In this article, we review Warren Buffett’s 1982 annual shareholder letter for his accumulated investing nuggets of wisdom. 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 the concepts holistically in his/her portfolio, there’s a good chance of success.
“We generally believe in pre-set, long-lived and small bulls-eyes.”
“You can be certain that this percentage will diminish in the future. Geometric progressions eventually forge their own anchors.” [speaking of Berkshire performance to-date]
“Berkshire’s economic goal remains to produce a long-term rate of return well above the return achieved by the average large American corporation.”
Warren characteristically opened the annual letter with the bottom-line review of Berkshire’s performance — operating earnings of $31.5 million, amounting to 9.8% of beginning equity capital, valuing securities at cost. This was a lower figure than last year’s 15.2% and well below the 1978 high of 19.4%. The reason? It was due primarily to the ever-increasing allocation of capital to stocks, instead of wholly-owned businesses and the accounting rules that dictated Berkshire’s pro-rata share of these earnings be excluded from Berkshire’s reported earnings. (For more background, this subject first appeared in the 1980 letter.)
In 1982, the pro-rata share of earnings from his top four stock holdings (GEICO, General Foods, The Washington Post (WPO, Financial), and RJ Reynolds (RJR, Financial)) amounted to $40 million-plus. This figure, not reflected at all in Berkshire’s operating earnings, was more than the total earnings from all of Buffett’s subsidiaries. The only amount that would show in their financial statements is the $14 million received in dividends.
Since the first letter, Buffett outlined that the best measure of managerial, single-year performance for the vast majority of companies was to measure operating earnings to equity capital employed. However, in this letter, Buffett conceded that for a company like Berkshire, continued use of this metric didn’t make sense anymore, as the magnitude of these undistributed earnings made their reported operating earnings figure of limited significance. He is warning his investors in advance of a change in the target, unlike so many managers that paint in the bullseye around their performance after they’ve measured it — beware of these types.
Against his long-term, managerial performance metric, Berkshire’s 1982 gain in net worth valuing equities at market value amounted to 40% on a beginning equity base of $519 million. During the 18-year period to this point, Berkshire grew book value at 22% CAGR.
“In our view, the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used — and not by the size of one’s ownership percentage.”
“It’s simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.”
Continuing from the concept above with the unreported aspects of pro-rata share of undistributed earnings from a stock portfolio, it’s important to remember that it’s an accountant's job to measure and record — that’s it. The job of interpreting and assessing belongs to managers and investors. Using accounting figures, without context, will not present a true picture of the operational performance of a company. Financial statements are then a beginning to determining the suitability of a stock as an investment. Look carefully through them and determine whether it’s a sound investment, then base your valuation on what you’ve uncovered.
“Our share issuances follow a simple basic rule: We will not issue shares unless we receive as much intrinsic business value as we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that.”
“At that point, as Yogi Berra has said, ‘You can observe a lot just by watching.’ For shareholders then will find which objective the management truly prefers — expansion of domain or maintenance of owners’ wealth.”
“We will not equate activity with progress or corporate size with owner-wealth.”
In the 1981 letter, Buffett commented on three reasons for the flurry of corporate M&A activity he saw, most of which was value-destructive. These reasons were: (1) they liked increased activity and a challenge; (2) their incentive structure was geared towards measuring size, not profitability; and (3) they’re over-confident in their managerial abilities to turn around, or integrate, a business. More often than not, it seems their track record was to perform high-premium acquisitions, and then to use their company stock as the currency of the transaction. In many cases, they were buying 50 cents for $1 of their own stock.
He spent considerable time discussing this subject and gave some reasons a CEO might give to use stock as currency in a value destructive manner: (1) “The company we’re buying is going to be worth a lot more in the future.”; (2) “We have to grow.”; and (3) “Our stock is undervalued and we’ve minimized its use in this deal - but we need to give the selling shareholders 51% in stock and 49% in cash so that certain of those shareholders can get the tax-free exchange they want.” All of these reasons are problematic in one way or another.
He did mention there were three ways to avoid value destruction for old owners: (1) have a true business-value-for-business-value merger; (2) use the old stock as currency when it’s selling at or above intrinsic value; and (3) move forward with the merger but then subsequently buy a quantity of shares equal to the number issued in the merger in a damage-repair move (not ideal, but better than leaving it a value-destructive deal).
Additionally, he pointed out the negative effect language has on mergers which tends to confuse the issues and encourage irrational behavior by managers. For example, when reviewing a merger deal, a company will diligently analyze the dilutive aspects of it. Unfortunately, any number of reasons can be made to make it appear anti-dilutive, especially if the CEO is visibly panting at the thought of the acquisition. A second language problem comes in relating the equation of exchange. Usually you’ll see an announcement similar to “Company A to acquire Company B” or “B sells to A.” Clearer thinking would exist if more accurate phrases were used, such as “Part of A sold to acquire B” or “Owners of B to receive part of A in exchange for their property.”
