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.]

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Rocky Mountain Chocolate Factory

Lately I’ve been sleuthing for rational capital management. Impressed by FortuNet’s cash distribution, disappointed by Moody’s stagnant buyback plan, and annoyed by KSW’s passivity, it is clear to me that rational management can be found in unlikely places, and that even the most virtuous can settle into vice (which in this case is sloth—sitting lazily on shareholders’ cash).

Reader Sam highlighted Rocky Mountain Chocolate Factory (RMCF)—a franchiser and confectionary manufacturer with 334 stores (as of 2/29/08)—as an interesting wide moat business whose current market price resembles what Warren Buffett paid for See’s Candies, on a number of important metrics. And a quick glance at the recent 10-Ks and Qs depicts a management who has a habit of returning excess cash to shareholders—via dividends and share repurchases. In fact, on its $5.64 share price (as of 4/22/08), RMCF offers a 10 cent quarterly dividend, bringing the stock’s yield to over 7%.

Though the share repurchases seem to have stopped since February 2008 (filings reveal no share repurchases from March 2008-November 2008), management was an aggressive purchaser in better times. And their 10-K reveals their record:

“between January 9, 2008 and February 8, 2008, the Company repurchased 391,600 shares at an average price of $11.94. Between August 15, 2007 and August 28, 2007, the Company repurchased 16,000 shares at an average price of $15.96 per share. Between March 1, 2007 and May 15, 2007 the Company repurchased 76,335 shares at an average price of $13.12 per share. Between May 1, 2006 and February 28, 2007 the Company repurchased 253,141 shares at an average price of $12.94 per share. Between March 24, 2006 and April 28, 2006 the Company repurchased 74,249 shares at an average price of $14.90 per share. Between October 7, 2005 and February 3, 2006 the Company repurchased 185,429 Company shares at an average price of $14.6 3 per share. Between April 18 and April 20, 2005, the Company repurchased 18,529 Company shares at an average price of $13.28 per share.”

All told, that amounts to over 1 million repurchased shares in a three year period, or about 14% of outstanding shares.

Over that same period, RMCF also paid out significant quarterly dividends. Combined with its share repurchases, shareholders basically saw 100% of RMCF’s FCF returned to them.  Perhaps shareholders should rename them the Rocky Mountain Cash Factory.  In fact, it would be hard to ask for much more as an owner; one would only wish that the school that teaches such value creation would open its enrollment to a few more students.

Perhaps in future posts, we’ll look more carefully at RMCF’s financials, and do a comparison with Buffett’s purchase of See’s Candies. But trading less than 9x FCF, and with a management that has demonstrated sound capital management, it certainly warrants that closer look.

Disclosure: I, or persons whose accounts I manage, own shares of Rocky Mountain Chocolate Factory at the time of this posting.

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.

Pricing Power and Economic Moats

What products do you use that you would be willing to pay double the current price? Food and energy, being necessities, would be likely candidates. Of course, doubled prices would likely change your consumption habits. How about discretionary items? Books, news subscriptions, your iPhone?

Yesterday we observed Warren Buffett describing the importance of investing in businesses that could raise their prices “rather easily without fear of significant loss of either market share or unit volume.” In 1981, consistently raising prices was a necessity for business survival, with the consumer price index increasing at 10% annually. For Buffett, inflation was a giant corporate tapeworm, which “preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.” In many ways, highly competitive environments often treat a business in the same way; as the competition spends capital to update its stores, you have to spend just as much to maintain your market share.

Excellent businesses then—those with wide economic moats—are able to survive difficult macroeconomic environments because their products carry pricing power. For Buffett, See’s Candies and Coca Cola wield this power; for See’s, Buffett has unfailingly increased prices on the day after Christmas.

These days, newspapers, magazines, and periodicals—faced with declining advertising revenues—are considering price increases. As The New York Times recently reported, the average Time subscriber only paid 58 cents per issue, and Newsweek readers paid 47 cents. True to its moniker, The Economist raised its price per issue to $6.99 last year, all while seeing its subscriptions rise 60% since 2004.

At our house over the last few months, we have been surprised to find—instead of subscription notices—cancellation notices from publishers. With declining advertising revenues, these periodicals were forced to close their doors for good. And I recall thinking—why didn’t they raise their prices? Because I would have easily paid twice what I had been.

