Two value investors I admire, Whitney Tilson (Trades, Portfolio) and Bill Ackman (Trades, Portfolio), have recommended that to learn about value 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 go over the 1979 letter.
By now Buffett’s letters are starting to increase a bit in length. I will mostly skip over the sections on textiles, retailing and insurance underwriting, where the most interesting point Buffett made was in respect to textiles:
"Both our operating and investment experience cause us to conclude that 'turnarounds' seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price."
And on underwriting Buffett noted that higher interest rates encourage the obtaining of business at underwriting loss levels formerly regarded as totally unacceptable. While insurance managers do not like this strategy, Buffett said he thought the industry was headed that way, creating a new threshold of tolerance for underwriting losses and leading to combined ratios averaging higher in the future than in the past. Buffett seems to understand the bigger picture in the insurance business very well in that insurance investments can be just as important, if not more so, than insurance underwriting.
In the operating results section, Buffett once again reminded readers that “the primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”
Buffett went on to say he believes shareholders and the general public would better understand many businesses if managements and financial analysts made earnings on equity capital employed their primary focus, instead of the obsession with earnings per share. Over 40 years later, I still think too many investors care too much about earnings per share.
Insurance investments
The most interesting commentary comes from the insurance investments section.
On bonds, Buffett said he recognizes the fact the insurance industry has probably lost too much money in bonds because their accounting allows them to be carried at amortized cost, rather than market value, even when impaired. He wrote, “...had management been forced to recognize market values, its attention might have been focused much earlier on the dangers of a very long-term bond contract.”
Buffett goes on to explain in as many words that interest rate risk is higher in long-term bonds (what we call duration) and that Berkshire was not cautious enough. He wrote, “The mild degree of caution that we exercised was an improper response to the world unfolding about us.” Remember, this was a time of rising interest rates. Somehow Berkshire found itself buying 15-year bonds, which the guru admits was the first mistake.
A classic Buffett line follows: “You do not adequately protect yourself by being half awake while others are sleeping.” The more serious mistake was not selling the 15-year bonds Berkshire owned, at losses, when their view on interest rates became clearer.
Some bonds were owned for the asset-liability matching needed for Berkshire’s insurance operations. However, Buffett noted that Berkshire’s net fixed dollar commitments were limited to the purchase of convertible bonds because “We believe that the conversion options obtained, in effect, give that portion of the bond portfolio a far shorter average life than implied by the maturity terms of the issues (i.e., at an appropriate time of our choosing, we can terminate the bond contract by conversion into stock).” In short, the Oracle of Omaha is savvy when it comes to incorporating convertible bonds into the overall Berkshire portfolio.
Buffett goes on and still seems frustrated for having bought longer-term bonds when he had strong feelings their value was at risk of being highly damaged. He made it clear he would try to avoid making this mistake again:
“We have severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day. Those dollars, as well as paper creations of other governments, simply may have too many structural weaknesses to appropriately serve as a unit of long term commercial reference.”
In the letter, Buffett was humble enough to recognize, despite his strong views, he could be wrong. He wrote, “…of course, there is the possibility that our present analysis is much too negative. The chances for very low rates of inflation are not nil. Inflation is man-made; perhaps it can be man-mastered.”
He hinted that “other powerful groups” might introduce an “appropriate response” – I think he was referring to Paul Volcker, who went on to beat inflation.
He finishes the insurance investment section with:
"Overall, we opt for Polonius (slightly restated): 'Neither a short-term borrower nor a long-term lender be.'”
This is actually good advice. Short-term borrowing can be unstable and disappear quickly. Long-term lending carries a lot of interest rate risk, inflation risk and credit risk, where value can swing around severely based on these difficult-to-predict variables.
Financial reporting
The financial section has a couple of noteworthy comments. First, Buffett wrote:
"In large part, companies obtain the shareholder constituency that they seek and deserve. If they focus their thinking and communications on short-term results or short-term stock market consequences they will, in large part, attract shareholders who focus on the same factors. And if they are cynical in their treatment of investors, eventually that cynicism is highly likely to be returned by the investment community."
Buffett is noting that Berkshire will try to be transparent on an annual basis because it is fair and useful. The company’s reporting will no be public relations fluff, but nor will it give excessive short-term detail, which Buffett thinks will be unhelpful to shareholders. He is getting at the importance of focused communication. Commenting on Phil Fisher, a respected investor and author, he wrote:
"[Fisher] once likened the policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A restaurant could seek a given clientele - patrons of fast foods, elegant dining, Oriental food, etc. - and eventually obtain an appropriate group of devotees. If the job were expertly done, that clientele, pleased with the service, menu, and price level offered, would return consistently. But the restaurant could not change its character constantly and end up with a happy and stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revolving door of confused and dissatisfied customers."
Fisher wrote a couple of classic investment books, including "Paths to Wealth through Common Stocks" in 1960 and "Common Stocks and Uncommon Profits"in 1958. An updated version of "Common Stocks and Uncommon Profits and Other Writings"was published in 1996. On Fisher, Buffett said, “I am an eager reader of whatever Phil has to say, and I recommend him to you”.
