This post continues our series on Berkshire Hathaway’s performance from 1977 to today. Shareholder letters can be found here.
In 1979, the S&P 500 returned 18.52%.
In January, the United States and the People’s Republic of China established full diplomatic relations. In February, the Iranian army ceded power to Ayatollah Khomeini’s Islamic Republic. In May, Margaret Thatcher became the first woman Prime Minister of the United Kingdom. In June, McDonald’s introduced the first Happy Meal. In September, the first cable sports channel, ESPN, was launched. In November, Khomeini declared the United States “The Great Satan” and a hostage crisis ensued. In December, the Soviet Union invaded Afghanistan.
It was against this backdrop of cold war and rising inflation that Berkshire Hathaway listed on the NASDAQ exchange at a price of around $200. Today, that price is about $300,000.
Buffett begins this year with a discussion on managerial performance:
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.
To evaluate a single year, Buffett used operating earning (before securities gains/losses) divided by shareholders’ equity with securities valued at cost. It wasn’t that security gains were unimportant, but that their impact in any given year could be volatile and distort short-term performance. For longer-term performance, Buffett would add back in realized capital gains/losses and extraordinary items and used shareholders’ equity with securities valued at market. The basic idea was that over a period of say five or more years, an accurate track record of capital allocation would emerge.
Today, this is commonly referred to as return on equity (ROE). ROE has maintained a large following among analysts over the years, largely in part due to its simplicity and focus on shareholder’s returns. However, as with any single metric, it has its problems. For example, deteriorating operations can be masked by using increased leverage or stock buybacks. To avoid such manipulations, other metrics have been developed to get a better gauge at how well a business is operating as a whole – ROA, ROIC, ROTIC, etc.
I prefer to use free-cash-flow-to-the-firm (FCFF) divided by invested capital. FCFF is basically the money left over for both shareholders and bondholders after all expenses and reinvestments have been paid for. Invested capital is basically the total amount of money raised from shareholders and bondholders excluding non-invested capital such as cash. Put together, this tells us how well management is using its capital to produce cash for a single owner of the whole enterprise.
Investor Misery Index
Buffett moves on to talk about a big issue at the time – inflation and taxation:
A few years ago, a business whose per-share net worth compounded at 20% annually would have guaranteed its owners a highly successful real investment return. Now such an outcome seems less certain. For the inflation rate, coupled with individual tax rates, will be the ultimate determinant as to whether our internal operating performance produces successful investment results – i.e., a reasonable gain in purchasing power from funds committed – for you as shareholders.
Say we have a $100 investment that gains 20%. If our $20 profit is taxed at 30% it would become a $14 profit and our return would drop to 14%. If inflation happens to be 14% (which wasn’t that far of a reach in 1979), then our real return would actually be 0%. Buffett refers to this interaction of inflation and taxation as the investor misery index. In the end, what investors should really care about is increases in their purchasing power over time. Buffett admits he doesn’t know how to counter the investor misery index:
We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.
Historically, there are assets that hold up better under inflationary periods (real estate, gold, oil, TIPS, etc), but there is probably no better investment during these periods than a business with pricing power. Buffett inherently knew this at the time and was already shifting his investments towards companies like See’s Candy which had tremendous pricing power. I think See’s has increased their prices every year or something ever since Buffett took over.
Imagine a business that experiences an inflationary doubling of its input costs overnight. Say a loaf of bread needed to make a sandwich now costs the business $2 instead of $1. If the business can charge customers an extra dollar to balance out the increased cost, without losing volume, it would be no worse off than before the inflation. However, if the business can’t raise prices – maybe it is locked into a promotion, or sold sandwiches ahead of time at a fixed price, or competition would just undercut them – then the business would be in trouble. Pricing power is key.
Good Business Premium
Once again, Buffett uses this year’s textile section to talk about the businesses that he would rather be in. Sunk costs are a powerful thing:
In some businesses – a network TV station, for example – it is virtually impossible to avoid earning extraordinary returns on tangible capital employed in the business. And assets in such businesses sell at equally extraordinary prices, one thousand cents or more on the dollar, a valuation reflecting the splendid, almost unavoidable, economic results obtainable. Despite a fancy price tag, the “easy” business may be the better route to go.
