Two investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we cover the 1992 letter.
The float
The 1992 letter has two very interesting sections. The first is an analysis of Berkshire’s insurance operations and the float it generates. Buffett says what counts in Berkshire’s insurance business is "the cost of funds developed from insurance" or, in the vernacular, "the cost of float."
Berkshire’s float has been key to its success. It gives the company access to low-cost funds which do not mature like most debt finance, so it can almost be considered permanent capital.
Float is calculated as the total of loss reserves, loss adjustment expense reserves and unearned premium reserves minus agents' balances, prepaid acquisition costs and deferred charges applicable to assumed reinsurance. The cost of float is measured by the underwriting loss. To show how cheap this funding is, Buffett explained that in 21 years out of the (then) 26 years Berkshire had been in the insurance business, it had achieved a cost lower than the U.S. government's yield on newly issued long-term bonds, often by a wide margin.
Berkshire’s equity investing strategy
The second very interesting section of the letter is a detailed update on the 1977 statement on Berkshire’s equity investing strategy, which said:
"We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at an attractive price."
Buffett said only one update was needed; given both market conditions and Berkshire’s size, "an attractive price" is now substituted with "a very attractive price." So how do we decide what exactly defines attractive? Buffett noted most investors put themselves in one of two camps: value or growth. In 2023, this still holds true.
Yet Buffett wrote in the ’92 letter that he saw this dichotomy as “fuzzy thinking,” but admitted he engaged in this some years earlier. Since his thinking evolved, he said value and growth are joined at the hip. He continued:
"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term 'value investing' is redundant. What is 'investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation."
Still, the term value investing is widely used and usually relates to equities having a low comparable multiple (price-book, price-sales or price-earnings) or a high cash flow or dividend yield.
Buffett said these types of characteristics do not in and of themselves indicate if an investor is buying something for what it is worth. By the same token, he emphasized the opposite characteristics - a high ratio of price-book value, a high price-earnings ratio and a low dividend yield - are “in no way inconsistent” with a "value" purchase.
This might surprise people who have assumed Buffett is strictly a value investor in the traditional sense. The guru goes on to say that business growth, per se, also tells us little about value. Sometimes growth can positively influence value, but not if that business growth is profitless.
In Buffett’s words:
"Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."
Buffett is a legendary investor, so, of course, the financial media like to cover him and drop his soundbites. I once met a financial journalist who wrote a prestigious column at a top financial publication. We got to talking about valuation, and I was shocked to learn he did not understand the important concept of discounted cash flow. This could be why we do not hear Buffett quotes on the subject – as the media tends to simplify its content. I write this because in the 1992 letter, Buffett explained something so fundamental to finance, which overrides the concepts of growth strategy or value strategy:
"In 'The Theory of Investment Value,' written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future 'coupons.' Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity 'coupons.'"
We should think about equity coupons not as dividends, but as free cash flow. So instead of value or growth strategies, investment strategy is about calculating intrinsic value based on reasonable estimates for the future and then buying stocks that are cheap relative to our calculation of value. That is why an understanding of a company’s industry and economics is so important, to make reasonable forecasts and use an appropriate discount rate.
Buffett wrote:
"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought."
Building a discounted cash flow model is not rocket science. However, estimating the “future coupons” can be tricky and models are very sensitive to the assumptions made. Buffett said Berkshire deals with this problem in two ways. First, sticking to businesses that it understands, which Buffett said means companies “must be relatively simple and stable in character” as a complex business or one subject to constant change as “we're not smart enough to predict future cash flows.”
He continued:
"Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes."
The second and equally important way Berkshire overcomes the issue of sensitive discounted cash flow models is to “insist on a margin of safety in our purchase price.”
Buffett said this margin of safety principle - so strongly emphasized by Benjamin Graham - is the cornerstone of investment success.