Buffett reminded shareholders that he wouldn’t succumb to such activity. To the extent Berkshire stock would be used as currency in an M&A transaction, Berkshire shareholders would receive in business value as much as they give — $1 for $1.
“Satisfactory as our partial-ownership approach has been, what really makes us dance is the purchase of 100% of good businesses at reasonable prices. We’ve accomplished this feet a few times (and expect to do so again), but it is an extraordinarily difficult job — far more difficult than the purchase at attractive prices of fractional interests.”
“In case you haven’t noticed, there is an important investment lesson to be derived from this table: nostalgia should be weighted heavily in stock selection. Our two largest unrealized gains are in Washington Post and GEICO, companies with which your Chairman formed his first commercial connections at the ages of 13 and 20, respectively. After straying for roughly 25 years, we returned as investors in the mid-1970s. The table quantifies the rewards for even long-delayed corporate fidelity.”
“Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles.”
“In many industries, differentiation simply can’t be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable.”
“For the great majority of companies selling “commodity” products, a depressing equation of business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability.”
There are a lot of stocks and companies out there — some of them excellent, a lot of them mediocre, and yet even more of them plagued with terrible economics. Here Buffett is pointing out that the world is your canvas — spend the time and pick the good ones. The good ones are defined by the $1 Premise outlined here before — where a company, over time, should be able to turn every $1 retained in the business into at least $1 of market value. Commodity-based businesses are troublesome because it’s very difficult for them to achieve sustainable profitability unless there’s a cartel, or government intervention, controlling price or supply. To the extent you feel inclined to invest in this type of business, look for one that has a cost advantage that is both wide and sustainable.
Additionally, there is the lesson of patience. You may find an investment that fits all your criteria except price. The best thing to do is wait, keep it on your radar and track it. One day you’ll be presented with an opportunity, and if the company still fits your criteria, back the truck up and buy. In his case he waited 25 years before he had the wherewithall to do something about it.
“…GEICO’s increase in market value during the past two years has been considerably greater than the gain in its intrinsic business value, impressive as the latter has been. We expected such a favorable variation at some point, as the perception of investors converged with business reality.”
“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
“Should the stock market advance to considerably higher levels, our ability to utilize capital effectively in partial-ownership positions will be reduced or eliminated.”
“There were as many good businesses around in 1972 as in 1982, but the prices the stock market placed upon those businesses in 1972 looked absurd.”
“Our willingness to purchase either partial or total ownership positions in favorably-situated businesses, coupled with reasonable discipline about the prices we are willing to pay, should give us a good chance of achieving our goal.”
“Year-to-year variances, however, cannot consistently be in our favor. Even if our partially-owned businesses continue to perform well in an economic sense, there will be years when they perform poorly in the market. At such times our net worth could shrink significantly. We will not be distressed by such a shrinkage; if the businesses continue to look attractive and we have cash available, we simply will add to our holdings at even more favorable prices.”
In the short-term the stock market’s a voting machine — highly responsive to investor sentiment, opinion, fear and greed. In the long term the stock market’s a weighing machine — rationally assessing the overall business performance over time and valuing it accordingly.
The price you pay is paramount, and will determine your future returns. Pay close attention to the price you pay for the growth you receive. Buying an excellent business at stratospheric valuations will only damage your pocket book in the long-run. Remember to keep your cool and avoid the “got to have it at any cost” mentality. The margin of safety is there to prevent you from making cataclysmic valuation blunders.
As the stock market advances, you’ll gradually find fewer and fewer bargains. Your hunt for good value prospects will be more difficult. In fact, in Buffett’s comparison of the 1972 and 1982 markets, he pointed out that Berkshire’s stock holdings amounted to just 15% in 1972 as opposed to 80% in 1982.
This concludes the review of the 1982 Berkshire Hathaway shareholder letter.
Follow back next time as we continue with the 1983 letter.
To see the previous article of this series, please click here.
On Judging Performance
“Yardsticks seldom are discarded while yielding favorable readings. But when results deteriorate, most managers favor disposition of the yardstick rather than disposition of the manager. To managers faced with such deterioration, a more flexible measurement system often suggests itself: Just shoot the arrow of business performance into a blank canvas and then carefully draw the bulls-eye around the implanted arrow.”“We generally believe in pre-set, long-lived and small bulls-eyes.”
