Warren Buffett has been writing the Berkshire Hathaway (BRK.A)(BRK.B) letters to shareholders since 1965 and signing them as Chairman since 1970. Going through these letters and other sources, we can see how Buffett communicates his evolving investment thoughts over time.
Starting out as a Ben Graham disciple, Buffett looked for cigar butt investments in which he didn’t pay much relative to net tangible assets. Over time this changed, especially after things like the successful See’s acquisition with Charlie Munger. Still, it is wrong to say that Buffett moved on from Graham. Ever since reading Graham at age nineteen, Buffett has always used a great deal of what Graham taught him.
1. Berkshire Hathaway Letters to Shareholders 1965 - 2012 ISBN 978-1-59591-077-6
2. Online Berkshire Hathaway Shareholder Letters 1977 - 2012
3. The Intelligent Investor by Benjamin Graham ISBN 978-0-06-055-566-5
4. Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger by Janet Lowe ISBN 978-0-471-4469
5. Poor Charlie’s Almanack ISBN 978-1-57864-501-5
The Early Years for Buffett at Berkshire [1965 to 1968]
Buffett has said that one of his biggest mistakes was buying Berkshire Hathaway. This is because it was just a “bargain price” textile company. Like many commodity businesses with excess supply, it had bad economics.
In the 1967 letter Buffett says he is pleased about acquiring National Indemnity Company and National Fire and Marine. We now know that insurance companies like National Indemnity propelled the growth that turned Berkshire Hathaway into the company we see today. Even back in 1967 Buffett could see the limited earning potential of the textile business. In the same letter he states that the 1967 earnings of subsidiaries were substantially higher than the earnings attributable to a bigger capital investment in the textile business.
Berkshire Under the Return on Shareholders’ Equity Yardstick [1969 to 1982]
The Berkshire letters from 1969 to 1982 emphasize return on shareholders’ equity. Using this yardstick, it doesn’t take Buffett long to see that the textile purchase was a mistake.
In the 1969 letter Buffett reveals that four years prior they had sought to invest outside the textile industry to get more consistent earning power.
The 1978 letter explains that the textile industry shows how companies producing similar goods in capital intensive businesses earn inadequate returns in the long run.
The 1979 letter repeats the fact that the textile business brings in cash at a low rate compared to capital employed. It notes that easier businesses may be the way to go despite the fact that they are more expensive. It goes on to explain that the Graham-like purchase of the Waumbec Mills was another mistake.
Cutting back on the textile business was one of the keys to success for Buffett. His 1980 letter explains that the number of looms at New Bedford have been reduced. His reasoning is that even when things went well the looms didn’t generate a good return. In the same letter he says their preference is for businesses that generate cash as opposed to consuming it. He differentiates between earnings and true cash that doesn’t have any strings attached.
Buffett is always thinking about return on equity but his 1982 letter explains why accounting rules limit its use as a yardstick at Berkshire. He explains that they prefer to look at “economic” earnings which include all undistributed earnings but accounting rules only let them include dividends in certain cases.
The Last Days for Textile Operations at Berkshire [1983 to 1985]
Starting in 1983, the letters use book value as a proxy for intrinsic value.
We see Buffett communicating different thoughts with respect to net tangible assets and goodwill in the 1983 letter:
Learning a great deal from the 1972 See’s acquisition, Buffett talks about its significance in the appendix of the 1983 letter. Having a 1972 price of 25 million with just 8 million in net tangible assets, it was not a Graham type purchase. It shows that businesses are worth a lot more than net tangible assets when they can produce earnings on assets considerably higher than market rates of return. The difference between net tangible assets and the price paid for the company is goodwill. He explains that accounting goodwill (the difference between the price paid and net tangible assets) disappears after 40 years because of amortization but economic goodwill can actually increase over this time period.
My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.
Keynes identified my problem: “The difficulty lies not in the new ideas but in escaping from the old ones.” My escape was long delayed, in part because most of what I had been taught by the same teacher had been (and continues to be) so extraordinarily valuable. Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tangible assets.
Revealing the closure of the textile operation in the 1985 letter is a key milestone. Buffett notes that they got into the insurance business in 1967 using textile earnings and cash freed up from decreased textile investments in inventories, receivables and fixed assets. He repeats the fact that the domestic textile industry is in a commodity business with excess capacity. The textile closure provides a great lesson about book value. Equipment with a book value of $866,000 sold for just $163,122. Looms that were purchased for $5,000 each in 1981 could not be sold for $50 each.
Mature Berkshire Hathaway [1986 to Present]
The 1989 letter points out that time is the friend of the wonderful business and the enemy of the mediocre business. It commits serious real estate to explain the “bargain-purchase” folly. Buying a lousy business because of a great price can be a big mistake if there are no future hiccups that let the buyer unload. We are reminded of bargains that did not work out like the Berkshire textiles and the Hochschild Kohn department store. Buffett makes it clear what he has learned:
Buffett also talks about management more than Graham and we see this in the 1989 letter. He talks about the fact that even brilliant managers tend to fail when they’re at a business with bad economics.
I could give you other personal examples of "bargain-purchase" folly but I'm sure you get the picture: It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.
