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
“We continue to aim for a 15% average annual gain in intrinsic value. But, as we never tire of telling you, this goal becomes ever more difficult to reach as our equity base, now $5.3 billion, increases.”
“If we do attain that 15% average, our shareholders should fare well.”
“Charlie and I always have preferred a lumpy 15% return to a smooth 12%.”
“Lethargy bordering on sloth remains the cornerstone of our investment style.”
“Beware of past-performance 'proofs' in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.”
In 26 years at the helm, Warren increased Berkshire’s per-share book value from $19.46 to $4,612.06 — 23.2% CAGR. However, in this particular year his major holdings traded sideways, showing little change in market value. Recall in the 1989 letter, he mentioned his stock holdings were significantly above intrinsic value. Additionally, Buffett reminds us once again, that size eventually becomes its own anchor. The bigger Berkshire would get, the more difficult it would be to sustain 15%-plus returns. However, I personally believe since he doesn’t like to let people down, this is his way of “under-promising and over-delivering.”
During this year, he didn’t buy or sell much stock… pretty boring except for his purchase of Wells Fargo (WFC). However, there were promoters out there selling up the junkiest of the junk bonds, pointing to "scholarly" research that indicated the higher interest rates received from low-grade bonds had more than compensated for their higher rate of default. Thus, they concluded a diversified portfolio of junks bonds would provide larger net returns than a portfolio of high-grade bonds. Many financial institutions fell into this trap and suffered.
On GAAP & Earnings Power
“In reality, however, earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surface, but in the meantime a lot of money can change hands. Indeed, some important American fortunes have been created by the monetization of accounting mirages.”
“Clearly, investors must always keep their guard up and use accounting numbers as a beginning, not an end, in their attempts to calculate true 'economic earnings' accruing to them.”
“Our perspective on such ‘forgotten-but-not-gone’ earnings is simple: the way they are accounted for is of no importance, but their ownership and subsequent utilization is all-important.”
“I believe the best way to think about our earnings is in terms of 'look-through' results…”
“As I mentioned last year, we hope to have look-through earnings grow about 15% annually.”
The term “earnings” rings of precision — especially when an auditor puts his stamp on it. But as Warren pointed out previously, accounting is a beginning to understanding, not the end. More money has been stolen by the pen than at gunpoint. For the crooked chief executive that's willing to cook the books and hoodwink his own bosses (the shareholders), earnings are just something to be molded as if they were Play-doh. Unfortunately, this sad fact is not new.
In his letter at Appendix A, Warren included a 1936 unpublished satire written by Ben Graham discussing a company’s use of “advanced bookkeeping methods.” With these new methods, the company was going to transform its earnings power. Mind you, in this satire the company did nothing different operationally — it was all on paper in the accounting books. To do so all they had to do was: (1) write down the plant account to negative $1 million; (2) reduce common stock par value to $0.01; (3) pay all wages and salaries in option warrants; (4) carry inventory at $1.00; (5) replace preferred stock with non-interest bearing bonds redeemable at a 50% discount; and (6) establish a $1 billion contingency reserve.
The result of these “advanced methods” was to dramatically increase EPS from negative $2.76 to $49.80. Voila! And because of these changes, they’d have an enormous competitive advantage and sell their products at exceedingly low prices and still show a nice profit margin. And what would happen if institutional imperative set in and their competitors followed suit? Simple — they would just introduce even more “advanced bookkeeping methods” which were being developed in their Experimental Accounting Lab.
Moral of the story? Focus on the cash flow. Take Warren’s counsel, critically review financial statements, and look at owner earnings to determine what's actually happening inside the company operationally.
In Berkshire's case, their reported earnings are misleading, but in a different and good way. Because of accounting conventions, Berkshire has large investments whose retained earnings far exceed the dividends paid, which appear on the books as earnings. Their per-share amount of the retained earnings at the company goes unnoticed and unrecorded. As an example, Buffett owned 17% of Capital Cities/ABC. His portion of their earnings amounted to $83 million, yet the $530K of dividends paid was counted in Berkshire’s GAAP earnings. The remaining $82 million stayed with Cap Cities as retained earnings to continue being compounded by management. To give the shareholders perspective, Warren examines “look through” earnings, which sums the hidden portion retained at the companies with Berkshire’s operating earnings. In 1990 it amounted to $590 million — $220 million retained by the investees, and Berkshire’s operating earnings of $371 million.
Essentially, over one-third of their total earnings power was hidden from view, just waiting for the stock market to realize it and properly revalue it upwards.
On Intrinsic Value
“Ideally, the results of every Berkshire shareholder would closely mirror those of the company during his period of ownership. That is why Charlie Munger, Berkshire’s Vice Chairman and my partner, and I hope for Berkshire to sell consistently at about intrinsic value.”
