This article is the second in a series reviewing each of Warren Buffett’s annual shareholder letters. Although he’s never written a book, he pens these letters each year covering many subjects of interest to his shareholders, and uses it as a vehicle to discuss the subject of investing. At times his wisdom is right out in the open, and at other times it requires a little thought. If an investor can understand his methods and apply it holistically, there’s a good chance of success. In each article, I extract the investing nuggets of wisdom, by subject matter, for commentary. We now turn to the 1978 shareholder letter.
Referring to the 1971 market, “There were equities of identifiably excellent companies available – but very few at interesting prices. (An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities – at full prices they couldn’t buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.)”
“A second footnote: in 1978 pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities – breaking the record low figure set in 1974 and tied in 1977.”
Referring to the performance of his equities from 1975-1978, in which his cost was $39.3 million, “Therefore, our overall unrealized and realized pre-tax gains in equities for the three year period came to approximately $112 million. During this same interval the Dow-Jones Industrial Average declined from 852 to 805. It was a marvelous period for the value-oriented equity buyer.”
“This program of acquisition of small fractions of businesses (common stocks) at bargain prices, for which little enthusiasm exists, contrasts sharply with general corporate acquisition activity, for which much enthusiasm exists. It seems quite clear to us that either corporations are making very significant mistakes in purchasing entire businesses at prices prevailing in negotiated transactions and takeover bids, or that we eventually are going to make considerable sums of money buying small portions of such businesses at the greatly discounted valuations prevailing in the stock market.”
In these paragraphs, Mr Buffett is reminding us of the folly of the auction pricing mechanism we refer to as the stock market. In short periods of time, investment fund managers, acting on the behalf of the investing public through purchase and redemption requests, cast their votes on the popular stocks driving prices up, and pull their votes on the unpopular stocks driving prices down. In 1971, even though the overall market was fully priced, these fund managers continued to buy. There were plenty of good businesses available, but the price wasn’t right for Buffett. By the time the 1973 bear market arrived, this same group had all but lost interest all the way through 1978. However, it’s critical to repeat an important item—pay attention to valuation. He illustrates this point against the DJIA which lost 5.5% from 1975-1978. During the same 3-year period, Mr Buffett gained 187% on his investments. The lesson? Price matters, and price determines your returns. You won’t find bargain prices when there is nothing but enthusiasm for your potential stock purchase.
“Of course, our enthusiasm for stocks is not unconditional. Under some circumstances, common stock investments by insurers make very little sense.”
“We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do.”
“In the longer run, however, we feel that many of our major equity holdings are going to be worth considerably more money than we paid, and that investment gains will add significantly to the operating returns of the insurance group.”
“We are not concerned with whether the market quickly revalues upward securities that we believe are selling at bargain prices. In fact, we prefer just the opposite since, in most years, we expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up in stock prices to levels at which we are unwilling to continue buying.”
Market-timing is the siren’s call to many investors. Few can do it successfully as the daily price squiggles move about. What’s important to internalize about a value investing program is to realize that you’re market-pricing, not market-timing. In essence you are time arbitraging between short-term speculation and long-term business results. You’ve dictated the price at which you’re willing to buy and you’re letting the price come to you, which takes patience not many people have. Once the price is in your buy zone, it’s in your best interests for it to stay there a while to enable you to complete your purchasing program. Take advantage of the market; don’t let it take advantage of you.
“We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively. We usually can identify a small number of potential investments meeting requirements (1), (2), and (3), but (4) often prevents action.”
“Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are convinced as to attractiveness, we believe in buying worthwhile amounts.”
