In 1962, Warren Buffett began purchasing shares of Berkshire Hathaway – a textile manufacturing company in the process of downsizing. In 1965, after feeling slighted by management, Buffett acquired control of Berkshire. In 1967, Berkshire purchased an insurance company and began using its float to fund investments. Through acquisitions and investments, Berkshire’s share prices would appreciate from $8 in 1962 to $276,800 in 2017 (20% annualized).
This post begins my series on Berkshire Hathaway. The goal is to gain some insight into one of the most successful companies in modern history. We will be looking at Warren Buffett’s shareholder letters which can be found here.
In 1977, the S&P 500 returned -6.98%.
The Cold War and Energy Crisis continued throughout the year. In January, Jimmy Carter became President of the United States and Apple was incorporated. In April, optical fiber was used for the first time to carry live telephone calls. In May, Star Wars was released and quickly became the highest-grossing film of its time. In June, Oracle was incorporated. In August, Elvis Presley died at the age of 42. In September, The Voyager program launched seeking of exploring our outer solar system. In November, Havey Milk was elected City Supervisor of San Francisco, becoming the first openly gay elected official in a major U.S. city.
Return on Equity
Buffett begins the letter by making sure he and his investors are on the same page when it comes to what he is being graded on:
Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.
Buffett is referring to the interaction between retained earnings and cost of capital. Imagine that we, as investors, always had the option of investing funds in low-risk Treasury bonds that yield 5%. If a company wants to keep a dollar in their hands rather than dividend it out to us, they better be able to make more than 5% with it. If they produce 4%, sure they are increasing their earnings, but not at a sufficient level. Buffett offers a better yardstick:
Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.
Though simple to define (Net Income/Equity), Return on Equity (ROE) is a pretty deep concept. The folks over at DuPont Corporation spent much of the 1920s devising their own analysis on the subject. According to DuPont, ROE is affected by three main categories: operating efficiency (profit margin), asset efficiency (total asset turnover), and financial leverage (equity multiplier). The question we want to ask is which of these categories are most responsible for our ROE.
For example, a company that wanted to boost its ROE could simply borrow a bunch of money and invest it in treasury bonds. Since they will be making more money through interest, while the equity base remains the same, ROE goes up. To get around some of these capital structure issues, many investors prefer Return on Invested Capital (ROIC) or Return on Tangible Invested Capital (ROTIC). These are measures of how well a company is using all of its capital, minus cash and non-interest bearing current liabilities.
The Textile Anchor
The textile industry had some issues. As new technology developed, capital had to be deployed to maintain efficiency. The problem was that everyone in the industry was doing the same. Prices fell, customers captured the savings, and inefficient mills were shut down. The textile business would continue to be a drag on Berkshire’s performance for the next decade. Buffett would later refer to not shuttering the business sooner as the greatest mistake he ever made. In 1977, Buffett defended that choice:
Our reasons are several: (1) Our mills in both New Bedford and Manchester are among the largest employers in each town, utilizing a labor force of high average age possessing relatively non-transferable skills. Our workers and unions have exhibited unusual understanding and effort in cooperating with management to achieve a cost structure and product mix which might allow us to maintain a viable operation. (2) Management also has been energetic and straightforward in its approach to our textile problems. In particular, Ken Chace’s efforts after the change in corporate control took place in 1965 generated capital from the textile division needed to finance the acquisition and expansion of our profitable insurance operation. (3) With hard work and some imagination regarding manufacturing and marketing configurations, it seems reasonable that at least modest profits in the textile division can be achieved in the future.
It’s interesting how this line of thinking goes counter to what Buffett was saying in the earlier section. The capital deployed in textiles could achieve a better return elsewhere, therefore, it should be redeployed elsewhere. However, that calculation ignores the behavioral issues that make humans human. In one sense, Buffett made a moral call, understanding that the human suffering of mass layoff would outweigh the gain for him. In another sense, Buffett was suffering from wishful thinking, an endowment effect, and pride. He wanted to make the textile business work despite mounting evidence to the contrary.
Good Business / Bad Business
Unlike textiles, the insurance business at Berkshire was firing on all cylinders. Buffett noted that even when they made a mistake the outcome seemed to still be positive:
It is comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved. In a sense, this is the opposite case from our textile business where even very good management probably can average only modest results. One of the lessons your management has learned – and, unfortunately, sometimes re-learned – is the importance of being in businesses where tailwinds prevail rather than headwinds.
As Buffett often says, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” In other words, turnarounds rarely turn and any idiot could run a business with a strong economic moat.
Discipline Through Cycles
Buffett goes on to talk about how, after years of steady performance, monetary inflation and adverse legal judgments were increasing insurance costs policy rates stayed flat:
As markets loosen and rates become inadequate, we again will face the challenge of philosophically accepting reduced volume. Unusual managerial discipline will be required, as it runs counter to normal institutional behavior to let the other fellow take away business – even at foolish prices.
