Investment Theory #17: Berkshire Hathaway’s 1978 Letter

In 1962, Warren Buffett began purchasing shares of Berkshire Hathaway – a downsizing textile manufacturing company. In 1965, after feeling slighted by management, Buffett acquired control of Berkshire. Shortly after, Berkshire purchased an insurance company and began using its float to fund investments and acquisitions. Using this as a launching pad, Berkshire’s share price rose from $8 in 1962 to $276,800 in 2017 (20% annualized).

This post continues our series on that performance. Our goal is to gain some insight into one of the most successful investment vehicles in history. Warren Buffett’s shareholder letters can be found here.

Links to Berkshire’s past years: 1977

Links to Buffett’s partnership years: 1957, 1958, 1959, 1960, 1961, 1962, 1963, 1964, 1965, 1966, 1967, 1968

Historical Context

In 1978, the S&P 500 returned 6.51%.

In February, the first global positioning satellite was launched by the United States. In April, Jimmy Carter postponed production on the neutron bomb. In May, the first Unabomber attack occurred at Northwestern University. In June, California voters passed Proposition 13, reducing property taxes for decades to come. In September, the Camp David Accords were signed between Israel and Egypt. In November, Harvey Milk and George Moscone were assassinated in San Francisco. In December, Cleveland became the first major American city to go into default since the Great Depression.

Accounting For Economic Reality

Buffett opens the letter by discussing some necessary changes to account for Berkshire’s increased ownership in Blue Chip Stamps. Instead of reporting earnings and assets for Blue Chip Stamps as a single line item on the income statement and balance sheet, Berkshire would now fully consolidate the subsidiaries. This meant that candy operations would appear mixed in with textile operations and insurance operations. Buffett explains:

Such a grouping of Balance Sheet and Earnings items – some wholly owned, some partly owned – tends to obscure economic reality more than illuminate it. In fact, it represents a form of presentation that we never prepare for internal use during the year and which is of no value to us in any management activities.

The problem with this approach is that it obscures the metrics needed to judge the performance of individual businesses. A 10% return on the textile assets might have been outperforming the industry, but a 10% return on the insurance assets might have been underperforming. Combining the two gives us no real insight into how well each unit is being managed.

Accounting is a necessary tool for business, but it has plenty of drawbacks. Accruals are subjective, assets that may be increasing in value are amortized, assets that may be worthless are held at cost, management can pull strings to get the numbers they want, etc. As investors, we always need to look past the numbers to the underlying economics.

Commoditized Businesses

Buffett goes on to talk about how bad the textile manufacturing business was:

The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed.

The textile business required high levels of working capital (mainly receivables and inventories) relative to its sales. As we saw last time with DuPont Analysis, low capital turnover coupled with low-profit margins meant a low return on capital. Textile’s capital-intensive nature wasn’t about to change so Berkshire had to do something about the profit side:

Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management is diligent in pursuing such objectives. The problem, of course, is that our competitors are just as diligently doing the same thing.

Competing in a commoditized space isn’t easy. If we invest in machinery that reduces our costs, and our competition invests in the same machinery, the only winners are the consumers. Since operational advantages are easily copied, profits in a commoditized industry are largely dependent on being the low cost producer and where in the cycle we are. Good times lead to investment, which leads to oversupply, which leads to poor times, which leads to divestment, which leads to good times. The firms that can survive the down-cycle are the ones that profit in the up-cycle.

For example, just look at the North American energy sector in late 2014. Years of tight supply led to rapid investment in new wells. Then prices cratered, firms started to go bankrupt, and for the past three years we have been working through that over-investment. It’s important to remember that undersupply corrects a lot quicker than oversupply.

Institutional Handicaps

In 1971, the market was soaring and Berkshire couldn’t find investments at attractive prices. In 1978, this position flipped, the market dropped, and Berkshire’s equity holdings grew 20x from their 1971 level. Buffett noted that during this time institutional investors were doing the opposite:

An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities – at full prices they couldn’t buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.

A second footnote: in 1978 pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities – breaking the record low figure set in 1974 and tied in 1977.

Buy high and sell low. We should remember that Institutional Investors have their own sets of incentives and limitations. Often times, long-term performance takes a backseat to relative performance and job security.

Dividends and Reinvestment

Buffett spends some time talking about dividends and retained earnings:

We are not at all unhappy when our wholly-owned businesses retain all of their earnings if they can utilize internally those funds at attractive rates. Why should we feel differently about retention of earnings by companies in which we hold small equity interests, but where the record indicates even better prospects for profitable employment of capital? (This proposition cuts the other way, of course, in industries with low capital requirements, or if management has a record of plowing capital into projects of low profitability; then earnings should be paid out or used to repurchase shares – often by far the most attractive option for capital utilization.)

To understand if a company should retain its earnings, we have to understand how those earnings will be used and what returns they will produce. If every dollar a company retains can create more value than what the investor could make elsewhere, the company should keep that dollar. Investing is all about opportunity costs.

For example, take See’s Candy which requires very little capital and experiences very little unit growth. Any earnings retained by See’s would have no where to be profitably reinvested. perhaps they could expand stores, but more than likely this would prove unprofitable since the unit demand wouldn’t support it. Instead, all of their earnings could be dividended out to Buffett for reinvestment elsewhere.

For a counter example, take Apple which for most of the past two decades has funneled all of its earnings back into research and development. The returns on those investments (mainly the iphone) have been far greater than what individual investors could have gotten elsewhere.

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