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 GAAP & Earnings Power
“…our share of the retained earnings of these investees totaled about $212 million last year, not counting large capital gains realized by GEICO and Coca-Cola (KO). If this $212 million had been distributed to us, our own operating earnings, after payment of additional taxes, would have been close to $500 million rather than the $300 million shown in the table.”
“In our view, Berkshire’s fundamental earning power is best measured by a ‘look-through’ approach, in which we append our share of the operating earnings retained by our investees to our own reported operating earnings, excluding capital gains in both instances.”
Usually I start with “On Judging Performance” which is below; however, I thought I’d lead in with this section in the event new readers hadn’t come across the earnings “iceberg,” originally mentioned in the 1980 letter. This is the first time he referred to it as “look through earnings” though.
The “iceberg” was due to the way Berkshire’s investments were organized. GAAP rules had him treat his wholly-/partially-owned subsidiaries differently from his stock investments. The former found their way into the operating earnings of the financial statements. But, only dividends received from the stock investments were counted in the financial statements. Since he holds for long periods, a company that did well, and whose price was following performance, wouldn’t be reflected in Berkshire’s operating performance until the investment was sold. Hence, he came up with the concept of “look-through” earnings to evaluate the per-share impact of those earnings on Berkshire’s operating performance.
In this way, the companies in his portfolio registered roughly $212 million of “look-through” earnings versus the $300 million actually recorded by Berkshire’s subsidiaries, contrasted with the recorded $45 million in dividends which were actually reported against operating earnings. In subsequent years, GAAP rules changed to where he had to mark the stock portfolio to market.
On Judging Performance
“A high growth rate eventually forges its own anchor.”
“For our intrinsic business value to grow at an average of 15% per year, our ‘look-through’ earnings must grow at about the same pace.”
During 1989, Berkshire’s gain in net worth was $1.515 billion, or 44.4% ROE. During his 25-year track record at the helm of the company, he’d grown book value from $19.46 to $4,296.01, or at a 23.8% CAGR.
For a number of contiguous annual letters now, Buffett commented on the fact that the bigger Berkshire got, the slower its growth would become. This letter was no different. But as can be seen, his internal scorecard for performance is to achieve 15% CAGR. In order to get this kind of growth from his companies, their operating earnings need to grow at that rate minimally. Since the stock market is a weighing machine over time, to achieve the same effect from the stock portfolio would require that the “look-through” earnings grow at the same minimum rate.
On Intrinsic Value
“What counts, however, is intrinsic value — the figure indicating what all of our constituent businesses are rationally worth.”
“With perfect foresight, this number can be calculated by taking all future cash flows of a business — in and out — and discounting them at prevailing interest rates. So valued, all businesses, from manufacturers of buggy whips to operators of cellular phones, become economic equals.”
“In other words, our performance to date has benefited from a double-dip: (1) the exceptional gains in intrinsic value that our portfolio companies have achieved; (2) the additional bonus we realized as the market appropriately ‘corrected’ the prices of these companies, raising their valuations in relation to those of the average business. We will continue to benefit from good gains in business value that we feel confident our portfolio companies will make. But our ‘catch-up’ rewards have been realized, which means we’ll have to settle for a single-dip in the future.”
In previous articles, discussions of intrinsic value were merged in the “On Judging Performance” section. For easier future reference, I thought I’d separate it into a section of its own since he began discussing the “hows” of calculating intrinsic value.
He originally defined intrinsic value in the 1983 letter, and reminds us in the first quote that it’s the figure that counts — not market quotations since those are driven by human emotion in the short term. In a previous letter, he let us know that discounted cash flows were the appropriate technique to use to value any investment — companies were no different, whether wholly-owned or purchased in fractional pieces through the stock market.
In the second quote he expanded on that idea by letting us know that it’s the cash flows in and out of business that are needed to calculate intrinsic value, and to then discount them at “prevailing interest rates.”
But what “cash” is he talking about? In my view, it’s the owner earnings. Recall from the 1986 letter in which he said owner earnings were the relevant item for valuation purposes, and not GAAP accounting earnings. If you were the sole owner of a business, owner earnings would represent the “cash” you could pull out of it and not hurt its position in the competition.
Therefore, if you could see into the future and know exactly what the cash flows (aka owner earnings flows) were in and out of a business, you’d have an exact calculation of intrinsic value. However, we know that this impossible, so what’s needed is a reasonable assessment of the company’s prospects and ability to generate owner earnings — this is why it’s difficult. But, the job is made easier if you can focus on predictable companies, because their owner earnings would be simpler to forecast — which he alluded to in the 1987 letter. Additionally, don’t forget about the Margin of Safety. It’s there to help protect you if your forecasts and calculation of intrinsic value are off.
What about the discount rate? He inferred using “prevailing interest rates.” In this case, the 10-year Treasury yielded between 7.9% and 9.3% in 1989.
On Selecting Investments
“In selecting marketable securities for our insurance companies, we generally 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.”
