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Accounting
At first, he came to talk about the change in current accounting at that time. Before, the equity securities owned by insurance companies were carried at lower cost or market. But now, the accounting profession determines it should be carried at the market value. As equity securities had kept increasing in value, the change in accounting had made Berkshire Hathaway to recognize huge unrealized gains, boosting the 1978 and 1979 net worth significantly, even after the appropriate liability for capital gain taxes. It resulted in the poorer ROE than it actually looked.
We can see that the economic side did not change at all, but the figures in financial statement and the ratios changed very significantly. That should be taken into consideration whenever we evaluate any businesses.
Measuring performance
Warren Buffett mentioned the most appropriate way to measure any single year’s operating performance is the ratio of operating earnings (before securities gains or losses) to shareholders’ equity. He added further: “Measuring such results against shareholders’ equity with securities valued at market could significantly distort the operating performance percentage because of wide year-to-year market value changes in the net worth figure that serves as the denominator. For example, the large decline in securities values could result in a very low “market value” net worth that, in turn, could cause mediocre operating earnings to look unrealistically good. Alternatively, the more successful that equity investments have been, the larger the net worth base becomes and the poorer the operating performance figure appears.” That was the reason why Berkshire Hathaway kept reporting operating performance against the beginning net worth, with securities valued at its costs.
Like the past year letter, he wrote about the rise in earning per share might not be as good as it looked. “Earnings per share” will rise constantly on the dormant savings account or on a U.S Savings Bonds bearing a fixed rate of return simply because “earnings” (the stated interest rate) are continuously plowed back and added to the capital base. Thus, even a “stopped clock” can look like a growth stock if the dividend payout ratio is low.”
And about the test of managerial economic performance, it was the “achievement of high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”
The long-term economic performance was measured differently from the yearly performance, Buffett believed that “it is appropriate to recognize fully any realized capital gains or losses as well as extraordinary items, and also to utilize financial statements presenting equity securities at market value. “ So In effect, for any single year, the security investment result should not be taken into account seriously, but it is the very useful indicator for the long-term performance.
Talking about the gain in the book value of 20.5% compounded annually from 1964, Buffett noted that Berkshire had achieved this result but using the low amount of both financially leverage (debt/equity) and operating leverage (premium volume to capital funds of insurance business), and without significant issuance or repurchases of shares.
Bad and good economic business
The textile arm of the group continued to produce some cash, but at the low rate compared to capital employed. Buffett stressed it was not the reflection on the managers, but rather in the industry. In contrast, in some great business, network TV station for example, “it is virtually impossible to avoid earning extraordinary returns on tangible capital employed in the business. And assets in such businesses sell at equally extraordinary prices, one thousand cents or more on the dollar, a valuation reflecting the splendid, almost unavoidable, economic results obtainable. Despite the fancy price tag, the easy business may be the better route to go.”
Buffett recalled the experience of cigar butt business (bad but cheap), it was to purchase Waumbec Mills in Manchester, New Hampshire, to expand the textile business. “By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing. But the purchase was a mistake. While we labored mightily, new problems arose as fast as old problems were tamed….. Both our operating and investment experience cause us to conclude that the “turn around” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchase at a bargain price.”
Insurance Underwriting
“We hear a great many insurance managers talk about being willing to reduce volume in order to underwrite profitably, but we find that very few actually do so. Phil Liesche is an exception: If the business makes sense, he writes it; if it doesn’t, he rejects it. It is not our policy to lay off people because of the large fluctuations in work load produced by such voluntary volume change. We would rather have some slack in the organization from time to time than keep everyone terribly busy writing business on which we are going to lose money.” The discipline in insurance underwriting can be seen the most important in the business, we’d rather write less business than writing business we do not understand.
Then the importance of the manager in insurance business: “We believe that insurance can be a very good business. It tends to magnify, to an unusual degree, human managerial talent – or the lack of it… However, the business has the potential for really terrible results in a single specific year. If accident frequency could turn around quickly in the auto field, we, along with others, are likely to experience such a year.”
Insurance investment (bond)
A lot of insurance companies invested in bonds. And during the recent period, a large amount of companies in the industry had lost their money. However, the accounting convention allowed insurance companies to carry bond investment at amortized cost, regardless of declining market value. Then he commented “that very accounting convention may be contributed in a major way to the losses; had management been forced to recognize market value, its attention might have been focused much earlier on the dangers of a very long-term bond contracts.”
“We never would buy thirty or forty-year bonds; instead we tried to concentrate in the straight bond area on shorter issues with sinking fund and on issues that seemed relatively undervalued because of bond market inefficiencies.”
“You do not adequately protect yourself by being half awake while others are sleeping. It was a mistake to buy fifteen-year bonds, and yet we did; we made an even more serious mistake in not selling them (at losses, if necessary) when our present views began to crystallize… Of course, we must hold significant amounts of bonds or other fixed dollar obligations in conjunction with our insurance operations”.
For the bond portfolio in insurance investment, Berkshire held mainly convertible bonds. Buffett thought that when the conversion options were obtained, in effect, it would give the portion of the bond portfolio far shorter average life than implied by the maturity terms of the issue.
Shareholders
Buffett ended his letter by discussing about the difference of Berkshire shareholders (long-term holding) versus the short term shareholders of other corporations: “In large part, companies obtain the shareholder constituency that they seek and deserve. If they focus their thinking and communications on short-term results or short-term stock market consequences they will, in large part, attract shareholders who focus on the same factors”. Phil Fisher had compared attracting shareholders to those of a restaurant attracting potential customers. “And if the business vacillated between French cuisine and take-out chicken, the result would be revolving door of confused and dissatisfied customers."
For previous years of Buffett’s Letter to shareholders highlights, please check the following links:
1977: http://www.gurufocus.com/news/136076/buffetts-letter-to-shareholders-highlights-1977-
1978: http://www.gurufocus.com/news/136506/buffetts-letter-to-shareholders-highlights-1978
About the author:
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam Visit Anh Hoang's Website
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