These two paragraphs simply and elegantly urge an investor to buy significant quantities, concentrate your holdings, and pay close attention to what you’re willing to pay. If you’ve done your due diligence and are convinced your investment thesis is sound, that it offers a reasonable prospect for return and protection of principal, then make this holding a significant portion of the portfolio. At the same time, concentrate your holdings. If you’re intent to hold a large number of issues, in the end you’ll only dilute your returns once the market re-values your stocks upwards. Maintain a sufficient minimum quantity for diversification, but don’t hold so many that you “diworsify” (as coined by Peter Lynch) and essentially become an index fund. Not only will you marginalize your returns, but you’ll have difficulty keeping up with the business results of each company. There are many academic studies available that indicate the point of diminishing returns is over 30 holdings—beyond this and your results begin to match those of an index. By the same token, if you’ve discovered a stock you want to buy, and it meets all criteria except price, the smartest thing you can do is not buy and to wait for the price to come to you.
“The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.”
Referring to the textile industry, “We hope we don’t get into too many more businesses with such tough economic characteristics.”
An undifferentiated good is another way of saying commoditized product. Since there is nothing to set it apart and command a premium price from consumers, these goods compete on price. When manufacturers have the ability to produce excess supply with a given level of demand, prices naturally gravitate downward. Businesses built on commodities and price competition seldom produce adequate returns, unless those returns are built on price spikes due to supply restrictions (ie. oil, grain shortages, etc.) Remember as an investor to think about the business, and consider Buffett’s second filter—buy a business with favorable long-term prospects. If you do, odds are you’ll favor businesses offering differentiated products which can command a price premium from consumers. Businesses with tough economic characteristics eventually yield marginal investment performance.
“It is a real pleasure to work with managers who enjoy coming to work each morning and, once there, instinctively and unerringly think like owners.”
“Of course, with a minor interest we do not have the right to direct or even influence management policies of SAFECO. Buy why should we wish to do this? The record would indicate that they do a better job managing their operations than we could do ourselves. While there may be less excitement and prestige in sitting back and letting others do the work, we think that is all one loses by accepting a passive participation in excellent management. Because, quite clearly, if one controlled a company run as well as SAFECO, the proper policy also would be to sit back and let management do its job.”
“Our experience has been that the manager of an already high-cost operation frequently is uncommonly resourceful in finding new ways to add to overhead, while the manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors.”
As an investor, you will sleep better at night when you align yourself with honest and competent managers. Find the ones that think like owners and you’ll have an investment that takes care of itself. Good managers beget good business results. And good business results beget increased capital gains in the stock market over time. If you were to buy an entire company which had proven management history of excellent performance, you’d be wise to instill a culture of decentralized management and let them continue their excellent operations. As a stock market investor, who thinks about the business, this situation is no different. In this case, you’re a silent partner, a passive participant without the right to influence the operations of the company. If you pick a company with excellent management, problem solved…let the managers continue their excellent results. However, if you pick a company with terrible and/or dishonest management, in time their poor performance will reflect in the stock market price. In this case vote with your feet, sell, and find a better prospect before they, and your investment, go bankrupt.
“In fact, SAFECOS’s retained earnings (or those of other well-run companies if they have opportunities to employ additional capital advantageously) may well eventually have a value to shareholders greater than 100 cents on the dollar.”
“We are not at all unhappy when our wholly-owned businesses retain all of their earnings if they can utilize internally those funds at attractive rates. Why should we feel differently about retention of earnings by companies in which we hold small equity interests, but where the record indicates even better prospects for profitable employment of capital?”
Here we’re reminded that a CEO allocates capital. Some allocate efficiently, and some allocate inefficiently. When a company retains earnings for the shareholders, it’s supposed to be done with the prospect of being employed at attractive rates of return. If the CEO is unable to do this, then this capital must be returned to shareholders through dividends or share buybacks. This is a fact of life that’s unchanged whether the company is private or public. And if it is public, why should we (as a fractional owner through a stock purchase) expect anything different? A well-run company allocates capital efficiently, and Warren hints at a litmus test: retained earnings should provide value to shareholders greater than 100 cents on the dollar. Said another way, for every dollar retained in the business it should produce at least a dollar change in capital gains over time. Otherwise, the CEO’s capital allocation decisions are value-destructive…the very antithesis of his/her job description.
