At times his wisdom is right out in the open, and at other times it requires a little thought and sleuth work to piece 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.
On Judging Performance“The major problem we face is a growing capital base.”
“With no benefit from financial leverage, this group earned about 67% on average equity capital.”[speaking of the “Sainted Seven”]
“The supreme irony of business management is that it is far easier for an inadequate CEO to keep his job than it is for an inadequate subordinate.”
“At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands.”
In 1988, Berkshire’s net worth increased $569 million, or 20%. By this time, Warren had been at the helm managing things for 24 years, and during that period he was able to grow per-share book value from $19.46 to $2,974.52, or 23% CAGR. Remember, he uses book value as a reasonable, but understated, proxy to Berkshire’s intrinsic value, to judge performance against the S&P 500. His internal scorecard for performance, based on previous letters, is 15% CAGR. The “Sainted Seven” includes his top wholly-owned subsidiaries: Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See’s, and World Book. Amazingly, these seven produced an average ROE of 67%, without financial leverage.
Unfortunately, size becomes a drag on performance — like the difference in turning radius between a speed boat and an ocean liner. He reminds us each letter, that as Berkshire grows, the ability to find places to deploy capital becomes increasingly difficult — especially if he’s going to continue looking for strong business operations with durable competitive advantages. In this case, in order for him to hit his 15% target for the coming decade, Berkshire would need profits of $10.3 billion. It was only four years previous that this figure was $3.9 billion.
It’s important though, whether investing for yourself, others, or running a company, that performance targets be established up front— not after the fact as so many CEOs were doing. Buffett wrote at length that many of these CEOs clearly didn’t belong in their job — but unfortunately their jobs were rather “secure.” One reason was that performance criteria for the CEO is fuzzy (if it exists), as compared to a secretary that might have steadfast typing speed targets. Second, the CEO has no immediate boss whose performance is itself getting measured, ie., the board. And, lastly, relations between the CEO and the board are expected to be congenial to the point that critical review of a CEO’s performance is “viewed as the social equivalent of belching.”
One lesson from his letters should be glaringly clear: CEOs allocate capital. They need to be good at it. If in their corporate upbringing they weren’t exposed to capital allocation decision making, they’ll likely be a stunning underperformer.
Crack open the proxy statement and look for the compensation schedule. See if the corporate officers’ compensation is built around their ability to allocate capital and look after the shareholder — their ultimate boss. What you find may surprise you.
On GAAP & Earnings“The limitations of the existing set, however, need not be inhibiting: CEOs are free to treat GAAP statements as a beginning rather than an end to their obligation to inform owners and creditors – and indeed they should. After all, any manager of a subsidiary company would find himself in hot water if he reported barebones GAAP numbers that omitted key information needed by his boss, the parent corporation’s CEO. Why, then, should the CEO himself withhold information vitally useful to his bosses – the shareholder-owners of the corporation?”
“What needs to be reported is data – whether GAAP, non-GAAP, or extra-GAAP – that helps financially-literate readers answer three key questions: (1) Approximately how much is this company worth? (2) What is the likelihood that it can meet its future obligations? And (3) How good a job are its managers doing, given the hand they have been dealt?”
“Further complicating the problem is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to overcome.”
“As long as investors – including supposedly sophisticated institutions – place fancy valuations on reported ‘earnings’ that march steadily upward, you can be sure that some managers and promoters will exploit GAAP to produce such numbers, no matter what the truth may be.”
“It has been far safer to steal large sums with a pen than small sums with a gun.”
GAAP isn’t perfect, but it is what it is. As he outlined previously, accountants record what happens, but it’s up to investors and managers to evaluate. GAAP is the starting point for analysis — never the end point, and not a substitute for judgement.
Buffett discussed some mandatory accounting changes Berkshire had to make this particular year, which involved fully consolidating all of their subsidiaries in their balance sheet and earnings statement, i.e., consolidating each asset and liability of each company in the balance sheet and each item of their income and expense on the earnings statement.
He’s always provided the consolidated GAAP figures as required in the filings. However, he’s also always published supplementary information to help the shareholders measure business value and managerial performance, presenting the information in a way that aids analysis, while striving to give the important information in a form that he would wish to receive if the roles were reversed.
That perspective should be the gold standard for CEOs. Sadly, not all of them view it this way. Over the decades, there have been innumerable corporate scandals, cheats, acts of commission and omission, etc., both of the legal and illegal variety. A legal example we run across every quarter is the Street’s incessant obsession with “earnings season.” When everyone’s focus is on EPS (and nothing else) there are those that’ll invent numbers, or “creatively determine” certain figures, all while staying within legal and GAAP parameters, so that EPS always marches skyward.
All is not lost, there is an antidote to this madness. The wise person should focus on owner earnings that Buffett described in the 1986 letter. Owner earnings will tell you what’s happening inside the business—are they chewing through cash or making money hand over fist?
On Selecting Investments“…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.”
“I realize that many of you do not pore over our figures, but instead hold Berkshire primarily because you know that: (1) Charlie and I have the bulk of our money in Berkshire; (2) we intend to run things so that your gains or losses are in direct proportion to ours; and (3) the record has so far been satisfactory.”