“However, we have no ability to forecast the economics of the investment banking business (in which we have a position through our 1987 purchase of Salomon convertible preferred), the airline industry, or the paper industry.”
“Our lack of strong convictions about these businesses, however, means that we must structure our investments in them differently from what we do when we invest in a business appearing to have splendid economic characteristics.” [referring to the convertibles he purchased.]
“In one major respect, however, these purchases are not different: We only want to link up with people whom we like, admire, and trust.” [referring to the convertibles he purchased.]
“The only way Berkshire can achieve satisfactory results from its four preferred issues is to have the common stocks of the investee companies do well.”
“I continued to note these qualities for the next 52 years as Coke blanketed the world. During this period, however, I carefully avoided buying even a single share, instead allocating major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses, trading-stamp issuers, and the like….Only in the summer of 1988 did my brain finally establish contact with my eyes.”
“I’ve learned my lesson: My response time to the next glaringly attractive idea will be slashed to well under 50 years.”
First outlined in the 1986 letter, Buffett lets us know his investing hierarchy, if you will. His first preference is to buy a business out right. After that, it stocks, bonds, cash and arbitrage, whichever provides the highest potential return.
During this period, he purchased three convertible preferred stocks: $600 million of Gillette at 8.75% dividend; $358 million of USAir at 9.25% dividend; and $300 million of Champion Int’l at 9.25% dividend.
Why didn’t he purchase the stocks of these companies instead? His forecasting quote above is telling. We know from previous letters and the discussion of intrinsic value above, that he’s interested in valuing the cash flows of the business. If he has a good sense of the industry and strong convictions, he can more accurately predict the cash flows and by extension derive an intrinsic value.
The investment banking (through his Salomon purchase in 1987), paper, and airline industries were apparently beyond his circle of competence to evaluate the economics. He therefore took a pass on determining intrinsic value. However, he must’ve felt comfortable enough with the individual business’ economics to loan them money. In return, he got a dividend yield roughly equivalent to the prevailing 10-year Treasury, with the additional upside of conversion to common stock if he so chose later. Of his three purchases, Gillette was the only company that he and Charlie had a better sense of business economics.
It’s also interesting to note that he still applies the “like, admire and trust” test even when loaning money to a company.
On Mr. Market and Valuations
“At year end these securities were valued at higher prices, relative to their own intrinsic business values, than has been the case in the past. One reason is the buoyant 1989 stock market. More important, the virtues of these businesses have been widely recognized. Whereas once their stock prices were inappropriately low, they are not now.”
“…the year end prices of our major investees were much higher relative to their intrinsic values than theretofore. While those prices may not yet cause nosebleeds, they are clearly vulnerable to a general market decline.”
“A drop in their prices would not disturb us at all – it might in fact work to our eventual benefit – but it would cause at least a one-year reduction in Berkshire’s net worth.”
“In the rest of the year we had a fairly good-sized cash position and even so chose not to engage in arbitrage. The main reason was corporate transactions that made no economic sense to us; arbitraging such deals comes too close to playing the greater-fool game.”
Continuing from the 1988 letter, Buffett had been suggesting for some time that the market was generally getting expensive — his cash holdings were rising and arbitrage deals (his cash alternative) were in a speculative frenzy. Admittedly, his major holdings were now priced significantly above intrinsic value.
For perspective, inflation ranged between 4.25% and 5.2%, and the 10-year Treasury ranged between 7.9% and 9.3%.
On Portfolio Management and Holding Periods
“We will keep most of our major holdings, regardless of how they are priced relative to intrinsic business value. This till-death-do-us-part attitude, combined with the full prices these holdings command, means that they cannot be expected to push up Berkshire’s value in the future as sharply as in the past.”
“…we substantially reduced our holdings in both medium- and long-term fixed-income securities.”
“We also sold many of our medium-term tax-exempt bonds during the year. When we bought these bonds we said we would be happy to sell them – regardless of whether they were higher or lower than at our time of purchase – if something we liked better came along.”
“Because of the way the tax law works, the Rip Van Winkle style of investing that we favor – if successful – has an important mathematical edge over a more frenzied approach.”
“We have not, we should stress, adopted our strategy favoring long-term investment commitments because of these mathematics. Indeed, it is possible we could earn greater after-tax returns by moving rather frequently from one investment to another. Many years ago, that’s exactly what Charlie and I did. Now we would rather stay put, even if that means slightly lower returns.” [referring to the tax advantages of delaying capital gains.]
“…we think it makes little sense for us to give up time with people we know to be interesting and admirable for time with others we do not know and who are likely to have human qualities far closer to average. That would be akin to marrying for money – a mistake under most circumstances, insanity if one is already rich.”
Even though his major holdings were now overpriced relative to intrinsic value, he lets us know he’d continue to hold them rather than sell them. I suspect this admonition has more to do with the sheer size of money he was dealing with and his ability to close a position in a timely manner without getting competition from tail-coat investors — a problem that would only persist the bigger Berkshire got.
