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.

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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.]