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
“What counts, of course, is the rate of gain in per-share business value, not book value. In many cases, a corporation’s book value and business value are almost totally unrelated.”
“At Berkshire, however, the two valuations have tracked rather closely, with the growth in business value over the last decade moderately outpacing the growth rate in book value.”
“By itself, this figure says nothing about economic performance. To evaluate that, we must know how much total capital – debt and equity – was needed to produce these earnings.” [speaking of the $180 million in operating earnings produced by their seven largest subsidiaries.]
“If these seven business units had operated as a single company, their 1987 after-tax earnings would have been approximately $100 million – a return of about 57% on equity capital.”
“Eventually, our economic fate will be determined by the economic fate of the businesses we own, whether our ownership is partial or total.”
In 1987, Berkshire’s net worth had grown $464 million, or 19.5% contributing to a 23-year track record that averaged 23.1% compounded annually. As Buffett notes, the growth of per-share business value is the thing that matters, not the growth in book value. After all, anyone can retain earnings in the business and buy Treasuries and continually roll them over and “grow” book value. But to grow book value by wisely allocating retained earnings takes management skill. To test the ability of management to wisely allocate capital, refer to the “$1 Test” he initially referenced in the 1978 letter.
In his earlier letters he told us he would operate the company on the premise that buying good, solid businesses with high returns on capital and solid management would eventually be recognized in the stock’s market valuation over time. At this point, he’d been vindicated in this presumption. A decade later, the market was now valuing Berkshire at a premium to book value. This was due to two simple reasons: remarkable businesses and remarkable managers. Additionally, recall from the 1984 letter that he manages Berkshire’s communications and policies to allow Berkshire’s stock price to trade in a rational window related to business performance. Here he lets us know that over the last decade the two have tracked closely, which is what he intended.
In previous letters, Buffett taught us that return on equity capital (ROE) was an important metric as businesses with moats (aka "wonderful" businesses) have sustainably elevated ROEs. However, with this letter it seemed he clarified it for us further. To measure the economic performance of a company we must know the total capital employed, both debt and equity, which would imply that return on capital (ROC/ROIC) is the preferred metric. Going forward, I believe it’s worth remembering that when he says “return on equity capital” he’s referring to ROC.
As an illustration, his seven largest subsidiaries, which produced about 42% of Berkshire’s 1987 after-tax earnings, achieved 57% ROC… wonderful businesses indeed. The intrinsic business value of these seven companies was far above their historical book value and needed little capital to run, enabling concurrent growth and deployment of capital in new opportunities. Although not mentioned to-date, he re-allocates excess capital from the subsidiaries into other investments.
On GAAP & Earnings“Where 'earnings' can be created by the stroke of a pen, the dishonest will gather.”
“The result: GAAP accounting lets us reflect in our net worth the up-to-date underlying values of the businesses we partially own, but does not let us reflect their underlying earnings in our income account.”
“In the case of our controlled companies, just the opposite is true. Here we show full earnings in our income account but never change asset values on our balance sheet, no matter how much the value of a business might have increased since we purchased it.”
“Our mental approach to this accounting schizophrenia is to ignore GAAP figures and to focus solely on the future earning power of both our controlled and non-controlled businesses.”
In the 1986 letter, Buffett reminded us of the utility of determining ‘owner earnings,’ as opposed to using accounting net income or earnings per share. Why? Because they’re reflective of what’s actually happening in the business. You can tell whether a prospective purchase is actually chewing through cash or whether they’re making money hand over fist.
An accountant’s job is to record what happened in the language of accounting called GAAP. It’s the job of the manager/investor to evaluate. Since the constituent parts to determine net income or EPS can be manipulated, it stands to reason that the unscrupulous company won’t have any qualms with painting an ‘earnings mirage’ to make you think things are fine when they otherwise aren’t and are actually burning through cash by the boatload. Sadly, some companies resort to this chicanery, although a lot don’t. However, it’s worth relying on owner earnings vice EPS to get a truer picture of the cash flows within the business.
On Selecting Investments“Severe change and exceptional returns usually don’t mix.”
“Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today’s business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be.”
“Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.”
“But a business that constantly encounters major change also encounters many chances for major error.”
“Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.”
“The Fortune champs may surprise you in two respects. First, most use very little leverage compared to their interest-paying capacity. Really good businesses usually don’t need to borrow. Second, except for one company that is “high-tech” and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane.” [from a Fortune study…only 25 of 1000 companies had avg ROE>20% for 10 years, with no one year<15%]
“The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.”
“Our managers have produced extraordinary results by doing rather ordinary things – but doing them exceptionally well.”
“The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. In such a commodity-like business, only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels.”
