The full audio of the 1979 Berkshire Hathaway Shareholders Letter is out. Here are my curated thoughts from the letter.
You can see this effect in action in your own portfolio: as the market rises and the value of your holdings goes up, the earnings yield of the entire portfolio will shrink while during a market decline, the earnings yield of your portfolio will increase.
Earnings per share is the place to start when beginning the journey in security analysis and valuation, but you need to look at the cash flow generation, specifically your estimated free cash flow generation and growth to be able to accurately value a business. Valuation simply comes down to all of the cash profit generation ability of a business discounted back to the present.
Return on Capital Employed (ROCE) is a very important ratio to utilize in order to gauge a management’s performance.
It’s amazing that book value has compounded at that stated rate in 1979 all the way up to 2015/2016, with book value clocking in at $157,365 as of the latest quarter in 2016. It’s important to keep in mind that there is accounting value and intrinsic value: accounting value may peg certain assets at a certain price, but the “real” (intrinsic) value of those assets may diverge significantly. When assets become impaired, the value is written down but the impairment probably took place before the accounting value was adjusted to reflect the real/intrinsic value of the asset.
What I found so amazing reading The Snowball was the details it provided in this steady transformation from taking the profits from the textile business and diverting it towards more promising business. The purchase of National Indemnity was possible by avoiding reinvestment of profits back into the textile business, rather purchasing a promising insurance business instead that kickstarted a lot of growth for Berkshire Hathaway.
The late-1970s into the early-1980s saw some unreal inflation, resulting in sky-high interest rates. Even great business performance will be dragged down by high inflation rates.
High inflation rates combined with frictional costs tied to buying, trading, and taxes can eat away into even great returns.
When inflation and frictional costs exceed the Return on Equity (ROE), be weary.
It would have been folly to hold onto that one-half ounce of gold from 1964 to today versus a share of Berkshire Hathaway, as gold compounded at 7% over the past 52 years versus nearly 20% for Berkshire. However, it would have been infinitely wiser to hold onto gold over the past 52 years as opposed to a $20 bill as that $20 bill is still only worth $20 while a half-ounce of gold is worth around $672. The all important lesson is that, outside of a deflationary environment, it is highly unwise to stuff cash underneath the mattress.
Again, a reminder on the importance of knowing the basics of financial accounting. I’ve recommended this book before and I’ll recommend it again for those starting out: How to Read a Financial Report was very helpful as a first introduction to how the three financial statements worked and how they connected.
You want to avoid investing your hard earned cash in poor industries. You want to find businesses that earn extraordinary returns on tangible capital employed. And you want businesses where the value of assets are actually valuable – the opposite of this was the Berkshire textile business where the assets valued in accounting terms far exceeded what the value of those assets would be worth in a liquidation event, which was pennies on the dollar. This must be Munger’s influence showing up in the shareholders letter: Buffett moving away from the cigar butt approach to favouring splendid businesses that could be run by a ham sandwich.
Buffett describing how the cigar butt approach was beginning to get inferior to just identifying great business to buy at a good price.
The first time on paper where I see that famous quip of Buffett’s “turnarounds seldom turn.” Again, he is reiterating a lot throughout this shareholders letter that a good business purchased at a fair price is superior to a poor business purchased at a bargain price.
I found Buffett’s humour shining through this paragraph as he talks about the irony of how insurance companies wouldn’t dare take on policies during the 1980s exceeding 6 months due to high inflation rates yet would willingly purchase 30 to 40 years bonds in their portfolios. In hindsight, it worked out pretty well for these companies to have purchased long term bonds with such high interest rates attached as interest rates eventually settled down. However, in the moment it would have seemed foolish to commit to a multi-decade fixed rate bond when it was entirely unknown if high inflation rates would keep going higher or for a long period of time. The high probability and less risky move at the time would have been to sit on the side lines and not participate, even though it worked out well for those who did participate. However, no one had a crystal ball and could have known that it would have worked out so well, making me attribute it to a lot of luck than anything else that buying multi-decade bonds during that era worked out.
Again, in the moment of the era, it seemed striking that one would commit to such long term fixed bond coupons when no one would be willing to give you fixed prices for the next 5 years on everyday goods and services.
Buffett has always loved those convertible quasi bond-equity options. Those are what he issued during the 2008 financial crisis. In 2011, for example, he loaned Bank of America $5 billion in return for preferred stock that pays a 6% dividend, which Bank of America can buy back at anytime for a 5% premium, and warrants to purchase 700 million shares of Bank of America anytime before mid-2017 for $7.14 per share. That’s what I’d call protecting your downside while maximizing your upside.
Buffett wasn’t wrong that the value of the dollar would shrink by the day – see the above comment on gold. To reiterate, cash under the mattress (or in a 0% interest bearing savings account) is a sure way to destroy your wealth.
His analysis at the time, while I believe was prudent, did turn out to be wrong (high inflation was tamed). However, we have been in a steadily declining low rate environment for awhile now. The financial crisis of 2008 seems to have put to world since then in an unusually low rate environment for almost a decade now.
It’s a great thing that the price per pound of See’s Candy was not fixed for 30 to 40 years as almost all of See’s expanding profits has come from its ability to hike the price per pound of its candies year over year.
Reminds me of Buffett’s oft quipped saying about how reputation takes a lifetime to create: Buffett has been molding the business owners (the investors) he has wanted over the decades.
The importance of consistency in what you are offering. This applies to many things outside of a business and its shareholders. This website should probably ponder on this one.
Again, Buffett has been incredibly consistent in what he has believed and promised for a very, very long time. You build up trust and reputation like this.