This post continues our series on Berkshire Hathaway’s annual letters. Original letters can be found here.
In 1980, the S&P 500 returned 31.74%.
In January, Jimmy Carter authorized legislation bailing out the Chrysler Corporation to the tune of $1.5 billion. In February, an FBI sting operation, codenamed Abscam, led to the convictions of multiple US Congressmen. In March, the price of Silver crashed after an attempt by the Hunt brothers to corner the market. In May, the eruption of Mount St. Helens led to 57 deaths and over $3 billion in damages. In June, the first 24-hour news network, CNN, was launched. In September, the Iran-Iraq War began. In November, Ronald Reagan was elected President of the United States. In December, John Lennon was shot dead outside his apartment in New York City.
Buffett begins this letter by talking about the various accounting standards for Berkshire’s stakes in other companies. If a company is more than 50% owned, it is said to be controlled and must be fully consolidated into the parent’s income statement with an offsetting minority interest line item for the amount not owned. If a company is 20% to 50% owned, its earnings must be included in the parent’s income statement on a pro rata basis. If a company is less than 20% owned, only the dividends received from the company will show up on the parent’s income statement.
These accounting standards, though probably the best we can do, create some distortions and rarely reflect the true economic earnings of a company in any given period. For example, if we own 10% of a company with $10 billion in earnings that pays no dividends, our $1 billion claim on earnings wouldn’t show up in our earnings. Similarly, if we own 100% of a company with $10 billion in earnings that has to reinvest all $10 billion in maintenance CapEx, our $0 of actual economic earnings would show up as the full $10 billion.
Buffett naturally ignores all of this and gets to the heart of the matter: how well are those earnings being put to work?
The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage. This is true whether we determine the usage, or whether managers we did not hire – but did elect to join – determine that usage. (It’s the act that counts, not the actors.) And the value is in no way affected by the inclusion or non-inclusion of those retained earnings in our own reported operating earnings. If a tree grows in a forest partially owned by us, but we don’t record the growth in our financial statements, we still own part of the tree.
Our view, we warn you, is non-conventional. But we would rather have earnings for which we did not get accounting credit put to good use in a 10%-owned company by a management we did not personally hire, than have earnings for which we did get credit put into projects of more dubious potential by another management – even if we are that management.
That last line was probably alluding to Berkshire’s textile business where value was being destroyed despite having 100% control. It doesn’t matter how amazing management is; bad economics will always win out.
One of Buffett’s favorite ways of putting retained earnings to work is through stock buybacks. Berkshire, as a matter of principle, has never paid any dividends to its investors, but it has had a long-standing stock buyback plan.
The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price?
The competitive nature of corporate acquisition activity almost guarantees the payment of a full – frequently more than full price when a company buys the entire ownership of another enterprise. But the auction nature of security markets often allows finely-run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise.
When a company buys back shares of its own stock and retires them, they increases the ownership percentage of the remaining investors, which in turn means more earnings per investor, which in turn means a higher share price. There are some caveats, however: 1) the company needs to be able to afford the buyback and 2) the company’s share price needs to be below its intrinsic value. If either of these rules is ignored, share buybacks can do more damage than good.
Consider Netflix, who between 2007 and 2011 spent over $1 billion on share repurchases despite having to fund a growth plan that required a constant acquisition of new content. In 2011, subscriptions slowed and Netflix had to raise money to make good on its obligations. It was forced to sell 5.16 million shares through a secondary and convertible debt offering for a total of $400 million. Those shares would be worth over $9 billion today. Sometimes the optionality of having a cash cushion outweighs the benefit of returning cash to shareholders.
The Inflation Problem
Inflation has been in the news lately, and lucky for us, Buffett spends a good portion of this letter on the subject. For some context, inflation, which had averaged 3.2% annually for much of the post-war era, had more than doubled throughout the 1970s and reached 13.5% in 1980. Accordingly, Buffett was worried about the situation:
Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer.