As investors, we should avoid picking up nickels in front of a steamroller. Yet, at market tops, that’s exactly what most investors do. Whether we call it chasing yield, or leveraged arbitrage, or new-economy momentum, or just greed, the risk eventually catches up. Remember that every business can be a great deal at one price and a liability at another. When we fall in love with the story behind a stock and ignore the price, bad things happen.
The Management Asset
Buffett takes some time to thank his management:
Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition. It is commonplace, in corporate annual reports, to stress the difference that people make. Sometimes this is true and sometimes it isn’t. But there is no question that the nature of the insurance business magnifies the effect which individual managers have on company performance.
When there are no barriers to entry, the only way to compete is through operating efficiency. In insurance, this means risk management. Any manager can go the AIG route and make loads of money issuing policies, that if claimed, would bankrupt the company. It takes an above average manager to think more about the downside than the upside.
The insurance float and the liquidation of mills provided Buffett with a capital base to make investments. Buffett explained what he looked for:
We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.
Let’s take these in order.
First, Buffett quickly filters out ideas that are too complicated for him. As Tom Watson, the founder of IBM, once said, “I’m no genius. I’m smart in spots and I stay around those spots.” The importance of this step is that it means we don’t have to be an expert on every company or even many. We can pick a niche that we know and build around it.
Second, Buffett looks for companies with a sustainable competitive advantage. It’s often said that Buffett avoids technology companies because he doesn’t understand them but in reality, it is because of a lack of sustainable competitive advantage. He understands that there is very little stopping some college student in a garage from disrupting their entire business. It’s much harder to disrupt companies like Coke.
Third, Buffett wants quality management. It is always nice to have a management team whose interests are aligned with shareholders. This usually means a substantial portion of the manager’s wealth and reputation is tied to the company. However, sometimes an owner-manager’s wealth can grow to a level where marginal value creation takes a back seat to ego, legacy, and control.
Fourth, and most important, Buffett requires an attractive price. This means the company has to be selling for less than its intrinsic value. As investors, we often make mistakes when estimating intrinsic value, so buying at a lower price gives us a margin of safety.
Buffett then talks about one of his largest investments:
Capital Cities possesses both extraordinary properties and extraordinary management. And these management skills extend equally to operations and employment of corporate capital. To purchase, directly, properties such as Capital Cities owns would cost in the area of twice our cost of purchase via the stock market, and direct ownership would offer no important advantages to us. While control would give us the opportunity – and the responsibility – to manage operations and corporate resources, we would not be able to provide management in either of those respects equal to that now in place. In effect, we can obtain a better management result through non-control than control. This is an unorthodox view, but one we believe to be sound.
Capital Cities was funded in 1957 after the merging of two older broadcasting companies. It would spend the next decade purchasing television, radio and publishing assets. During the 1970’s, when Buffett would make his purchase, the company greatly expanded its local newspaper assets.
Buffett has always had a soft spot for newspapers and broadcasting monopolies. In the past, before the internet, these institutions acted as the gatekeeper between businesses and consumers. If a business wanted to borrow the megaphone, they had to pay the toll. Since most consumers wanted to subscribe to one newspaper in each city, it followed that most towns would end up with one newspaper. When competition did exist, economies of scale (more circulation > more ads > more circulation) ensured that the largest newspaper would win – similar to the network effects found in companies like Facebook today.
Capital Cities would leverage these mini-monopolies to average earnings growth of 22% annually for decades to come.
Buffett ends his letter with a note about See’s corporation:
Since See’s was purchased by Blue Chip Stamps at the beginning of 1972, pre-tax operating earnings have grown from $4.2 million to $12.6 million with little additional capital investment. See’s achieved this record while operating in an industry experiencing practically no unit growth.
The no unit growth aspect is worth delving into. As we talked about earlier with DuPont analysis, companies can earn a return through profit margin (markup) or through asset turnover (volume). Think of this as return due to demand versus the return due to production. Since unit growth was stagnant at See’s, it meant that its entire earnings growth could be attributed to its markup.
Unlike the newspaper example, See’s had no monopoly. Customers didn’t need chocolate, there were plenty of competitors, and there were no switching costs. So what explains the high markup for its products? Brand value. When you think soda, you think Coke. When you think shoes, you think Nike. In both cases, they are similar to the competition but can charge a markup because of their brand value. When people think of chocolate in California, they think See’s. We wouldn’t find See’s in the candy aisle at the grocery store because that’s not the brand story they wanted to tell. They wanted us to believe See’s was a premium product that commanded a premium price. And it largely worked.
This brand value was nowhere to be found on See’s financial statements, but Buffett knew it was there and was willing to pay up for it. Think of how Apple is able to charge a markup today for hardware that could be found elsewhere for cheaper. Some of this markup is for the unique software, but a lot of it is due to the brand. Like See’s, Apple created its own retail stores to tell a story that their product was different than others. Unlike See’s, Apple also has the production side of the equation locked down (massive unit growth). It’s no wonder why Apple is the most profitable company in history.