With regard to taxes, he laid out an example of the benefits of delaying the realization of capital gains. In Case No. 1, a $1 investment doubled each year for 20 years, but was sold each year and taxed at the 34% capital gains. In Case No. 2, the same $1 investment was allowed to compound continuously for 20 years and then sold at the end, with the same level of taxation. In Case No. 1, the individual would’ve paid $13,000 to the government and be left with about $25,ooo. In Case Np. 2, however, taxes would’ve been $356.5K, but the individual would’ve been left with $692,000, a 27:1 differential.
Time and patience do good things. So why be hyperactive with trading?
On Financial Products Engineering
“But as happens in Wall Street all too often, what the wise do in the beginning, fools do in the end.”
“No financial instrument is evil per se; it’s just that some variations have far more potential for mischief than others.”
“To these issuers, zero (or PIK) bonds offer one overwhelming advantage: It is impossible to default on a promise to pay nothing.”
“This principle at work – that you need not default for a long time if you solemnly promise to pay nothing for a long time – has not been lost on promoters and investment bankers seeking to finance ever-shakier deals.”
“Debt now became something to be refinanced rather than repaid.”
“Soon borrowers found even the new, lax standards intolerably binding. To induce lenders to finance even sillier transactions, they introduced an abomination, EBDIT – Earnings Before Depreciation, Interest and Taxes – as the test of a company’s ability to pay interest.”
“Promoters needed to find a way to justify even pricier acquisitions. Otherwise, they risked – heaven forbid! – losing deals to other promoters with more ‘imagination.’”
“But in the end, alchemy, whether it is metallurgical or financial, fails.”
“The blue ribbon for mischief-making should go to the zero-coupon issuer unable to make its interest payments on a current basis.”
“Our comments about investment bankers may seem harsh. But Charlie and I – in our hopelessly old-fashioned way – believe that they should perform a gatekeeping role, guarding investors against the promoter’s propensity to indulge in excess.”
In this letter, Warren spoke at length of Zero Coupon Bonds, describing how they worked, why Berkshire issued some, and the duplicitous actions issuers and promoters were engaging in.
In Berkshire’s case, they issued $902 million of Zero-Coupon Convertible Subordinated Debentures in denominations of $10,000 and convertible into 0.4515 shares of BRK. A zero-coupon bond requires no current interest payments. Rather, the investor gets his yield by purchasing the security at a discount from maturity value — the Series E US Savings Bond is a popular example. In this case, investors in Berkshire’s zero-coupon bonds received an equivalent yield of 5.5% compounded semi-annually. Warren could call the bonds at any time after September 1992 at their accreted value, and on two specified days in September 1994 and Sept 1999, bondholders could require Berkshire to buy the securities at their accreted value. The conversion privilege was worth $9,815 a share, a 15% premium to the market price.
For tax purposes, he was also able to deduct the 5.5% interest accrual each year, even though no actual interest payments were made to bondholders. The result was positive cash flow. No doubt this was a sweet deal for Berkshire and the bondholders who’d be able to convert their investment into shares of the company later.
However, Warren railed on the unscrupulous practices of the issuers and promoters in general who used this type of bond in deceptive ways and the resulting deadly consequences to investors. Through originally innocent financial engineering of zero-coupon US Treasuries, financiers were able to repackage and securitize an instrument that promised the purchaser of any given maturity a guaranteed compounded rate for his entire holding period, which wasn’t possible with the original instrument.
Promoters found a way to sell these to the public and figured out new ways to make companies appear able to meet their interest payment obligations. In any case, many of these companies had no intent to pay. And since there are no coupon payments on a zero-coupon bond, the bondholders were left holding the bag — an empty bag, since their investment was now worthless.
It’s a good read, and is eerily prescient of the sub-prime debacle of recent years. In fact, if you read it in detail, substitute “sub-prime” for “zero-coupon” and pick your favorite issuer or promoter and you’d think it was written recently.
On Buffett’s Mistakes in the First 25 Years
“My first mistake, of course, was in buying control of Berkshire.”
“Good jockeys will do well on good horses, but not on broken-down nags.”
“Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them.”
“My most surprising discovery: the overwhelming importance in business of an unseen force that we might call ‘the institutional imperative.’”
“After some other mistakes, I learned to go into business only with people whom I like, trust, and admire.”
“It’s no sin to miss a great opportunity outside one’s area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding. For Berkshire’s shareholders, myself included, the cost of this thumb-sucking has been huge.”
“A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns.”
“Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds – though we have learned to live with those also.”
We all make mistakes. Warren is no exception. He spent some time recounting his major investment mistakes from the previous 25 years, and vowed to offer them up again in 2015 for another review of 25 years of mistakes. Each quote represents the essence of each itemized idea in his letter.
This concludes the review of the 1989 Berkshire Hathaway Letter.
Follow back next time as we continue with the 1990 letter.
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