“However, Berkshire’s corporate gains will produce an identical gain for a specific shareholder only if he eventually sells his shares at the same relationship to intrinsic value that existed when he bought them.”
“Berkshire’s intrinsic value continues to exceed book value by a substantial margin. We can’t tell you the exact differential because intrinsic value is necessarily an estimate; Charlie and I might, in fact, differ by 10% in our appraisals.”
“In the final chapter of The Intelligent Investor, Ben Graham forcefully rejected the dagger thesis: ‘Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.’ Forty-two years after reading that, I still think those are the right three words. ”
It’s very clear Warren likes to remove as much volatility from Berkshire’s stock price as possible. It has advantages for both the seller and buyer — allowing either to pay/receive a fair price, and not get a dislocated return at the expense of the other party. I’d contend he’d probably hope for absolute-zero volatility — a perfectly stable price. But we know that won’t happen in our auction-style stock market.
Intrinsic value is not a matter of precision. It’s necessarily an estimate, and probably more like a range of possible values in practice. Ten different people, provided the same financial information, will conclude ten different intrinsic values. And that’s OK, because your margin of safety is there to give you some “wiggle room,” or tolerance, in the event your assumptions were off. In fact, Buffett has said that the two most important chapters of "The Intelligent Investor" are Chapter 8, The Investor and Market Fluctuations, and Chapter 20, Margin of Safety. In Chapter 8, Ben introduces the character “Mr. Market” and in Chapter 20 he discusses the wisdom of leaving enough room to cover mistakes in judgment on a company’s intrinsic value.
On Selecting Investments
“The banking business is no favorite of ours.”
“In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.”
“Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a ‘cheap’ price. Instead our only interest is in buying into well-managed banks at fair prices.”
“Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.”
“As usual, the Street’s enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce. Mountains of junk bonds were sold by those who didn’t care to those who didn’t think – and there was no shortage of either.”
“Junk bonds remain a mine field, even at prices that today are often a small fraction of issue price. As we said last year, we have never bought a new issue of a junk bond. (The only time to buy these is on a day with no ‘y’ in it.) We are, however, willing to look at the field, now that it is in disarray.”
“Just as buying into the banking business is unusual for us, so is the purchase of below-investment-grade bonds. But opportunities that interest us and that are also large enough to have a worthwhile impact on Berkshire’s results are rare. Therefore, we will look at any category of investment, so long as we understand the business we’re buying into and believe that price and value may differ significantly.”
“Since our purchase, the economics of the airline industry have deteriorated at an alarming pace, accelerated by the kamikaze pricing tactics of certain carriers. The trouble this pricing has produced for all carriers illustrates an important truth: in a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor.” [speaking of his US Air convertibles]
Banks at the time followed the institutional imperative — since all the other banks were doing it, then it must be OK for them to do also. What was it? High leverage, poor management and lending practices, and, as noted earlier, purchasing junk bonds. Sounds eerily similar to recent history, doesn’t it?
In his three previous letters, Warren outlined what I’ll call his investment-selection hierarchy of choices: (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.
With the collapse and disarray of the junk bond market, something he’d normally shy away from, there was such a dislocation between price and value that he was willing to sift through the rubble. But with this letter, he opened up the flood gates to his shareholders letting them know he would consider anything, really, so long as there was a dislocation he could take advantage of and that was also in his circle of competence.
Lastly, Warren reminds us again, as he’s done so many times previously, of the dangers investing in companies that produce commodity products — they tend to have terrible economics, eventually competing on price and eroding margins along the way.
On Mr. Market and Valuations
“Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.”[referring to his purchase of Wells Fargo]
“Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall.”
“We will be buying businesses – or small parts of businesses, called stocks – year in, year out as long as I live (and longer, if Berkshire’s directors attend the séances I have scheduled). Given these intentions, declining prices for businesses benefit us, and rising prices hurt us.”
“The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”
“None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling.”
As Bertrand Russell once said, “Most people would rather die than think: many do.”
Thinking is tough — many people don’t like to do it, choosing instead to become lemmings and eventually suffering a lemming’s fate.
Warren, on the other hand, thinks.
In this case, he studied and thought about Wells Fargo deeply and concluded they didn’t have the troubles impacting the other banks. As a result, during the widespread pessimism about the banking industry and California real estate disaster, he was able to pick up additional shares of Wells Fargo for a song — it fell 50% within a few months of his initial purchase.
As mentioned previously, Chapter 8 of "The Intelligent Investor" deals with how to think about market fluctuations. For those that haven’t had the privilege of reading this seminal text, buy it — if at least for Chapters 8 & 20, and refer to them frequently.
This concludes the review of the 1990 Berkshire Hathaway Letter.
Follow back next time as we continue with the 1991 letter.