For many goods and services, tight economic times trigger the tightening of budgets. However, even during such times, the most desired goods and services will still command a premium and increasing price. For the investor, these are the wide moat businesses that should find a home in one’s portfolio, at an attractive price.

So, is The Economist for sale?

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway.

Buffett’s Berkshire Letter for 1979

1979 saw the Shah of Iran depart his homeland for Egypt, enabling Ayatollah Khomeini to return to Tehran after fifteen years of exile. Chrysler went begging to the U.S. government for $1.5 billion in loan guarantees. The S&P 500, like 1977 and 1978, spent the majority of the year trading within 10 points of 100.

Over at Kiewit Plaza in Omaha, Chairman Buffett reported operating earnings on shareholder capital of 18.6%. Though the tally fell short of the performances of 1977 and 78, the total approached within a few percentage points their best record. Buffett clearly describes the relevant metrics that shareholders should use to assess Berkshire’s annual performance—“we continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders’ equity with all securities valued at cost is the most appropriate way to measure any single year’s operating performance.” Over the longer term, owners should also assess the market value of its security investments. Speaking most generally, Buffett concludes that “the primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”

During 1979, worries about inflation permeated everyday discourse. With the consumer price index increasing more than 10% annually, mortgage rates seemed to have no ceiling, and hording necessities appeared the best “investment.” And Buffett noticed the new competition with his characteristic frankness—“if we should continue to achieve a 20% compounded gain… your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash… We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.” In an economy with double-digit annual inflation rates, even the best capital allocators struggle to tread water.

And all this from a man who had the pleasure of owning some great businesses, like See’s Candies and Illinois National Bank. How much more is the misery of the mediocre business operator. Far wiser to be in a very good businesses with solid long-term prospects, like insurance, which “tends to magnify, to an unusual degree, human managerial talent – or the lack of it,” than to acquire new textile mills in Waumbec. As Buffett sums, “both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.”

Lastly, Buffett concludes with some particularly useful comments about making bond investments. Observing that insurance competitors had given up one-year policies because of the inflationary environment, Buffett highlights the inconsistency expressed by their willingness to purchase long-term bonds. In short, “having decided that one year is too long a period for which to set a fixed price for insurance in an inflationary world, they then have turned around, taken the proceeds from the sale of that six-month policy, and sold the money at a fixed price for thirty or forty years.”

Inspired by Polonius, Buffett lays out what looks to be an absolute rule for bond investments: “neither a short-term borrower nor a long-term lender be.” For “even prior to this [inflationary] period, [Berkshire] never would buy thirty or forty-year bonds; instead we tried to concentrate in the straight bond area on shorter issues with sinking funds and on issues that seemed relatively undervalued because of bond market inefficiencies… Our unwillingness to fix a price now for a pound of See’s candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years.”

Here again we see Buffett’s reticence in projecting the earnings power for any business for any period longer than a decade. In his email conversation with Jeff Raikes of Microsoft, he insinuated that very few businesses are sufficiently predictable to submit to long-term forecasts about their earnings potential. And observers see this played out again and again in Buffett’s investments—in equities or fixed income. Berkshire will rarely give money away for longer than ten years, and it will rarely pay today for the discounted value of more than a decade’s earnings.*

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

* The one important and notable exception here is Coca Cola.

[This post continues our series on Warren Buffett’s letters to Berkshire Hathaway shareholders.]

Microsoft’s Moat

Yesterday we saw Jeff Raikes’ analysis of Microsoft’s moat. And many of his observations still hold true today, even though Microsoft has broadened its product line greatly since then—moving to the Web, to video games, mp3 players, and television.

Even today, Microsoft’s most profitable products—far and away—are its Windows operating system and its Office suite. What makes these products so profitable? As Raikes observed, the products are cheap to reproduce, easy to transfer and store, and they largely sell themselves. PC users are most familiar with these programs and reticent to try alternatives. As a result, and most importantly, they offer “pricing discretion.” On Microsoft’s financial statements, these qualities translate into a low cost of goods sold and high margins. High margins and high profitability give a company the resources to widen, deepen, and bolster its moat.