In the 1991 letter Buffett shows the way he thinks about businesses and franchises plus the importance of management:
Buffett is somewhere between Graham and Phil Fisher when it comes to his thoughts on management. In other words, he places more importance on management than Graham but less importance on it than Fisher, especially when dealing with franchises that can be held for the long term.
An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.
In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.
The 1991 letter goes on to talk about the significance of the See’s acquisition. It is a company with tremendous pricing power and it requires very little in the way of incremental capital. It went from an operating base of $7 million at the time of the acquisition to an operating base of $25 million in 1991. During this time it had pre-tax profits of $410 million against incremental capital of just $18 million. See’s taught Munger and Buffett a great deal about the excellent value of companies that have significant pricing power.
Repeating himself in the 1992 letter, Buffett says past mistakes caused him to revise his strategy to buy good businesses at fair prices as opposed to fair businesses at good prices.
Talking about Coca-Cola (KO) in the 1993 letter, Buffett shows the power of compounding while repeating Graham’s insight that the market is a voting machine in the short run but a weighing machine in the long run:
Buffett goes on to explain that value investing and growth investing are joined at the hip - growth is a component in the value calculation. He also states that the term "value investing" is redundant. The airline industry is cited as an example where growth doesn't necessarily have a positive impact on value.
Let me add a lesson from history: Coke went public in 1919 at $40 per share. By the end of 1920 the market, coldly reevaluating Coke's future prospects, had battered the stock down by more than 50%, to $19.50. At yearend [sic] 1993, that single share, with dividends reinvested, was worth more than $2.1 million. As Ben Graham said: "In the short-run, the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long-run, the market is a weighing machine."
In the 1996 letter Buffett says that if you aren't willing to own a stock for ten years then don't even think about owning it for ten minutes. This doesn't reconcile with Graham's cigar butt approach where he would sell stocks shortly after a hiccup in which they became fully valued.
The 1999 letter is written at a time when Buffett communicates that there aren't a lot of attractive opportunities out there. He says it is better to own a comfortable business at a questionable price than a questionable business at a comfortable price.
The 2004 letter repeats the fact that the 1967 purchase of National Indemnity was the propellant of Berkshire's growth. He says that if it wasn’t for that acquisition then Berkshire would be lucky to be worth half of its value.
Per the 2007 letter, long-term competitive advantage in a stable industry is what Buffett seeks - even if it comes without organic growth. He repeats the fact that See's is a dream company even though its organic growth has limits - it still gets most of its revenue from a small number of states.
The International Business Machines (IBM) purchase is revealed in the 2011 letter. Answering a question at a recent shareholder meeting, Buffett mentioned that some investors will be able to do well with technology companies. Using IBM as an example, Buffett goes on to explain that long term investors of companies that are buying back shares should be happy when prices languish. He reminds readers that chapter 8 of Graham’s The Intelligent Investor changed the way he viewed fluctuations in stock prices.
Buffett has said that Graham wrote the best investment book in existence:
Graham shaped Buffett’s investment framework with concepts like Mr. Market (mentioned in the 1987 and 1993 letters) and the margin of safety concept. When talking about common stocks in the 1992 letter, Buffett mentions that they insist on a margin of safety in the purchase price. This concept is repeated in other letters - it is a permanent fixture in Buffett’s investment philosophy.
I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.
[Preface to the Fourth Edition of The Intelligent Investor]
Munger was more outspoken than Buffett’s about some of the limits of Graham’s approach:
It wasn’t easy for Buffett to change his thinking about bargains - only someone special like Munger could make that happen:
Some of Graham's precepts did not impress him at all. "I thought a lot of them were just madness," he said. "They ignored relevant facts."
Specifically, said Munger, "Ben Graham had blind spots. He had too low an appreciation of the fact that some businesses were worth paying big premiums for."
[Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger by Janet Lowe pages 77 to 78]
In a 1994 USC speech, Munger makes some key points. He talks about the importance of Ben Graham's approach of valuing the whole enterprise and then taking the stock price and multiplying it by the number of shares. He notes that one of the best teachings of Graham is the "Mr. Market" concept. Still, Munger goes into some of the shortcomings of Graham like not wanting to talk to management. He then talks about the fact that companies at two or three times book value can still be great bargains based on quantitative measures not emphasized by Graham. He notes that Berkshire made the big money out of high quality businesses. There is a quote that stands out:
"Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact he had on me. It took a powerful force to move me on from Graham's limiting view. It was the power of Charlie's mind. He expanded my horizons."
[Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger by Janet Lowe pages 78 to 79]
Later in the speech Munger talks about the effect of taxes. Specifically, buying something which compounds for many years and then paying one tax at the end. This is a concept Buffett understands well - Berkshire has been holding Coca-Cola stock for years.
Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return — even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with a fine result.
So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects.
[Poor Charlie’s Almanack pages 201 to 206]
Ben Graham created the framework for Buffett’s investment philosophy. Through Buffett’s own experiences along with the influence of Charlie Munger and others, this framework grew over time.
Disclosure: I am long BRK.A, BRK.B, KO, IBM
Any material in this article should not be relied on as a formal investment recommendation.