“You can be certain that this percentage will diminish in the future. Geometric progressions eventually forge their own anchors.” [speaking of Berkshire performance to-date]
“Berkshire’s economic goal remains to produce a long-term rate of return well above the return achieved by the average large American corporation.”
Warren characteristically opened the annual letter with the bottom-line review of Berkshire’s performance — operating earnings of $31.5 million, amounting to 9.8% of beginning equity capital, valuing securities at cost. This was a lower figure than last year’s 15.2% and well below the 1978 high of 19.4%. The reason? It was due primarily to the ever-increasing allocation of capital to stocks, instead of wholly-owned businesses and the accounting rules that dictated Berkshire’s pro-rata share of these earnings be excluded from Berkshire’s reported earnings. (For more background, this subject first appeared in the 1980 letter.)
In 1982, the pro-rata share of earnings from his top four stock holdings (GEICO, General Foods, The Washington Post (WPO, Financial), and RJ Reynolds (RJR, Financial)) amounted to $40 million-plus. This figure, not reflected at all in Berkshire’s operating earnings, was more than the total earnings from all of Buffett’s subsidiaries. The only amount that would show in their financial statements is the $14 million received in dividends.
Since the first letter, Buffett outlined that the best measure of managerial, single-year performance for the vast majority of companies was to measure operating earnings to equity capital employed. However, in this letter, Buffett conceded that for a company like Berkshire, continued use of this metric didn’t make sense anymore, as the magnitude of these undistributed earnings made their reported operating earnings figure of limited significance. He is warning his investors in advance of a change in the target, unlike so many managers that paint in the bullseye around their performance after they’ve measured it — beware of these types.
Against his long-term, managerial performance metric, Berkshire’s 1982 gain in net worth valuing equities at market value amounted to 40% on a beginning equity base of $519 million. During the 18-year period to this point, Berkshire grew book value at 22% CAGR.
On GAAP and Retained Earnings Power
“Clearly ‘accounting’ earnings can seriously misrepresent economic reality.”“In our view, the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used — and not by the size of one’s ownership percentage.”
“It’s simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.”
Continuing from the concept above with the unreported aspects of pro-rata share of undistributed earnings from a stock portfolio, it’s important to remember that it’s an accountant's job to measure and record — that’s it. The job of interpreting and assessing belongs to managers and investors. Using accounting figures, without context, will not present a true picture of the operational performance of a company. Financial statements are then a beginning to determining the suitability of a stock as an investment. Look carefully through them and determine whether it’s a sound investment, then base your valuation on what you’ve uncovered.
On Mergers & Acquisitions
“As we look at the major acquisitions that others made during 1982, our reaction is not envy, but relief that we were non-participants. For in many of these acquisitions, managerial intellect wilted in competition with managerial adrenaline. The thrill of the chase blinded the pursuers to the consequences of the catch. Pascal’s observation seems apt: ‘It has struck me that all men’s misfortunes spring from the single cause that they are unable to stay quietly in one room.’”“Our share issuances follow a simple basic rule: We will not issue shares unless we receive as much intrinsic business value as we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that.”
“At that point, as Yogi Berra has said, ‘You can observe a lot just by watching.’ For shareholders then will find which objective the management truly prefers — expansion of domain or maintenance of owners’ wealth.”
“We will not equate activity with progress or corporate size with owner-wealth.”
In the 1981 letter, Buffett commented on three reasons for the flurry of corporate M&A activity he saw, most of which was value-destructive. These reasons were: (1) they liked increased activity and a challenge; (2) their incentive structure was geared towards measuring size, not profitability; and (3) they’re over-confident in their managerial abilities to turn around, or integrate, a business. More often than not, it seems their track record was to perform high-premium acquisitions, and then to use their company stock as the currency of the transaction. In many cases, they were buying 50 cents for $1 of their own stock.
He spent considerable time discussing this subject and gave some reasons a CEO might give to use stock as currency in a value destructive manner: (1) “The company we’re buying is going to be worth a lot more in the future.”; (2) “We have to grow.”; and (3) “Our stock is undervalued and we’ve minimized its use in this deal - but we need to give the selling shareholders 51% in stock and 49% in cash so that certain of those shareholders can get the tax-free exchange they want.” All of these reasons are problematic in one way or another.
He did mention there were three ways to avoid value destruction for old owners: (1) have a true business-value-for-business-value merger; (2) use the old stock as currency when it’s selling at or above intrinsic value; and (3) move forward with the merger but then subsequently buy a quantity of shares equal to the number issued in the merger in a damage-repair move (not ideal, but better than leaving it a value-destructive deal).
