On Judging Performance“As we discussed last year, the gain in per-share intrinsic business value is the economic measurement that really counts. But calculations of intrinsic value are subjective. In our case, book value serves as a useful, although somewhat understated, proxy.”
“We regard any annual figure for realized capital gains or losses as meaningless, but we regard the aggregate realized and unrealized capital gains over a period of years as very important.”
“Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)”
In this particular year, Buffett lamented that Berkshire’s book value gain was only 13.6%. By this time, double-digit inflation was tempering back down to its historical long-term average of approximately 3% (see the US inflation calculator). In the twenty-year period since he became manager, they’d averaged a 22.1% CAGR.
Intrinsic business value is the figure that counts, not the daily price Mr Market may serve up to you. However, he admits that the calculation of intrinsic value is not a matter of precision, but is instead subjective. As he reminded us in the previous letter, intrinsic value is about estimating the future cash you can take out of a business and discounting to present value. Therein lies the heart of the subjectivity--three different people can look at the same set of data and arrive at three different estimates for intrinsic value. However, that doesn’t mean all three people are right or wrong. In Berkshire’s case, due to the nature of the company, estimating intrinsic value is a bit more complicated. However, the growth in book value is a suitable proxy but will probably always be lower than the growth in intrinsic business value.
As he stated in the 1983 letter, a manager, or an investor, should assess performance over rolling 5-year periods against American industry in aggregate. Single year figures are meaningless. And in the case of Berkshire, single-year realized capital gains figures are meaningless because of the nature of accounting conventions discussed originally in the 1980 letter. In short, their pro-rata portion of earnings from their stock portfolio is effectively hidden away, like an iceberg, until they are sold for realized gains and booked. Until that time, only dividends are reported in operating earnings. For Berkshire, this unrealized value rivaled, and over the years exceeded, their normal operating earnings from their wholly-owned subsidiaries. It pays then to review the stock portfolio of a conglomerate you may have in your portfolio. Does it have a hidden ‘earnings iceberg’ that matches, or is larger, than the normal operating earnings of the company?
On Share Repurchases“When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.”
“The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value.”
“A manager who consistently turns his back on repurchases, when these clearly are in the interests of owners, reveals more than he knows of his motivations.”
Buffett favors companies that repurchase their own shares at a discount for two reasons. The first and obvious reason it increases in a highly significant way the per-share intrinsic business value because the company is able to get an investment in themselves of $2 for $1. Most corporate acquisition programs don’t deliver business-for-business value on a dollar-for-dollar basis.
The second, but subtler reason, is a result of management demonstrating they are there to enhance shareholder wealth and not managerial domain. As future investors witness this action, their estimates of business value increase over time. This action begets an upward revision in market prices more commensurate with intrinsic business value. These prices are entirely rational--an investor should be willing to pay up for a good company that’s in the hands of excellent managers with pro-shareholder tendencies instead of self-interested managers marching to their own beat.
On Selecting Investments“As you know, we buy marketable stocks for our insurance companies based upon the criteria we would apply in the purchase of an entire business. This business-valuation approach is not widespread among professional money managers and is scorned by
many academics. Nevertheless, it has served its followers well (to which the academics seem to say, “Well, it may be all right in practice, but it will never work in theory.”) Simply put, we feel that if we can buy small pieces of businesses with satisfactory underlying economics at a fraction of the per-share value of the entire business, something good is likely to happen to us - particularly if we own a group of such securities.”
“We extend this business-valuation approach even to bond purchases such as WPPSS.” (Washington Public Power Supply System)
“Our approach to bond investment - treating it as an unusual sort of “business” with special advantages and disadvantages - may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective.”
“In what I think is by far the best book on investing ever written - “The Intelligent Investor”, by Ben Graham - the last section of the last chapter begins with, “Investment is most intelligent when it is most businesslike.” This section is called ‘A Final Word’, and it is appropriately titled.”
“Only when bond purchases appear decidedly superior to other business opportunities will we engage in them. Those occasions are likely to be few and far between.”
Buffett looks for value where ever he can find it, as long as it’s in his circle of competence. In this case, Buffett’s purchase of WPPSS bonds is a good primer on the subject of viewing a bond as a “business” that competes with regular businesses for your investment dollars. In short, view the bond’s coupon as ‘earnings’ compared to a company producing the equivalent amount in earnings. In this case, WPPSS bonds had a $22.7M coupon, to which he paid $139M. This gave him an effective earnings yield of 16.3%. At that time, to buy a company producing the same $22.7M in earnings, he’d have to spend anywhere between $250M to $300M, which equates to an earnings yield in the range of 7.6% to 9%. There were some risks with the bond purchase, which he covered in the letter; however, when viewed this way, the WPPSS bonds had a superior yield and were the better investment. Alternatively, you can view it from the other direction, where a stock is an “equity-bond”, with a growing coupon over time, compared to prevailing bond yields.
On Dividend Policy“No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.”
“But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”
“...you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.”
“Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level,. the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.”
“Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)"
“If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.”
“But as long as prospective returns are above the rate required to produce a dollar of market value per dollar retained, we will continue to retain all earnings. Should our estimate of future returns fall below that point, we will distribute all unrestricted earnings that we believe can not be effectively used. In making that judgment, we will look at both our historical record and our prospects. Because our year-to-year results are inherently volatile, we believe a five-year rolling average to be appropriate for judging the historical record.”
In this letter, Buffett spent considerable time discussing dividend policy, in general and specific to Berkshire. Many companies report their dividend payout as what appears to be an arbitrary figure, such as 30% of earnings, without any analysis as to how they arrived at that value. As he’s pointed out many times before, capital allocation is an important function of the CEO--it’s crucial to business and investment management. Since it is, managers should think long and hard about the circumstances under which they’ll retain capital or distribute it.
Earnings are not created equal and fall into two camps: restricted and unrestricted. Restricted earnings are those that, if paid out, would be detrimental to the company’s sales volume, long-term competitive position, and financial strength. If your manager messes with these, that company will go the way of the Do-Do bird.
With regard to unrestricted earnings, a company has more leeway...but it should choose a path that’s beneficial to the shareholder. Not all management’s think this way and would rather expand the corporate empire over seeking investments with reasonable prospects where a dollar retained will produce at least a dollar in market value for the owners.
However, Buffett makes clear in the last quote what Berkshire’s dividend policy is--in essence, as long as he can continue to earn high rates of return on capital, the shareholder-friendly thing to do is allow him to compound it on their behalf.
On Mr Market and Valuations“In GEICO’s case, as in all of our investments, we look to business performance, not market performance. If we are correct in expectations regarding the business, the market eventually will follow along.”
“It’s been over ten years since it has been as difficult as now to find equity investments that meet both our qualitative standards and our qualitative standards of value versus price. We try to avoid compromise of these standards, although we find doing nothing the most difficult task of all.”
Mr Market is manic-depressive, and he’ll bug you everyday with a different price--sometimes, wildly so. Falling prices can be fearful to some, but when you see it accompanied with rising business fundamentals...that’s a good problem to have. Business performance matters, because the market is a weighing machine and in time the market price will catch up with the business’ performance.
Additionally, there will be times, like now, when finding those value bargains is difficult as Buffett had in 1984. However, he’s reminding us, as well as his shareholders, that you shouldn’t compromise your investment principles and standards just because you feel the need to do something. Buffett referred to this as “masterly inactivity.” His partner, Charlie Munger, has a slightly different version: “To deserve what you want you need a lot of ‘assiduity’ And what’s assiduity? It’s the ability to sit down on your ass until you do it.”
This concludes the review of the 1984 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.