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.”