Additionally, he pointed out the negative effect language has on mergers which tends to confuse the issues and encourage irrational behavior by managers. For example, when reviewing a merger deal, a company will diligently analyze the dilutive aspects of it. Unfortunately, any number of reasons can be made to make it appear anti-dilutive, especially if the CEO is visibly panting at the thought of the acquisition. A second language problem comes in relating the equation of exchange. Usually you’ll see an announcement similar to “Company A to acquire Company B” or “B sells to A.” Clearer thinking would exist if more accurate phrases were used, such as “Part of A sold to acquire B” or “Owners of B to receive part of A in exchange for their property.”
Buffett reminded shareholders that he wouldn’t succumb to such activity. To the extent Berkshire stock would be used as currency in an M&A transaction, Berkshire shareholders would receive in business value as much as they give — $1 for $1.
On Selecting Investments
“Within this gigantic auction arena, it is our job to select businesses with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.”“Satisfactory as our partial-ownership approach has been, what really makes us dance is the purchase of 100% of good businesses at reasonable prices. We’ve accomplished this feet a few times (and expect to do so again), but it is an extraordinarily difficult job — far more difficult than the purchase at attractive prices of fractional interests.”
“In case you haven’t noticed, there is an important investment lesson to be derived from this table: nostalgia should be weighted heavily in stock selection. Our two largest unrealized gains are in Washington Post and GEICO, companies with which your Chairman formed his first commercial connections at the ages of 13 and 20, respectively. After straying for roughly 25 years, we returned as investors in the mid-1970s. The table quantifies the rewards for even long-delayed corporate fidelity.”
“Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles.”
“In many industries, differentiation simply can’t be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable.”
“For the great majority of companies selling “commodity” products, a depressing equation of business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability.”
There are a lot of stocks and companies out there — some of them excellent, a lot of them mediocre, and yet even more of them plagued with terrible economics. Here Buffett is pointing out that the world is your canvas — spend the time and pick the good ones. The good ones are defined by the $1 Premise outlined here before — where a company, over time, should be able to turn every $1 retained in the business into at least $1 of market value. Commodity-based businesses are troublesome because it’s very difficult for them to achieve sustainable profitability unless there’s a cartel, or government intervention, controlling price or supply. To the extent you feel inclined to invest in this type of business, look for one that has a cost advantage that is both wide and sustainable.
Additionally, there is the lesson of patience. You may find an investment that fits all your criteria except price. The best thing to do is wait, keep it on your radar and track it. One day you’ll be presented with an opportunity, and if the company still fits your criteria, back the truck up and buy. In his case he waited 25 years before he had the wherewithall to do something about it.
On Mr. Market, Valuations and Margin of Safety
“And fractional purchases can be made in an auction market where prices are set by participants with behavior patterns that sometimes resemble those of an army of manic-depressive lemmings.”“…GEICO’s increase in market value during the past two years has been considerably greater than the gain in its intrinsic business value, impressive as the latter has been. We expected such a favorable variation at some point, as the perception of investors converged with business reality.”
“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
“Should the stock market advance to considerably higher levels, our ability to utilize capital effectively in partial-ownership positions will be reduced or eliminated.”
“There were as many good businesses around in 1972 as in 1982, but the prices the stock market placed upon those businesses in 1972 looked absurd.”
“Our willingness to purchase either partial or total ownership positions in favorably-situated businesses, coupled with reasonable discipline about the prices we are willing to pay, should give us a good chance of achieving our goal.”
“Year-to-year variances, however, cannot consistently be in our favor. Even if our partially-owned businesses continue to perform well in an economic sense, there will be years when they perform poorly in the market. At such times our net worth could shrink significantly. We will not be distressed by such a shrinkage; if the businesses continue to look attractive and we have cash available, we simply will add to our holdings at even more favorable prices.”
In the short-term the stock market’s a voting machine — highly responsive to investor sentiment, opinion, fear and greed. In the long term the stock market’s a weighing machine — rationally assessing the overall business performance over time and valuing it accordingly.
The price you pay is paramount, and will determine your future returns. Pay close attention to the price you pay for the growth you receive. Buying an excellent business at stratospheric valuations will only damage your pocket book in the long-run. Remember to keep your cool and avoid the “got to have it at any cost” mentality. The margin of safety is there to prevent you from making cataclysmic valuation blunders.
As the stock market advances, you’ll gradually find fewer and fewer bargains. Your hunt for good value prospects will be more difficult. In fact, in Buffett’s comparison of the 1972 and 1982 markets, he pointed out that Berkshire’s stock holdings amounted to just 15% in 1972 as opposed to 80% in 1982.
This concludes the review of the 1982 Berkshire Hathaway shareholder letter.
Follow back next time as we continue with the 1983 letter.
To see the previous article of this series, please click here.