“Whenever Charlie and I buy common stocks for Berkshire’s insurance companies we approach the transaction as if we were buying into a private business.”
“When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.”
“We really don’t see many fundamental differences between the purchase of a controlled business and the purchase of marketable holdings such as these. In each case we try to buy into businesses with favorable long-term economics. Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price. Charlie and I have found that making silk purses out of silk is the best that we can do; with sow’s ears, we fail.”
“…we can choose among five major categories: (1) long-term common stock investments, (2) medium-term fixed-income securities, (3) long-term fixed income securities, (4) short-term cash equivalents, and (5) short-term arbitrage commitments.”
“We have no particular bias when it comes to choosing from these categories. We just continuously search among them for the highest after-tax returns as measured by ‘mathematical expectation,’ limiting ourselves always to investment alternatives we think we understand.”
“We are, however, willing to invest a moderate portion of our funds in this category if we think we have a significant edge in a specific security.” [Speaking of his general fear of long-term bonds.]
“We enter into only a few arbitrage commitments each year and restrict ourselves to large transactions that have been publicly announced.”
“Though we’ve never made an exact calculation, I believe that overall we have average annual pre-tax returns of at least 25% from arbitrage.”
“By their nature, the economics of this industry are far less predictable than those of most other industries in which we have major commitments. This unpredictability is one of the reasons why our participation is in the form of a convertible preferred.” [Speaking of the investment banking industry and his purchase of Salomon 9% preferred stock.]
Here, Warren counsels us that a business or industry that sells disruptive products or services usually doesn’t make for a good investment… and don’t bother to expect exceptional returns from it either. Technology is a prime example… by its very nature, it’s disruptive. As a rule, I enjoy technology as a user… just not as an investor.
Why? I view it this way. In order to evaluate the intrinsic value of a business, you need to be able to look into the future, as it were, and think about the sustainability of margins, competition, growth, etc. From this springboard, you’re in a position to evaluate how much to pay. But, severe change in an industry clouds the future, and by extension clouds your ability to assess the very things you need to evaluate the company and its intrinsic value. Businesses in this kind of industry find it difficult to carve a moat for themselves when the very foundations they built them on are crumbling due to a better mouse trap. And it’s moats with high and sustainable ROCs that we’re after.
However, all is not lost. He teaches us that it’s far better to seek companies that do boring things, quite frankly. This is a fertile hunting ground because it’s these companies/industries that are structurally better at maintaining moats and high ROE/ROC.
In support of his view, he pointed out a Fortune Magazine study that showed that only 25 out of 1000 companies met two tests of economic excellence – a 10-year average ROE over 20%, and no one-year ROE worse than 15%. During 1977-1986, 24 of the 25 outperformed the S&P 500. Additionally, these companies used very little leverage and produced items that were rather mundane.
In previous letters, Warren gave us his performance goal of 15% CAGR. However, he’s been moot on providing a parameter for high ROC. I find it curious that he would use the Fortune Magazine test as a data point. I can only conclude that he concurs with these two tests of economic excellence since he used them in the letter… sustained average ROE>20%, and single year ROE>15%.
Repeating from the 1986 letter, Warren reminds us of his five basic investing categories outside of wholly-owned subsidiaries. It’s apparent that he scans for the best possible investment given the existing investing conditions at the moment in time he’s dealing with. His statement that he searches and commits money to the highest after-tax return as measured by "mathematical expectation" tells me that he has to have a method to compare expected stock returns to bond returns, to make an apples-to-apples comparison in order to allocate capital.
Lastly, in Buffett’s final quote of this section, I believe it’s a reverse method of advising us to look for predictability in a business. The very fact that investment banking was unpredictable prevented him from purchasing equity in Salomon. However, his references here imply that his major commitments in equities are predictable businesses. And it makes sense. If you can find a predictable company with steady sales growth, consistent cost control, and consistent earnings growth, then to me it’s a glaring indicator that there’s something right with the business and/or the company/management — and more than likely the presence of a moat exists. The more predictable it is, the more confidence you can have in your analysis of their future.
Businesses built on commodities normally fail to meet this test since they compete on price. In order for one of these to dominate the industry with high profitability, it needs to be a very low cost operator, or have some kind of protection, i.e. government or cartel, to protect pricing levels.
On Mr Market and Valuations“…we have found little to do in stocks during the past few years.”
“Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but.”
“…Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.”
“Ben’s Mr. Market allegory may seem out-of-date in today’s investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising ‘Take two aspirins’?”
“Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.”
“Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful.”
“The market may ignore business success for a while, but eventually will confirm it. As Ben said: ‘In the short run, the market is a voting machine but in the long run it is a weighing machine.’”
