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.”

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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.

Buffett’s Berkshire Letter for 1983

1983 saw Israel, Lebanon, and the United States sign an agreement that called for Israel’s withdrawal from Lebanon. In Japan, the Nintendo Entertainment System hit the market for the first time. Bjorn Borg won his fifth straight Wimbledon title and announced his retirement. And in the world of crime, 6800 gold bars, worth 26 million British Pounds, were heisted from the Brinks Mat vault at Heathrow Airport. In the equity markets, the S&P 500 entered the year near 140, made a steady march higher until June, and then plateaued, to finish the year near 165.

Over at Berkshire, their book value increased from $737.43 per share to $975.83 per share, or by 32%. As Buffett observed last year, his favored metric for business assessment—return on shareholder equity—has become less useful for evaluating Berkshire now that the undistributed earnings of its common stock holdings have grown so large.

However, Buffett is quick to caution that Berkshire’s book value far understates its intrinsic business value, and it is the latter measurement that really counts. Whereas book value “is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings,” intrinsic business value “is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.” Though book value can serve as a shorthand proxy for economic value, better for the aspiring analyst to dig more deeply and discern Berkshire’s intrinsic value.

More than his past letters, Buffett reflects at length on the business moats that Berkshire’s subsidiaries currently enjoy. Over at the newly-acquired Nebraska Furniture Mart, their moat derives primarily from being the lowest cost provider—by far—and then passing on those savings to its customers. To keep costs lean is no small feat, and Buffett highlights, in particular, the purchasing acumen of Mrs. B and her son, Louie Blumkin, who is “widely regarded as the shrewdest buyer of furniture and appliances in the country.” As Buffett quips, “I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.”

Over at Buffalo Evening News, business has finally blossomed. With its primary competitor gone, Buffalo is now a one-paper town, and fully enjoying the pricing power that such dominance commands. Even better, Buffalo Evening News commands more readers than most one-paper towns, and Buffett takes note, for “a paper’s penetration ratio [we believe] to be the best measure of the strength of its franchise. Papers with unusually high penetration in the geographical area that is of prime interest to major local retailers, and with relatively little circulation elsewhere, are exceptionally efficient buys for those retailers.” Lastly, Buffalo Evening News’ protective moat draws width from its superior news product. In 1983, the News’ “news hole” (i.e., its editorial material, not ads) “amounted to 50% of the newspaper’s content… Among papers that dominate their markets and that are of comparable or larger size, we know of only one whose news hole percentage exceeds that of the News.”

Berkshire’s third featured wide moat business is See’s Candies. Despite stagnant volume growth over the last five years (1979-1983), See’s has grown its sales over 50%, and more than doubled its operating profits, largely by pushing through consistent annual price increases. Though some of the volume stagnation may derive from See’s relatively high prices, See’s commands ample pricing power because its candy “is preferred by an enormous margin to that of any competitor. In fact, [Berkshire] believe[s] most lovers of chocolate prefer it to candy costing two or three times as much.” An excellent product, made with the highest quality ingredients, and delivered by cheerful, helpful personnel, is about as close to a successful retail formula that one will ever find coming from Buffett.

All told, Buffett’s descriptions of his best businesses’ economic moats may seem rather elementary. However, there is good reason to believe that simplicity here is the key to their sustained success. For many businesses, daily operations prolifically produce new and unforeseen problems, and managers’ minds must be constantly vigilant and rational to dispense solutions and move to the next. Without relatively simple competitive advantages, the plethora of daily problems may overwhelm attentions and distract focus. What the successful business needs is a singular principle to refocus their energies. For Nebraska Furniture Mart, that principle is to always buy merchandise more smartly than competitors. For Buffalo Evening News, their principle is maximizing the size of the news hole with competitive costs. At See’s, it is providing a premium product with pleasant service. In each case, the advantage seems so simple that it should be easily stolen. But when attacking a business with a wide moat, merely having the key is not enough to breech the castle.

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

Warren the Impulsive?

In the summer of 1983, Warren Buffett sauntered into Nebraska Furniture Mart, then Omaha’s privately-owned, market-trouncing behemoth run by Rose Blumkin and her family. After a look around, Buffett asked “Mrs. B” to sell him the place. Mrs. B said sure, for sixty million. Buffett shook her hand, and the deal was sealed.

A familiar story for Buffetteers it is. And told so, it affirms the mystique associated with Buffett’s decisiveness. As he himself has relayed in his annual letters, business owners looking to sell can usually receive an answer from Buffett within five minutes.

Yet, as with most good yarns, the real history rarely runs that way. In the case of Nebraska Furniture Mart, Buffett had been stalking the furniture giant for quite some time, having even made an offer much earlier in his career, which Mrs. B deemed “too cheap.” As Roger Lowenstein recounts in his Buffett: The Making of an American Capitalist (Random House: 1995), Warren had expressed his lust for the Mart to business writer “Adam Smith” in the early seventies, spouting off its operating statistics—volume, floor space, turnover, etc. And this for a private company.

Before that happy day in 1983 (Buffett’s birthday, in fact), Buffett had heard that Mrs. B was entertaining a $90 million offer from a German furniture retailer. Prior to his offer, Buffett had studied the Furniture Mart’s tax returns and found that it had earned $15 million pre-tax in years previous. Buffett had met with her son Louie and discerned the price point that Mrs. B had in mind. He knew that the Mart’s $100 million in sales commanded two-thirds of Omaha’s furniture sales, and its moat so wide that Dillard’s refused to sell furniture in Omaha. Mrs. B “had a toll bridge to the living rooms of Omaha” (Lowenstein 250).

I’ll admit—the familiar story tells better than the truth. But the truth will better serve the fellow investor. Decisive action may give the appearance of reckless impulse, but in the case of Buffett, it is merely a convenient façade that covers detailed preparation and measured calculation.

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