“In our own investing, we search for situations in which both approaches give us the same answer.” [referring to the ‘faith’ approach above vs. the ‘analysis’ approach to investing.]
“It only makes us hope that we run into some other large stigmatized issue, whose troubles have caused it to be significantly misappraised by the market.”
“…our insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents. We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas.”
“To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire – a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?”
Repeating from the 1986 letter, Buffett reminds us of his five basic investing categories outside of wholly-owned subsidiaries, scanning for the best possible after-tax investment returns as measured by “mathematical expectation.”
In the second quote above, Buffett describes what he calls a faith approach to investing where the investor relies on the management’s commitment to the business through their significant personal wealth in the company and performance history. This comment also seems to suggest that they look to large insider ownership, shareholder friendly management teams, and records above 15% when looking for their investments, because ‘satisfactory’ in his definition would seem to come from his own internal metric of 15% that he uses for himself.
As he told us in the previous letter, he uses arbitrage as a short-term alternative to cash. In this letter, he provided a bit more of a primer by itemizing the major questions that need to be asked in order to have a successful transaction. He only engages in publicly announced deals that are virtually certain to go through.
On Mr Market and Valuations“All of these companies have superb management and strong properties. But, at current prices, their upside potential looks considerably less exciting to us today than it did some years ago.”
“One pleasant reason is that our cash holdings are down – because our position in equities that we expect to hold for a very long time is substantially up.” [referring to reasons not to pile into the RJR Nabisco arbitrage.]
“Some extraordinary excesses have developed in the takeover field.”
“We have no desire to arbitrage transactions that reflect the unbridled – and, in our view, often unwarranted – optimism of both buyers and lenders.”
Speaking of his permanent holdings (Cap Cities/ABC, GEICO, and the Washington Post) although his enthusiasm about these companies remained the same, the prices Mr Market offered weren’t appealing, and not likely to add to his existing holdings—another signal he considered the market over-priced. Another clue, was the rampant extent to which merger and acquisition arbitrage was occurring. Judging by the letter, “everyone” was doing it, filled with enthusiasm, ie. greedy. And when everyone’s greedy, it’s time to be fearful. During this period, the ten-year T-bill came in at about 9%, where inflation hovered around 4%. The TMC/GDP ratio was approximately 0.65.
On Portfolio Management and Holding Periods“We continue to concentrate our investments in a very few companies that we try to understand well.”
“There are only a handful of businesses about which we have strong long-term convictions. Therefore, when we find such a business, we want to participate in a meaningful way.”
“We expect to hold these securities a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”
In Warren’s view, we know from previous letters that businesses with terrible economics will usually win over managers, no matter how great they are. But when you find a business with excellent economics, ran by excellent management then that would be a nirvana, of sorts. When you find these gems that fit within your circle of competence, and they’re trading at the right price, then “back up the truck,” as they say. Time, and their high returns on capital, will continually march your holdings upward. Buffett is the opposite of those who hurry to sell and book a profit, but who hang on for dear life to businesses that disappoint — cutting the flowers and watering the weeds, as Peter Lynch put it.
On the Efficient Market Theory“This doctrine became highly fashionable – indeed, almost holy scripture in academic circles during the 1970s.”
“Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient.”
“In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp., Buffett Partnership, and Berkshire illustrates just how foolish EMT is.”
“Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologists.”
“In any sort of a contest – financial, mental, or physical – it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.”
“From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.”
The EMT gained prominence in the 1970s. Essentially it said that analyzing stocks was pointless as all public information about them was already reflected in their prices — therefore, the market knew everything at all times. By extension then an investor could throw darts and select stocks, or pay any price, and do just fine.
Nonsense. The price you pay for any investment determines your returns.
There has been a continuous stream of value investors from the Graham mold, achieving unleveraged returns of 20%-plus, for EMT to be considered true. Over the same 63-year period, the market returned just under 10% yearly. That would be a significant statistical variance.
On Berkshire’s Stock Price“First, we do not want to maximize the price at which Berkshire shares trade. We wish instead for them to trade in a narrow range centered at intrinsic business value.”
“Second, we wish for very little trading activity.”
“Our goal is to attract long-term owners who, at the time of purchase, have no timetable or price target for sale but plan instead to stay with us indefinitely.”
“Therefore we try, through our policies, performance, and communications, to attract new shareholders who understand our operations, share our time horizons, and measure us as we measure ourselves.”
Berkshire’s stock was first listed on the NYSE on Nov. 29, 1988, helping investors reduce transaction costs and reduce the bid-ask spread compared to the over-the-counter market.
These quotes summarize Buffett’s interest in having a stable stock price, centered narrowly near intrinsic business value, which he outlined previously in the 1983 letter. By adopting policies to accomplish this, sellers and buyers can expect to have capital gains commensurate with the overall performance of the company, instead of one group benefiting over the other due to wild stock price swings.
This concludes the review of the 1988 Berkshire Hathaway Letter.
To see the review of the previous letter click here.
Follow back next time as we continue with the 1989 letter.