This concludes the review of the 1978 Berkshire Hathaway Shareholder Letter.
Follow back next week as we continue with the 1979 letter.
To see the first article of this series, click here.
On the Stock Market and Valuations
Referring to the 1971 market, “There were equities of identifiably excellent companies available – but very few at interesting prices. (An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities – at full prices they couldn’t buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.)”
“A second footnote: in 1978 pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities – breaking the record low figure set in 1974 and tied in 1977.”
Referring to the performance of his equities from 1975-1978, in which his cost was $39.3 million, “Therefore, our overall unrealized and realized pre-tax gains in equities for the three year period came to approximately $112 million. During this same interval the Dow-Jones Industrial Average declined from 852 to 805. It was a marvelous period for the value-oriented equity buyer.”
“This program of acquisition of small fractions of businesses (common stocks) at bargain prices, for which little enthusiasm exists, contrasts sharply with general corporate acquisition activity, for which much enthusiasm exists. It seems quite clear to us that either corporations are making very significant mistakes in purchasing entire businesses at prices prevailing in negotiated transactions and takeover bids, or that we eventually are going to make considerable sums of money buying small portions of such businesses at the greatly discounted valuations prevailing in the stock market.”
In these paragraphs, Mr Buffett is reminding us of the folly of the auction pricing mechanism we refer to as the stock market. In short periods of time, investment fund managers, acting on the behalf of the investing public through purchase and redemption requests, cast their votes on the popular stocks driving prices up, and pull their votes on the unpopular stocks driving prices down. In 1971, even though the overall market was fully priced, these fund managers continued to buy. There were plenty of good businesses available, but the price wasn’t right for Buffett. By the time the 1973 bear market arrived, this same group had all but lost interest all the way through 1978. However, it’s critical to repeat an important item—pay attention to valuation. He illustrates this point against the DJIA which lost 5.5% from 1975-1978. During the same 3-year period, Mr Buffett gained 187% on his investments. The lesson? Price matters, and price determines your returns. You won’t find bargain prices when there is nothing but enthusiasm for your potential stock purchase.
On Market Timing and Patience
“Of course, our enthusiasm for stocks is not unconditional. Under some circumstances, common stock investments by insurers make very little sense.”
“We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do.”
“In the longer run, however, we feel that many of our major equity holdings are going to be worth considerably more money than we paid, and that investment gains will add significantly to the operating returns of the insurance group.”
“We are not concerned with whether the market quickly revalues upward securities that we believe are selling at bargain prices. In fact, we prefer just the opposite since, in most years, we expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up in stock prices to levels at which we are unwilling to continue buying.”
Market-timing is the siren’s call to many investors. Few can do it successfully as the daily price squiggles move about. What’s important to internalize about a value investing program is to realize that you’re market-pricing, not market-timing. In essence you are time arbitraging between short-term speculation and long-term business results. You’ve dictated the price at which you’re willing to buy and you’re letting the price come to you, which takes patience not many people have. Once the price is in your buy zone, it’s in your best interests for it to stay there a while to enable you to complete your purchasing program. Take advantage of the market; don’t let it take advantage of you.
On Position Sizing, Concentration, and Valuations
“We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively. We usually can identify a small number of potential investments meeting requirements (1), (2), and (3), but (4) often prevents action.”
“Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are convinced as to attractiveness, we believe in buying worthwhile amounts.”
These two paragraphs simply and elegantly urge an investor to buy significant quantities, concentrate your holdings, and pay close attention to what you’re willing to pay. If you’ve done your due diligence and are convinced your investment thesis is sound, that it offers a reasonable prospect for return and protection of principal, then make this holding a significant portion of the portfolio. At the same time, concentrate your holdings. If you’re intent to hold a large number of issues, in the end you’ll only dilute your returns once the market re-values your stocks upwards. Maintain a sufficient minimum quantity for diversification, but don’t hold so many that you “diworsify” (as coined by Peter Lynch) and essentially become an index fund. Not only will you marginalize your returns, but you’ll have difficulty keeping up with the business results of each company. There are many academic studies available that indicate the point of diminishing returns is over 30 holdings—beyond this and your results begin to match those of an index. By the same token, if you’ve discovered a stock you want to buy, and it meets all criteria except price, the smartest thing you can do is not buy and to wait for the price to come to you.
