On Judging Performance
“Our equity capital is more than twenty times what it was only ten years ago. And an iron law of business is that growth eventually dampens exceptional economics.”
“...reported capital gains or losses in any given year are meaningless as a measure of how well we have done in the current year.”
In this particular year, Berkshire’s (NYSE:BRK.A)(NYSE:BRK.B) book value gain was an astounding 48.2%, a feat he referred to as occurring as about as frequently as Halley’s Comet and to which he gave two reasons: (1) current equity values weren’t cheap, so the capital would sit parked earning low rates; and (2) the sheer size of equity capital to employ presented an anchor to performance. In order for Berkshire to gain the 15% he sought, Berkshire would have to earn profits of $5.7 billion over the following decade — 48% higher than the $3.9 billion required for the following decade just the previous year.
For new readers, Buffett views reported capital gains/losses in any given year as meaningless for Berkshire because of the “earnings iceberg” issue pointed out in previous articles of this series. The short version: GAAP accounting conventions require him to report in a way that’s not reflective of the operational reality in the company. As a result, the per-share earnings of his stakes in individual stocks aren’t reported until they’re booked as capital gains, except for dividends received which were reported under operating earnings (see the 1980 letterfor the first time this subject was mentioned.)
In the 21-year period since he became manager, Berkshire averaged a 23.2% CAGR in book value.
On Selecting Investments
“The situation is suggestive of Samuel Johnson’s horse: ‘A horse that can count to ten is a remarkable horse - not a remarkable mathematician.’ Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company — not a remarkable business.” [while discussing the liquidation of the textile mills]
“My conclusion from my own experience and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row.” [while discussing the liquidation of the textile mills]
“Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.” [while discussing the liquidation of the textile mills]
“Ponder this: The economic goodwill attributable to two paper routes in Buffalo -— or a single See’s candy store — considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people.” [while discussing the liquidation of the textile mills]
“We have no master strategy, no corporate planners delivering us insights about socioeconomic trends, and no staff to investigate a multitude of ideas presented by promoters and intermediaries. Instead, we simply hope that something sensible comes along — and, when it does, we act.”
“The typical policyholder does not differentiate between products but concentrates instead on price.” [speaking to the inherent commodity nature of the insurance industry.]
“Berkshire’s financial strength (and our record of maintaining unusual strength through thick and thin) is now a major asset for us in securing good business.”
“These buyers today are attracted to Berkshire because of its strong capital position. But, in a development we did not foresee, we also are finding buyers drawn to us because our ability to insure substantial risks sets us apart from the crowd.”
Buffett finally realized, albeit late, that he needed to liquidate the textile business of Berkshire, which continued to consume major amounts of cash. He’d learned a hard lesson when it came to commodity-based businesses that have inherently poor economics — he’d rather not be in them. In the liquidation of the textile equipment, which originally cost $13 million and took up 750,000 square feet of floor space, gross proceeds from the sale amount to only $163,000. Looms that cost $5,000 in 1981 couldn’t be sold for $50, and eventually got sold for half that to the scrap yards.
Additionally, as he’d pointed out in previous letters, the insurance industry at one time had cartel-like pricing procedures. However, this arrangement vanished and prices were then set like any other commodity in a free market. This meant the industry had become commoditized, and consumers shopped based on price. But, as he points out in the last two quotes, Berkshire was carving a moat for itself within the industry based on financial strength and their ability to insure substantial risks that others couldn’t.
On Mr. Market and Valuations
“Today we cannot find significantly-undervalued equities to purchase for our insurance company portfolios. The current situation is 180 degrees removed from that existing about a decade ago, when the only question was which bargain to choose.”
“Today’s valuations mean that our insurance companies have no chance for future portfolio gains on the scale of those achieved in the past.”
“Management cannot determine market prices, although it can, by its disclosures and policies, encourage rational behavior by market participants. My own preference, as perhaps you’d guess, is for a market price that consistently approximates business value.”
“...we had learned from Ben Graham that the key to successful investing was the purchase of share in good businesses when market prices were at a large discount from underlying business values.” [speaking of the Washington Post purchase in 1973]
“You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not: Stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued.”
“We are enormously indebted to these academics: What could be more advantageous in an intellectual contest — whether it be bridge, chess or stock selection, than to have opponents who have been taught that thinking is a waste of energy?” [speaking of the efficient market theory]
Buffett suggests here that in 1985 markets weren’t cheap anymore — he couldn’t find any bargains. He was reminding his shareholders that when valuations get overstretched, and delinked from the underlying business fundamentals, it will provide a future environment of lower returns compared to the large gains they were used to getting, as a result of the cheap stock market deals a decade earlier.
When it comes to the quoted price of Berkshire’s stock, as he mentioned in the 1984 letter, and again here, he prefers it to sell at a rational price. In doing so, the stock price should undulate along with the actual business fundamentals and should therefore trade at a fair price most of the time, which is good for both sellers and buyers of the stock.
Outside of company performance, managements have an indirect effect on stock price through their policies and communications. If they create the right set of conditions, they’ll attract rational stockholders. I believe this is a major reason why Berkshire has never split the A-shares and in so doing allowed it to be the most expensive stock on the block, on an absolute basis. What better way to dis-incentivize hyper-active trading than by having a stock that currently costs $118,000+ per share?
Lastly, this letter has the first reference he made to the Efficient Market Hypothesis/Theory (EMH/EMT), in which he gives it, and active managers that practice it, a firm poke in the eye. The EMH/EMT postulates that the stock market is totally efficient, and therefore calculations of business value were of no importance in investment activities. By extension then, even thought itself wasn’t deemed all that important. In any game or contest in which you want to win, the best opponents are those that think it’s not even possible to win.
“In any business, insurance or otherwise, ‘except for’ should be excised from the lexicon. If you are going to play the game, you must count the runs scored against you in all nine innings. Any manager who consistently says ‘except for’ and then reports on the lessons he has learned from his mistakes may be missing the only important lesson — namely, that the real mistake is not the act, but the actor.”
“Inevitably, of course, business errors will occur and the wise manager will try to find the proper lessons in them. But the trick is to learn most lessons from the experiences of others. Managers who have learned much from personal experience in the past usually are destined to learn much from personal experience in the future.”
“Our Vice Chairman, Charlie Munger, has always emphasized the study of mistakes rather than successes, both in business and other aspects of life. He does so in the spirit of the man who said: ‘All I want to know is where I’m going to die so I’ll never go there.’ You’ll immediately see why we make a good team: Charlie likes to study error and I have generated ample material for him, particularly in our textile and insurance businesses.”
Success makes us jump for joy. But with respect to errors, we’re all human and errors are inevitable. This last quote was a lead-in to discuss the shutdown of the textile business — the company Berkshire-Hathaway was when Buffett bought into it before transforming it into the monolith we know today. How you react to your mistake, is just as important I believe to your long-term success as an investor or as a leader/manager. Maybe you bought outside of your circle of competence? Perhaps you over-estimated growth prospects and your valuation was off? Once a mistake is made, correct it and figure out what went wrong to avoid repeating it. When it comes to the managers you’ve entrusted your hard-earned capital to, do they study their mistakes? Are they self-reflecting? The honest and trustworthy manager will have the humility to admit a mistake, fix it, and carry on. The vain manager probably won’t — and would you want to be aligned with that type?
This concludes the review of the 1985 letter.
Follow back next time as we continue with the 1986 letter.