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 from various letters. 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. Although I’ve read all his letters a few times in their entirety, I always seem to come away with something new that I overlooked before.
On Judging Performance“In past reports I have noted that book value at most companies differs widely from intrinsic business value – the number that really counts for owners.”
“In our case, however, book value has served for more than a decade as a reasonable if somewhat conservative proxy for business value. That is, our business value has moderately exceeded our book value, with the ratio between the two remaining fairly steady.”
“…we hope to average a return of 15% on equity and we maintain that hope, despite some negative tax law changes…”
In the 22-year period since he became manager, Berkshire averaged a 23.3% CAGR in book value. During this period he increased book value an astounding 10,600% while keeping the number of shares outstanding relatively even, increasing less than 1%. As a reminder from the 1983 letter, he prefers Berkshire’s shares to trade in a relatively narrow and rational window related to the company’s performance and intrinsic business value. He doesn’t want wild and wide variations in the stock price. The key to a rational stock price is rational shareholders — current and prospective.
On GAAP & Earnings[Defining owner earnings] “These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less (c) the average annual amount of capital expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.”
“Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keyne’s observation: ‘I would rather be vaguely right than precisely wrong.”
“Questioning GAAP figures may seem impious to some. After all, what are we paying the accountants for if it is not to deliver us the ‘truth’ about our business. But the accountants’ job is to record, not to evaluate. The evaluation job falls to investors and managers.”
“Accounting numbers, of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress. Charlie and I would be lost without these numbers: they invariably are the starting point for us in evaluating our own businesses and those of others. Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.”
Buffett provided an appendix to this letter where he introduced the concept of "owner earnings." He did this by providing GAAP information for two companies with identical economics: company O and company N. Both had the same sales, wages, taxes, etc. However, one had net income of $28 million, the other $40 million. In reality, they were the same company, Scott Fetzer, that he’d acquired. However, what he did was illustrate the distortions that GAAP accounting conventions have on presenting a good economic picture of what’s really happening in the business.
Enter owner earnings…the only good method to figure out what’s going on. Admittedly, it’s not precise since you must make some estimate at capital expenditures. However, as he points out quite clearly, owner earnings is the relevant item for valuation purposes, not net income — for both investors and managers buying entire businesses. You’ll never get a precise figure with owner earnings — but that’s not the point. The point rather is to think about the business and what it needs for maintenance of its competitive position in industry, versus what it needs for growth.
Unfortunately, GAAP net income can be manipulated to a large degree, for both fraudulent (think Enron) and perfectly legal reasons (think US tax code). Tax law allows a business to depreciate assets. If for instance a company paid $1 million for equipment, it can depreciate that cost over 10 years. However, from a cash-flow point of view, the money was spent up front, and not in $100K increments for 10 years. If a business is having cash flow issues, calculating owner earnings will help you see it rather quickly. And, if you can spot a problem business, you can avoid it and side step permanent capital impairment.
Conversely, a company that you might not even look attractive based strictly on EPS may look completely different in performance, and therefore a purchase candidate, when viewed through the prism of owner earnings.
On Selecting Investments“In general, the businesses described in this section can be characterized as having very strong market positions, very high returns on capital employed, and the best of operating managements.”
“Fechheimer is exactly the sort of business we like to buy. Its economic record is superb; its managers are talented, high-grade, and love what they do; and the Heldman family wanted to continue its financial interest in partnership with us.”
“If our success were to depend upon insights we developed through plant inspections, Berkshire would be in big trouble. Rather, in considering an acquisition, we attempt to evaluate the economic characteristics of the business – its competitive strengths and weaknesses – and the quality of the people we will be joining.”
“On the other hand, we frequently get approached about acquisitions that don’t come close to meeting our tests: new ventures, turnarounds, auction-like sales, and the ever-popular (among brokers) ‘I’m-sure-something-will-work-out-if-you-people-get-to-know-each-other.’ None of these attracts us in the least.”
“We must of necessity, hold marketable securities in our insurance companies and, as money comes in, we have only five directions to go: (1) long-term common stock as investments; (2) long-term fixed-income securities; (3) medium-term fixed-income securities; (4) short-term cash equivalents; and (5) short-term arbitrage commitments.”
“…at best, the bonds are mediocre investments. They simply seemed the least objectionable alternative at the time we bought them, and still seem so.”
“Currently liking neither stocks nor bonds, I find myself the polar opposite of Mae West as she declared: ‘I like only two kinds of men – foreign and domestic.’”
“We restrict ourselves to large deals that have been announced publicly and do not bet on the outcome.” [referring to arbitrage investments.]
“Arbitrage is an alternative to Treasury Bills as a short-term parking place for money – a choice that combines potentially higher returns with higher risks.”
“We also, though it takes some straining, currently view medium-term tax-exempt bonds as an alternative to short-term Treasury holdings.”
“Even if we sell our bonds at a fairly large loss, however, we may end up reaping a higher after-tax return than we would have realized by repeatedly rolling over Treasury Bills.”
“Probably the best thing that could happen to us is a market in which we would choose to sell many of our bond holdings at a significant loss in order to re-allocate funds to the far-better equity values then very likely to exist.”
In this letter, Warren discussed the operating results at the Buffalo News, Nebraska Furniture Mart, See’s Candies, World Book, and Kirby and reminded us of the core tenants he looks for in investments, most notably strong market positions and high returns on capital — wonderful businesses with strong economic engines. But he clued us in that he doesn’t rely on site visits to a company to make a decision. He reads, evaluates and thinks. The same you and I can do with the publicly available information out there.
