshire’s share of its common stocks’ earnings. For those businesses that Berkshire owns less than a 20% stake, only dividends show up on the earnings statement; since dividend payouts represent only a small fraction of their earnings power, much of Berkshire’s value as an owner doesn’t find its way onto its balance sheet. In fact, were Berkshire to sell all its equities and pour the proceeds into tax-free bonds, Berkshire’s reported earnings would nearly double, adding at least $30 million annually.

Nowhere is this discrepancy between reported earnings and “true” earnings more clear than GEICO. Berkshire’s stake cost them $47 million, but at GEICO’s current dividend rate, Berkshire only reported earnings from GEICO of a little over $3 million annually. But, given their ownership stake, Buffett estimates their share of GEICO’s earnings power to be “on the order of $20 million annually. Thus, undistributed earnings applicable to this holding alone may amount to 40% of total reported operating earnings of Berkshire.”

But shouldn’t Buffett want a greater share of GEICO’s earnings annually deposited into Berkshire’s coffers? Absolutely not. As Buffett observes, “we should emphasize that we feel as comfortable with GEICO management retaining an estimated $17 million of earnings applicable to our ownership as we would if that sum were in our own hands. In just the last two years GEICO, through repurchases of its own stock, has reduced the share equivalents it has outstanding from 34.2 million to 21.6 million, dramatically enhancing the interests of shareholders in a business that simply can’t be replicated. The owners could not have been better served.” Despite relatively difficult economic conditions, GEICO bought back more than a third of its shares. Compare that to others’ recent performance.

Much of Buffett’s remaining reflections cheerlead his various managers and eulogize his friend and banker Gene Abegg, past owner of Illinois National. At National Indemnity, business looks lighter with industry-wide premiums softer, but Buffett sounds content—“while volume was flat, underwriting margins relative to the industry were at an all-time high. We expect decreased volume from this operation in 1981. But its managers will hear no complaints from corporate headquarters, nor will employment or salaries suffer.”

Over in reinsurance, Buffett forecasts ominous clouds rising soon over the horizon. With “the magnetic lure of [reinsurance’s] cash-generating characteristics, currently enhanced by the presence of high interest rates… the reinsurance market [has transformed] into “amateur night”.”

All told, Buffett says little about competitive advantages at this, the dawn of the Eighties. Berkshire’s mills, a high capex and low margin business, has trimmed its workforce and idled some looms. Inflation, torturous demon of prudent capital allocation, slowly stripped Berkshire of some of its relative value as an investment vehicle. “In a world of 12% inflation a business earning 20% on equity (which very few manage consistently to do) and distributing it all to individuals in the 50% bracket is chewing up their real capital, not enhancing it.” For even the best businesses, with the best competitive advantages, consistently high inflation requires abundant managerial skill while at the same time crippling investors’ real returns.

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

On Buying Castles with Moats

Please permit me to state the obvious. In the last five months, the U.S. stock market averages have sustained a nearly unprecedented decline. Stocks are the cheapest—relative to GDP and trailing earnings—that they have been in more than a decade. And at least some stocks represent ownership shares in highly profitable, wide moat businesses that cater to basic, enduring customer preferences. Yet, as we’ve seen, Warren Buffett has been writing derivative contracts and cutting deals in bonds and preferred stock, rather than adding to his share of Coca Cola. But why?

The simplest and most plausible explanation is that Coca Cola is not yet cheap. Berkshire Hathaway has found Burlington Northern attractive at these prices, and Mid American did make a stab at Constellation Energy, but for the most part, the castles with the widest moats still seem too expensive, despite the market’s current 30-50% off sale.

If we read between the lines correctly, then I think that we see an important facet of buying castles. The most highly desired castles with the widest moats rarely go on sale. In fact, even if the general market declines, they are not necessarily cheap. To get a bargain on the best castles, one needs more than market pessimism–one needs insane, crazy, irrational behavior.

For example, in 1963, when Buffett took his stake in American Express, the business had been swindled out of $50 million in Tino De Angelis’ salad oil scandal. In 1976, Geico announced a loss of $126 million. As the expectations of bankruptcy grew, Buffett was buying.

The most desirable castles with the widest moats receive many covetous glances from an abundance of suitors every day. In today’s market, such castles are rarely cheap, even in a market of overwhelming pessimism. To get a bargain on a castle is no small feat.

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