On Business Economics
“The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.”
Referring to the textile industry, “We hope we don’t get into too many more businesses with such tough economic characteristics.”
An undifferentiated good is another way of saying commoditized product. Since there is nothing to set it apart and command a premium price from consumers, these goods compete on price. When manufacturers have the ability to produce excess supply with a given level of demand, prices naturally gravitate downward. Businesses built on commodities and price competition seldom produce adequate returns, unless those returns are built on price spikes due to supply restrictions (ie. oil, grain shortages, etc.) Remember as an investor to think about the business, and consider Buffett’s second filter—buy a business with favorable long-term prospects. If you do, odds are you’ll favor businesses offering differentiated products which can command a price premium from consumers. Businesses with tough economic characteristics eventually yield marginal investment performance.
On Business Management
“It is a real pleasure to work with managers who enjoy coming to work each morning and, once there, instinctively and unerringly think like owners.”
“Of course, with a minor interest we do not have the right to direct or even influence management policies of SAFECO. Buy why should we wish to do this? The record would indicate that they do a better job managing their operations than we could do ourselves. While there may be less excitement and prestige in sitting back and letting others do the work, we think that is all one loses by accepting a passive participation in excellent management. Because, quite clearly, if one controlled a company run as well as SAFECO, the proper policy also would be to sit back and let management do its job.”
“Our experience has been that the manager of an already high-cost operation frequently is uncommonly resourceful in finding new ways to add to overhead, while the manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors.”
As an investor, you will sleep better at night when you align yourself with honest and competent managers. Find the ones that think like owners and you’ll have an investment that takes care of itself. Good managers beget good business results. And good business results beget increased capital gains in the stock market over time. If you were to buy an entire company which had proven management history of excellent performance, you’d be wise to instill a culture of decentralized management and let them continue their excellent operations. As a stock market investor, who thinks about the business, this situation is no different. In this case, you’re a silent partner, a passive participant without the right to influence the operations of the company. If you pick a company with excellent management, problem solved…let the managers continue their excellent results. However, if you pick a company with terrible and/or dishonest management, in time their poor performance will reflect in the stock market price. In this case vote with your feet, sell, and find a better prospect before they, and your investment, go bankrupt.
On Employment of Capital
“In fact, SAFECOS’s retained earnings (or those of other well-run companies if they have opportunities to employ additional capital advantageously) may well eventually have a value to shareholders greater than 100 cents on the dollar.”
“We are not at all unhappy when our wholly-owned businesses retain all of their earnings if they can utilize internally those funds at attractive rates. Why should we feel differently about retention of earnings by companies in which we hold small equity interests, but where the record indicates even better prospects for profitable employment of capital?”
Here we’re reminded that a CEO allocates capital. Some allocate efficiently, and some allocate inefficiently. When a company retains earnings for the shareholders, it’s supposed to be done with the prospect of being employed at attractive rates of return. If the CEO is unable to do this, then this capital must be returned to shareholders through dividends or share buybacks. This is a fact of life that’s unchanged whether the company is private or public. And if it is public, why should we (as a fractional owner through a stock purchase) expect anything different? A well-run company allocates capital efficiently, and Warren hints at a litmus test: retained earnings should provide value to shareholders greater than 100 cents on the dollar. Said another way, for every dollar retained in the business it should produce at least a dollar change in capital gains over time. Otherwise, the CEO’s capital allocation decisions are value-destructive…the very antithesis of his/her job description.
This concludes the review of the 1978 Berkshire Hathaway Shareholder Letter.
Follow back next week as we continue with the 1979 letter.
To see the first article of this series, click here.