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.
There used to be a time when owning a TV station was basically owning a government-sanctioned monopoly. Get a license, build a station, charge advertisers a toll, and generate cash flow for decades to come. The same was basically true for radio and newspapers. However, over time, new competitors emerged to challenge those distribution monopolies – Cable, Satellite, and now the Internet.
The recent Disney-Fox merger is worth taking a look at in this context. In one sense, it’s adding to a old world monopoly – more stations and content to build those toll booths around. In another sense, it’s just a move to compete with an established new world monopoly that is Netflix. Disney knows that if Netflix becomes the only toll bridge to consumers, in the way Network TV was in the past, it would have a tremendous amount of negotiating power and dominate the value chain. To avoid this, Disney is trying to compete head-on with Netflix. It is entirely possible that profits in the content and distribution industry will end up less concentrated as a result of the merger than if it didn’t occur. But this requires us to look ahead rather than behind.
Disciplined Risk Taking
Insurance is a business of risk management. You charge a fee, take on a risk that others want to avoid, and if the fees are greater than the eventual losses and expenses, you make a profit. The hard part, as Buffett notes, is shrinking your business when the risks are higher than the fees:
We hear a great many insurance managers talk about being willing to reduce volume in order to underwrite profitably, but we find that very few actually do so.
We would rather have some slack in the organization from time to time than keep everyone terribly busy writing business on which we are going to lose money.
We believe such strong-mindedness is as rare as it is sound – and absolutely essential to the running of a first-class casualty insurance operation.
There is an inherent do-something, growth-at-all-costs fallacy that managers tend to be afflicted by. It will always be easy for a manager to grow volume unprofitably – just charge a low price and eventually go bankrupt. Similarly, in investing, just pay a high price and eventually go bankrupt. As Charlie Munger says, “Assiduity is the ability to sit on your ass and do nothing until a great opportunity presents itself.” In other words, if prices don’t make sense, wait.
Recall that in the 1970s, inflation and rising rates led to a massive bear market in bonds that wouldn’t end until the mid-1980s. Up until this letter, Buffett had avoided commentary on his bond investments, but he opens up here:
An extraordinary amount of money has been lost by the insurance industry in the bond area – notwithstanding the accounting convention that allows insurance companies to carry their bond investments at amortized cost, regardless of impaired market value.
You do not adequately protect yourself by being half awake while others are sleeping. It was a mistake to buy fifteen-year bonds, and yet we did; we made an even more serious mistake in not selling them (at losses, if necessary) when our present views began to crystallize. (Naturally, those views are much clearer and definite in retrospect; it would be fair for you to ask why we weren’t writing about this subject last year.)
Harking back to our textile experience, we should have realized the futility of trying to be very clever (via sinking funds and other special type issues) in an area where the tide was running heavily against us.
Buffett often returns to this theme: If the tide is going against you, it doesn’t matter how smart you are, you’ll get pulled along with it. If the tide is going with you, it doesn’t matter how dumb you are, you’ll get pushed along with it. The tide in bonds, as with the tide in textiles, was clearly going against Buffett. What mattered now was when the tide would turn and who would be left swimming naked:
And, 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. The threat which alarms us may also alarm legislators and other powerful groups, prompting some appropriate response.
Furthermore, present interest rates incorporate much higher inflation projections than those of a year or two ago. Such rates may prove adequate or more than adequate to protect bond buyers. We even may miss large profits from a major rebound in bond prices. However, our unwillingness to fix a price now for a pound of See’s candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years. Overall, we opt for Polonius (slightly restated): “Neither a short-term borrower nor a long-term lender be.”
Buffett knew that there was no such thing as a good investment class, just a good investment price. At one price, bonds might be a bad bet, but at another price, if they eventually got so cheap that they more than covered the risk of inflation, they would be a great bet. In hindsight, this turn in the tide occurred in the early 1980s. In 1982, we could have loaned money to the U.S. government for a 10 year period and have gotten paid nearly 15% for having done so. Today, making that same loan would only get us about 2%. Anyone who went all in on bonds in 1982 would have timed the turn in the tide perfectly and would have done very well over the following 30 some years.
It is always important to remember that cycles, by definition, eventually turn.