Inflation rates not far from those recently experienced can turn the level of positive returns achieved by a majority of corporations into negative returns for all owners, including those not required to pay explicit taxes. (For example, if inflation reached 16%, owners of the 60% plus of corporate America earning less than this rate of return would be realizing a negative real return – even if income taxes on dividends and capital gains were eliminated.)
Buffett often refers to this interaction between inflation and taxes as the investor’s misery index. An investor might be happy to make a nominal 20% return on their investment, but if inflation is running at 20% per year, the real return is zero. Add on top of that taxes, which are levied on nominal returns, and there will be plenty of misery to go around.
The Inflation Solution
Buffett turns to some strategies for dealing with inflation:
Indexing is the insulation that all seek against inflation. But the great bulk (although there are important exceptions) of corporate capital is not even partially indexed.
For capital to be truly indexed, return on equity must rise, i.e., business earnings consistently must increase in proportion to the increase in the price level without any need for the business to add to capital – including working capital – employed. (Increased earnings produced by increased investment don’t count.) Only a few businesses come close to exhibiting this ability. And Berkshire Hathaway isn’t one of them.
Every business is a function of two things: inputs and outputs. Inputs are the raw materials, capital, labor, etc that go into producing outputs, which in turn are the products or services sold. To do well in an inflationary environment, a business needs to have the right relationship between the two.
For example, imagine a retail business that buys inventory for cash and turns around and sells it on account – usually receiving cash after about 6 months. When inflation hits, our retailer starts to notice that their existing cash flows aren’t covering the cost of new inventory. If our retailer wants to maintain the same unit volume (most businesses don’t like to shrink even if it’s the rational move) it needs to reinvest a larger portion of its current earnings in new inventory and also raise its prices (if it can) to right the ship. Earnings that would otherwise have gone to the owners are now reinvested just to keep the business running. Like the red queen’s race, our retailer has to run as fast as possible just to stay in place. Buffett puts it this way:
Our acquisition preferences run toward businesses that generate cash, not those that consume it. As inflation intensifies, more and more companies find that they must spend all funds they generate internally just to maintain their existing physical volume of business. There is a certain mirage-like quality to such operations. However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.
Now imagine a company like See’s Candy, which has an extremely short production cycle and receives cash payments upfront. When inflation hits, this reduced need to invest in working capital means that See’s can raise its prices to match its costs in real time. In fact, See’s has raised its prices at a rate greater than inflation for most of its history.
In short, minimal reinvestment needs and pricing power are the best ways to deal with inflation.
Handy & Harman Investment
Handy & Harman showed up in Berkshire’s top holdings this year and is worth taking a look at as an example of balance sheet investing. Throughout its history, by means of last-in, first-out (LIFO) accounting, Handy & Harman amassed a large number of precious metals on its books at a value well below market prices ($55 million versus $390 million). Buffett was able to buy those ~$17/share in precious metals for ~$10/share on the open market. As an added benefit, LIFO balances tended to gain in value during times of high inflation and high tax rates, since they meant businesses could show less taxable income by selling its high-cost inventory first.
Precious metals are also commonly thought of as an inflation hedge, and Buffett being Buffett found a way to purchase that hedge for 60 cents on the dollar.
To close this year, Buffett had some nice things to say about GEICO:
GEICO represents the best of all investment worlds – the coupling of a very important and very hard to duplicate business advantage with an extraordinary management whose skills in operations are matched by skills in capital allocation.
GEICO was designed to be the low-cost operation in an enormous marketplace (auto insurance) populated largely by companies whose marketing structures restricted adaptation. Run as designed, it could offer unusual value to its customers while earning unusual returns for itself. For decades it had been run in just this manner. Its troubles in the mid-70s were not produced by any diminution or disappearance of this essential economic advantage.
GEICO’s problems at that time put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true “turnaround” situation in which the managers expect – and need – to pull off a corporate Pygmalion.
Even the best of companies fall out of favor from time to time, and lucky for us, this can create an attractive entry point. The hard part here, as Buffett alludes to, is determining whether the pessimism is over something transitory, like a product recall, or over something fundamental to the business model, like a restaurant losing its liquor license. If the former is true, and we as investors are emotionally and financially able to weather the storm, then there is plenty of profit to be had.