As Buffett observes, it is as if Microsoft has a royalty on an increasingly important communications stream for our society. In a sense, Microsoft is the tollbooth that stands at the gateway to most modern communications and collects its hefty fee. Whereas in the recent past most communication could travel without such fees via typewriters or a pen and paper, Microsoft has positioned itself to command an upfront fee for access to communication, largely because our habits have shifted. Today almost every form of published or printed communication requires paying Microsoft the requisite access fee.

So, should the savvy wide moat investor throw all her capital into Microsoft, so long as the price was right? Perhaps not. For the worry, as Raikes also observes, is that a paradigm shift in communications may break our current habits. For example, if written communications shifted instead to cell phones, Microsoft may not be sufficiently prepared to provide the software and garner the fee. For a wide moat investor like Buffett, an important element of a company’s margin of safety is the durability of its customers’ preferences. For companies like See’s Candies or Coca Cola, Buffett expects that their customers’ preferences will be more enduring than Microsoft’s. If that is true, then Microsoft’s moat may be narrower than it initially seems. And the wide moat investor should wait for a fatter pitch.

Disclosure: No position in the aforementioned companies at the time of this post.

Warren Buffett on Moats

So long as we talk about businesses’ moats on this blog, you should expect to often see Warren Buffett’s wisdom amble by. Today I offer up a couple of extended quotes from an email exchange between Warren Buffett and Jeff Raikes on the topic of Microsoft’s moat. This 1997 email was revealed among the evidence in the trial Gordon v. Microsoft, which Microsoft eventually settled in 2004 for 182 million dollars. Though the Oracle has some interesting comments, I actually find Raikes’ comments on Microsoft more useful for the investor [comments edited for clarity]:

RAIKES: “In some respects, I see the business characteristics of Coca Cola or See’s Candy as being very similar to Microsoft. I think you would love the simplicity of the operating system business. For example, in 1996, there were 50 million PCs sold in the world, and about 80% of them were licensed for a Microsoft operating system. Although I would never write down the analogy of a “toll bridge,” people outside the company might describe the business in that way. Those 40 million licenses average about $45 per, for a total of about $1.8 billion in revenue…

In 2000, there will be about 100 million PCs sold. We think we can reduce piracy to 10% and license 90% or 90 million of the PCs. But we also have “pricing discretion” – I think I heard this term used in conjunction with your pricing decision on See’s Candy. We will be transitioning the world to a new version of our operating system, Windows NT… We can achieve average license revenue of $80. So 90 million licenses at $80 per license totals about $7.2 billion, up from just under $2 billion in 3 to 4 years. And since there are effectively no cost of goods sold and a worldwide sales force of only 100-150 people, this is a 90% plus margin business. There is an R&D charge to the business, but I’m sure the profits are probably as good as the syrup business…

So I really don’t see our business as being significantly more difficult to understand than the other great businesses you’ve invested in. But there is one potential difference that worries me, and it is key part of the reason I spent the time to share these thoughts with you. The difference I worry about is the “width of the moat.” With Coca-Cola, you can feel pretty confident that there won’t be a fast shift in user preferences away from drinking sodas, and in particular, Coke. In technology, we may more frequently see “paradigm shifts” where old leaders are displaced by new. Graphical user interface replaces character user interface, the Internet explodes, etc…

In technology, the moats may be narrower… I am very confident about our business for the next 5 to 10 years. But I will admit it is easier to be confident about Coke’s business for the next 10 years… My theory is that you don’t invest in technology or Microsoft because you see the moats are narrower; too much risk and the potential for a fast paradigm shift that would too quickly undermine your equity position…”

BUFFETT: “Your analysis of Microsoft, why I should invest in it, and why I don’t, could not be more on the money. In effect the company has a royalty on a communication stream that can do nothing but grow. It’s as if you were getting paid for every gallon of water starting in a small stream but with added amounts received as tributaries turned the stream into an Amazon. The toughest question is how hard to push prices…

Bill has an even better royalty [than Coke]—one which I would never bet against, but I don’t feel I am capable of assessing probabilities about, except to the extent that with a gun to my head and forced to make a guess, I would go with it rather than against… If I had to make such decisions, I would do my best but I prefer to structure investing as a no-called-strikes game and just wait for the fat one.”

Disclosure: No position in the aforementioned companies at the time of this post.