“In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.”
“The disadvantages of owning marketable securities are sometimes offset by a huge advantage: Occasionally the stock market offers us the chance to buy non-controlling pieces of extraordinary businesses at truly ridiculous prices – dramatically below those commanded in negotiated transactions that transfer control.”
As Buffett had mentioned in the 1986 letter, the stock market was getting expensive, and he reminded us again here. For perspective, in 1987 the inflation rate ranged between 1.45% and 4.34%, while the 10-year Treasury started the year with a 7% yield and ended the year with a 9% yield. The total market capitalization to GDP (TMC/GDP) ratio hovered between 0.6 and 0.65.
For the first time in his letters, Warren introduced Mr. Market to his shareholders and let them know of his manic-depressive personality. And his sage advice? Take advantage of him, because he’ll do crazy things. It’s his pocketbook you’re after, not his advice.
In reality, this section can be cleanly summed up in a short sentence, “It’s all about the business, stupid!” He reminds us continuously that you’re buying a fractional interest in a company when purchasing stock, so focus on the company. If you truly do that, everything else takes care of itself, whether you decide to purchase or pass.
On Portfolio Management“In the meantime, our major parking place for money is medium-term tax-exempt bonds.”
“Regardless of their market price, we are ready to dispose of our bonds whenever something better comes along.”
“Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better.”
“Of Wall Street maxims the most foolish may be ‘You can’t go broke taking a profit.’”
Warren said in last year’s letter, and repeats it here, that he’ll sell his bond holdings, at a loss if necessary, in order to re-deploy capital in a higher expected return. There’s an opportunity cost associated with not making an investment, and at times it’s better to take the loss and move on. Additionally, since Mr. Market will sometimes irrationally over-price a security, he advises us to sell it and re-allocate the capital. Lastly, it’s alright to sell a fairly-valued stock, or even one that hasn’t appreciated to fair value yet, if you get a much better investment idea.
On Holding Periods“Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate.”
“We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.”
Warren’s favorite holding period is “forever.” It produces decent results, especially if you find good businesses with high ROC and that increase their intrinsic value at a steady clip, because as we know the market will eventually recognize the company’s performance and value it accordingly. As he’s mentioned previously, he’s looking for a 15% CAGR. By implication then, the “satisfactory rate” he mentions above is 15%. When you buy a company with a high ROC and keep the capital in it, you’re allowing the management to compound your money at that particular rate.
On the 1987 Stock Market Crash“We have ‘professional’ investors, those who manage many billions, to thank for most of this turmoil. Instead of focusing on what businesses will do in the years ahead, many prestigious money managers now focus on what they expect other money managers to do in the days ahead. For them, stocks are merely token in a game, like the thimble and flatiron in Monopoly.”
“An extreme example of what their attitude leads to is ‘portfolio insurance,’ a money-management strategy that many leading investment advisors embraced in 1986-1987. This strategy – which is simply an exotically-labeled version of the small speculator’s stop-loss order dictates that ever increasing portions of a stock portfolio, or their index-future equivalents, be sold as prices decline. The strategy says nothing else matters: A downtick of a given magnitude automatically produces a huge sell order. According to the Brady Report, $60 billion to $90 billion of equities were poised on this hair trigger in mid-October of 1987.”
“The less these companies are being valued at, says this approach, the more vigorously they should be sold. As a ‘logical’ corollary, the approach commands the institutions to repurchase these companies – I’m not making this up – once their prices have rebounded significantly.”
“Considering that huge sums are controlled by managers following such Alice-in-Wonderland practices, is it any surprise that markets sometimes behave in aberrational fashion?”
“They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. This conclusion is dead wrong: such markets are ideal for any investor – small or large – so long as he sticks to his investment knitting.”
“Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves.”
In 1987 I was studying engineering at college. When the crash happened, I knew it was a big deal, but I didn’t understand anything about the stock market. It’s been a long time since that happened, and now I get it. One thing’s clear — Warren pokes a firm finger in the eyes of these fund managers. They let Mr. Market loose. But in the same vein, if it wasn’t for their irrationality, we wouldn’t get the screaming good deals that we need as value investors.
Although the Internet has had a democratizing influence in many aspects of human life, including investment knowledge and access to information, I believe things won’t change. There are those that opine that all information is instantly available which allows the Efficient Market Hypothesis to flourish.
I don’t see it that way.
Humans are what they are. Fear and greed will never go away. The Internet only allows them to exercise their irrationality faster. But, this is a good thing, because it means we’ll always have bear markets and the subsequent deals that come out of them.
Follow back next time as we continue with the 1988 letter.