Each year, Warren Buffett writes an open letter to Berkshire Hathaway shareholders which many value investors can’t wait to jump on reading. In this post, we have summarised the key learnings from the letter written in 1985, to save you the time from reading the whole letter (although still strongly recommended).
Berkshire Hathaway – 1985 Letter Learnings
Buffett: The second negative factor, far more telling, is our size. Our equity capital is more than twenty times what it was only ten years ago. And an iron law of business is that growth eventually dampens exceptional economics. just look at the records of high return companies once they have amassed even $1 billion of equity capital. None that I know of has managed subsequently, over a ten-year period, to keep on earning 20% or more on equity while reinvesting all or substantially all of its earnings. Instead, to sustain their high returns, such companies have needed to shed a lot of capital by way of either dividends or repurchases of stock. Their shareholders would have been far better off if all earnings could have been reinvested at the fat returns earned by these exceptional businesses. But the companies simply couldn’t turn up enough high-return opportunities to make that possible.
MoneyWiseSmart (MWS): How much equity base do your companies have, and can they reinvest all earnings back at high rates?
Buffett: Our 1985 results include unusually large earnings from the sale of securities. This fact, in itself, does not mean that we had a particularly good year (though, of course, we did). Security profits in a given year bear similarities to a college graduation ceremony in which the knowledge gained over four years is recognized on a day when nothing further is learned. We may hold a stock for a decade or more, and during that period it may grow quite consistently in both business and market value. In the year in which we finally sell it there may be no increase in value, or there may even be a decrease. But all growth in value since purchase will be reflected in the accounting earnings of the year of sale. (If the stock owned is in our insurance subsidiaries, however, any gain or loss in market value will be reflected in net worth annually.) Thus, reported capital gains or losses in any given year are meaningless as a measure of how well we have done in the current year.
MoneyWiseSmart (MWS): Do your companies record capital gains? If so, how do you interpret them?
Buffett: [On the sale of General Foods to Philip Morris], We thus benefited from four factors: a bargain purchase price, a business with fine underlying economics, an able management concentrating on the interests of shareholders, and a buyer willing to pay full business value. While that last factor is the only one that produces reported earnings, we consider identification of the first three to be the key to building value for Berkshire shareholders. In selecting common stocks, we devote our attention to attractive purchases, not to the possibility of attractive sales.
MoneyWiseSmart (MWS): Do you devote your attention to attractive purchases (with the business bailing you out), or the possibility of attractive sales (with the market bailing you out)?
Buffett: Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.
But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s capital investment decision appeared cost effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.
MoneyWiseSmart (MWS): Do your companies have pricing power, such that any reinvestments actually generate real return, instead of just keeping up?
Buffett: My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Some years ago I wrote: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
MoneyWiseSmart (MWS): Do you like to bet on the horse or the jockey?
Buffett: Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I’ll be happy to accept a lottery ticket as a gift – but I’ll never buy one.) In dividend policy also, the option holders’ interests are best served by a policy that may ill serve the owner. Think back to the savings account example. The trustee, holding his option, would benefit from a no-dividend policy. Conversely, the owner of the account should lean to a total payout so that he can prevent the option-holding manager from sharing in the account’s retained earnings.
Despite their shortcomings, options can be appropriate under some circumstances. My criticism relates to their indiscriminate use…
MoneyWiseSmart (MWS): How are the compensation, including the option component, for the management of your businesses structured?
Buffett: The only bright spot in this picture is that virtually all of the underreserving revealed in 1984 occurred in the reinsurance area – and there, in very large part, in a few contracts that were discontinued several years ago. This explanation, however, recalls all too well a story told me many years ago by the then Chairman of General Reinsurance Company. He said that every year his managers told him that “except for the Florida hurricane” or “except for Midwestern tornadoes”, they would have had a terrific year. Finally he called the group
together and suggested that they form a new operation – the Except-For Insurance Company – in which they would henceforth place all of the business that they later wouldn’t want to count.
In any business, insurance or otherwise, “except for” should be excised from the lexicon. If you are going to play the game, you must count the runs scored against you in all nine innings. Any manager who consistently says “except for” and then reports on the lessons he has learned from his mistakes may be missing the only important lesson – namely, that the real mistake is not the act, but the actor.
MoneyWiseSmart (MWS): How often do the managers of your businesses describe events as one-off and adjust them? Are they really one-off?
Buffett: Since large blocks frequently command premium prices, some might think we have injured Berkshire financially by creating such restrictions [on our purchased shares in Capital Cities]. Our view is just the opposite. We feel the long-term economic prospects for these businesses – and, thus, for ourselves as owners – are enhanced by the arrangements. With them in place, the first-class managers with whom we have aligned ourselves can focus their efforts entirely upon running the businesses and maximizing long-term values for owners. Certainly this is much better than having those managers distracted by “revolving-door capitalists” hoping to put the company “in play”. (Of course, some managers place their own interests above those of the company and its owners and deserve to be shaken up – but, in making investments, we try to steer clear of this type.)
Today, corporate instability is an inevitable consequence of widely-diffused ownership of voting stock. At any time a major holder can surface, usually mouthing reassuring rhetoric but frequently harboring uncivil intentions. By circumscribing our blocks of stock as we often do, we intend to promote stability where it otherwise might be lacking. That kind of certainty, combined with a good manager and a good business, provides excellent soil for a rich financial harvest. That’s the economic case for our arrangements.
MoneyWiseSmart (MWS): Are the managers of your businesses trying to attract, or distracted by, revolving-door capitalists, based on past records?
Key Insights from Berkshire Hathaway’s 1985 Letter
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Source: Berkshire Hathaway letter.
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