Additionally, he provided what I’ll call a hierarchy of his marketable security preference checklist… this describes his investment operation outside of acquiring whole companies. His obvious preference is to buy stocks, but when markets are overheated he’ll resort to other investments — bonds of various maturities and short-term arbitrage.
With respect to bonds, as you’ll note below in the valuation section, Buffett didn’t consider the markets cheap — he couldn’t find any equities to buy. He then resorted to bonds buying $700 million of tax-exempt bonds with maturities between 8 and 12 years. It was the lesser of two evils as far as he was concerned. However, due to opportunity costs, he’d sell the bonds at a loss if the price was right in the equities market.
He uses merger and acquisition arbitrage as a short-term parking spot for money. Notice he doesn’t speculate on take-over rumors… he waits until a deal is publicly announced and is virtually a “sure thing.” By this point in a particular M&A deal, the absolute percentage moves may be small; however, when on an annualized basis, they can significantly exceed short-term Treasuries. By focusing on “sure things” he protects capital by not engaging in speculation.
On Issuing Stock for Acquisitions“We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give.”
“Indeed, following recent advances in the price of Berkshire stock, transactions involving stock issuance may be quite feasible.”
In his 1982 letter, he laid out his original thoughts on the conditions under which he’d use Berkshire stock as “currency” in a negotiated transaction. He wants to be able to at least make a $1-for-$1 fair value business deal. With any stock, if it’s overvalued, it makes sense to sell it and use it to buy something that’s undervalued… even if that stock sold is your own company.
The second quote then, gives us a hint that he considered Berkshire stock to be over-priced at the time since he considered using it as currency. Note that the act of selling Berkshire, when overpriced, would be beneficial in something else he’d told us. Since the net effect of selling would lower Berkshire’s market price over time, this would aid in his goal of having a rational stock price related to business intrinsic value, as stated earlier, by pushing the price downward where it should be.
On Mr. Market and Valuations“I was unable to skillfully deploy much of the capital they generated.”
“Capital allocation at Berkshire was tough work in 1986.”
“…we had no new ideas in the marketable equities field, an area in which once, only a few years ago, we could readily employ large sums in outstanding businesses at very reasonable prices. So our main capital allocation moves in 1986 were to pay off debt and stockpile funds.”
“Under current stock market conditions, we have little hope of finding equities to buy for our insurance companies.”
“Markets will change significantly – you can be sure of that and some day we will again get our turn at bat. However, we haven’t the faintest idea when that might happen.”
“Unfortunately, however, stocks can’t outperform businesses indefinitely.”
“Bull markets can obscure mathematical laws, but they cannot repeal them.”
“Our aversion to long-term bonds relates to our fear that we will see much higher rates of inflation within the next decade.”
“Investing managers are even more hyperkinetic: their behavior during trading hours makes whirling dervishes appear sedated by comparison. Indeed, the term ‘institutional investor’ is becoming one of those self-contradictions called an oxymoron, comparable to ‘jumbo shrimp,’ ‘lady mudwrestler’ and ‘inexpensive lawyer.’”
“What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
Pardon the vast number of quotes here, but in his last few letters, he’d been giving indications that the market was getting progressively more expensive. This letter is chock full of market over-valuation references. To provide context, 1986 inflation hovered between 3.8% at the start of the year to 1.1% by year’s end. The 10-year T-Bill started the year with a yield of 9.19% lowering to 7.11% by the end of the year.
Although the TMC/GDP ratio was about 0.6, which would normally indicate an undervalued market, it appears the expected return from the market (somewhere between 9% and 17%) wasn’t enough to entice him into purchasing equities since T-bills, the risk-free asset, had a high yield. Additionally, he expected inflation to increase. In this situation, he stockpiled funds and bought bonds, although not his preference. However, this choice was more preferable to investing in over-valued markets, which would most certainly cause permanent capital impairment.
I believe Warren’s “fearful and greedy” quote is probably one of the most used quotes in his repertoire. The full paragraph is provided for context, in which he discusses the unpredictability of markets and the futility of market timing. Accordingly, he discussed his policy of not trying to time the market, but rather takes his cues from people — he just tries to be greedy when others are fearful and fearful when others are greedy.
On Holding Periods“We should note that we expect to keep permanently our three primary holdings, Capital Cities/ABC Inc., GEICO Corporation, and The Washington Post.”
“Despite the enthusiasm for activity that has swept business and financial America, we will stick with our ‘til-death-do-us-part policy. It’s the only one with which Charlie and I are comfortable, it produces decent results, and it lets our managers and those of our investees run their businesses free of distractions.”
It’s common knowledge that Warren’s favorite stated holding period is “forever.” In this letter he lets us know that it “produces decent results,” especially if you buy cheap, and keep. And what would be a “decent” result? I would suspect it’s his 15% CAGR goal mentioned at the start of this article.
Rather than hyperactively jumping in and out of a stock, I believe it makes sense to hold it if it has a strong economic engine, ie. high returns on capital. I view it this way—if I paid fair value for a company, I can expect the stock price, and my returns, to follow the company’s performance over time. If that company has an economic engine that produces a consistent ROC of 15%, then I can expect the capital I provide the company to double every 5 years. If my alternative investment is a bond yielding 5%, I would much rather leave the capital in the company, even if it appreciated to fair value, and allow management to compound it on my behalf. If, on the other hand, it was the same situation, but with a company with a consistent ROC of 5%, it would make more sense to me to put that capital in the 5% bond and preserve its value while I hunt for a better investment opportunity.
This concludes the review of the 1986 Berkshire Hathaway Letter.
Follow back next time as we continue with the 1987 letter.
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- Warren Buffett Undervalued Stocks
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