At times his wisdom is right out in the open, and at other times it requires a little thought and sleuth work to piece it together. I believe that if an investor can understand his methods and apply the concepts holistically in his/her portfolio, there’s a good likelihood of success.
Buffett didn’t open this letter in characteristic fashion with a review of Berkshire’s (NYSE:BRK.A)(NYSE:BRK.B) performance. Instead, he chose to summarize the 13 major business principles they follow as they relate to the manager-owner relationship — they had a substantial increase in the number of new shareholders from the Blue Chip Stamps merger. In a slight break from my previous formats, I summarize them (from his self-described “catechism”) at the end of this article.
On Judging Performance“We never take the one-year figure very seriously. After all, why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off?”
“Instead, we recommend not less than a five-year test as a rough yardstick of economic performance. Red lights should start flashing if the five-year average annual gain falls much below the return on equity earned over the period by American industry in aggregate.”
“We report our progress in terms of book value because in our case (though not, by any means, in all cases) it is a conservative but reasonably adequate proxy for growth in intrinsic business value - the measurement that really counts.”
“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.”
In the above quotes, Buffett is reminding his old shareholders, and letting his new shareholders know how they should assess Berkshire’s performance: on rolling 5-year periods, and the ROE should be greater than that of American industry in aggregate, of which a good proxy is the S&P500. How do your holdings stack up with this point of view?
Buffett also spends time on the difference between book value and intrinsic value. Intrinsic value is the most important figure and represents an estimate of the cash you can take out of the business. He tells us in one simple, easily missed phrase how to calculate it: estimating future cash output discounted to present value.
Since intrinsic value is an estimate of future cash output, then ask yourself: How confident are you those cash flows will be there? How confident are you of the magnitude of those cash flows? How confident are you of the timing of those cash flows?
The job of assessing the future based on the past is made easier if you examine predictable companies with steady and growing sales and earnings. Estimating future cash output of a cyclical business, or a business with little operating history will be trying, at best. The closer your estimate of future cash output, the better your intrinsic value estimate will be. So why not pick a company that’s easier to predict?
Against his long-term, managerial performance metric, Berkshire’s 1983 gain in net worth valuing equities at market value amounted to 32%. During the 19-year period to this point, Berkshire grew book value at 22.6% CAGR.
On Selecting Investments“One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it.” [in discussing the Nebraska Furniture Mart acquisition.]
“I had admired both the family and the business for decades, and a deal was made quickly.” [in discussing the Nebraska Furniture Mart acquisition.]
“It’s the ideal business — one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.” [in discussing the Nebraska Furniture Mart acquisition.]
“The business possesses a valuable and solid consumer franchise and a manager equally valuable and solid.” [speaking of See’s Candies.]
“You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject.”
“Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tangible assets.”
“...you should be aware that Charlie and I believe that Berkshire possesses very significant economic Goodwill value above that reflected in our book value.”
In previous letters, Buffett laid out his investment filters, the things he looks for in a “wonderful” business — franchise value, a moat, competent and honest management. The first quote, though, provides some perspective on assessing a business’ competitive position and whether it has a moat, by asking if you’d be able to compete provided you had sufficient resources. When considering an investment and performing the bottoms-up analysis, ask yourself this question. An honest appraisal of the situation will help you quickly identify their moat, or lack of one.
He felt it important enough to attach an appendix to the annual letter describing in detail the difference between economic and accounting goodwill. It’s a useful and excellent primer on the subject as he answers why asset-heavy businesses generally earn low rates of return and are hurt by inflation. In contrast, businesses that combine intangibles of lasting value with little needed in tangible assets weren’t hurt by inflation. Economic goodwill is the gift that keeps giving.
On Mr. Market and Valuations“In candy, as in stocks, price and value can differ; price is what you give, value is what you get.”
“A hyperactive stock market is the pickpocket of enterprise.”
“...our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy.”
“People who buy for non-value reasons are likely to sell for non-value reasons. Their presence in the picture will accentuate erratic price swings unrelated to underlying business developments.”
Our wonderful, hair-trigger market--it always amazes me, though, as I look at the daily squiggles. It’s as if these gyrations would have you believe that the value of a business enterprise changes on a second-by-second basis. Buffett said previously in the 1977 letter that he values stocks the same as he values entire businesses. So if someone is in a negotiated transaction, does it make sense to come back and request a new price simply because some exogenous event happened in the market place...? That’s in effect what the market is implying.
Those that speculate and fixate on price instead of value should be worried when price moves against them since they have no grounded basis in value in which to relate the price they paid. Curiously, this aspect of human psychology hasn’t changed since Ben Graham’s time. Perhaps we’ll always have over-active traders. But that’s ok ... it creates opportunities for the investor focused on value.
On Stock Ownership and Stock Splits“One of our goals is to have Berkshire Hathaway stock sell at a price rationally related to its intrinsic business value.”
“The key to a rational stock price is rational shareholders, both current and prospective.”
“Manic-depressive personalities produce manic-depressive valuations. Such aberrations may help us in buying and selling the stocks of other companies. But we think it is in both your interest and ours to minimize their occurrence in the market for Berkshire.”
“In large part, however, we feel that high quality ownership can be attracted and maintained if we consistently communicate our business and ownership philosophy - along with no other conflicting messages - and then let self selection follow its course.”
“We want those who think of themselves as business owners and invest in companies with the intention of staying a long time. And, we want those who keep their eyes focused on business results, not market prices.”
“Were we to split the stock or take other actions focusing on stock price rather than business value, we would attract an entering class of buyers inferior to the exiting class of sellers.”
“We will try to avoid policies that attract buyers with a short-term focus on our stock price and try to follow policies that attract informed long-term investors focusing on business values.”
At the time, the Berkshire A-shares traded around $1300. Now they’re priced at $123K--the most expensive in the market place. Why? Because, just as an investor can choose a company for their portfolio, a company can equally choose the investors they’d like to have by simply incorporating the right polices and communications to attract them. Stock splits serve no purpose but to lower price. This mere activity would then have you think that people somehow feel richer because they have 100 one-dollar bills instead of one $100 bill. Lowering the price through a split will just attract the investor fixated on price and not value, and who will ultimately sell at the first sign of bad news. When done in mass, this will create more volatility than if the company had pursued a path of disincentives designed to keep them away.
Additionally, by keeping a stable share price over time related to intrinsic business value, not only will an investor be able to buy growth at a reasonable price, but he will be able to sell if he chooses at a reasonable and rational price.
On Berkshire’s Manager-Owner Relationship“Although our form is corporate, our attitude is partnership.”
“... our directors are all major shareholders ... we eat our own cooking.”
“Our long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis.”
“Our preference would be to reach this goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries.”
“... consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers.”
“Accounting consequences do not influence our operating or capital-allocation decisions.”
“We rarely use much debt and, when we do, we attempt to structure it on a long-term fixed rate basis.”
“A managerial ‘wish list’ will not be fulfilled at shareholder expense.”
“We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained ... We will continue to apply it on a five-year rolling basis.”
“We will issue common stock only when we receive as much in business value as we give.”
“Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in it.”
“We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value ... We also believe candor benefits us as managers: the CEO who misleads others in public may eventually mislead himself in private.”
“Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are.”
This concludes the review of the 1983 Berkshire Hathaway shareholder letter.
Follow back next time as we continue with the 1984 letter.
To see the previous article of this series, please click here.