In anticipation of Berkshire’s 50th year under current management, I’m in the process of going through all of the annual letters with a fine toothed comb, and collecting what I find to be the best nuggets of wisdom. The formatting is messed up, and i'm not tech savvy enough to fix it. I hope the value of the info exceeds the price of the ugly formatting.
My favorites from 1977-1985 can be found here:
http://phillyvalueinvestor.blogspot.com/2015/02/lessons-from-berkshire-hathaway-annual.html
Below are my favorites from 1986-1995
Enjoy!
-PhillyValueInvestor
1986 Lesson - Fear and Greed
We have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future. What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
Top 4 portfolio positions at the end of 1986 (cost)
Cap Cities/ABC 79%, Lear Siegler 7%, GEICO 7%, Handy & Harman 4%
Top 4 portfolio positions at the end of 1986 (market)
Cap Cities/ABC 43%, GEICO 36%, Wash Post 14%, Handy & Harman 3%
Top 4 non-insurance operating businesses:
Buffalo News $16.9M, See’s $15.2M, Scott Fetzer Mfg. $13.4, World Book $11.7M
1987 Lesson #1 - Wonderful businesses and technologic change
At Berkshire, however, my appraisal of our operating managers is, if anything, understated. To understand why, first take a look at page 7, where we show the earnings of our seven largest non-financial units: Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See's Candies, and World Book. In 1987, these seven business units had combined operating earnings before interest and taxes of $180 million.
By itself, this figure says nothing about economic performance. To evaluate that, we must know how much total capital - debt and equity - was needed to produce these earnings. Debt plays an insignificant role at our seven units: Their net interest expense in 1987 was only $2 million. Thus, pre-tax earnings on the equity capital employed by these businesses amounted to $178 million. And this equity - again on an historical-cost basis - was only $175 million.
If these seven business units had operated as a single company, their 1987 after-tax earnings would have been approximately $100 million - a return of about 57% on equity capital. You'll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage. Here's a benchmark: In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and 500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade.
There's not a lot new to report about these businesses - and that's good, not bad. Severe change and exceptional returns usually don't mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today's business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be. Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.
The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000 companies met two tests of economic excellence - an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.
The Fortune champs may surprise you in two respects. First, most use very little leverage compared to their interest-paying capacity. Really good businesses usually don't need to borrow. Second, except for one company that is "high-tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane. Most sell non-sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.
1987 Lesson #2 – Mr. Market
Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."
Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising "Take two aspirins"?
The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben's Mr. Market concept firmly in mind.
Top 4 portfolio positions at the end of 1987 (cost)
Cap Cities/ABC 90%, GEICO 8%, Wash Post 2%, no other positions
Top 4 portfolio positions at the end of 1987 (market)
Cap Cities/ABC 49%, GEICO 36%, Wash Post 15%, no other positions
Top 4 non-insurance operating businesses:Buffalo News $21.3M, Scott Fetzer Mfg. $17.5, See’s $17.4M, World Book $15.1M
1988 Lesson – on Efficient Market Theory
The preceding discussion about arbitrage makes a small discussion of “efficient market theory” (EMT) also seem relevant. This doctrine became highly fashionable - indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market wasfrequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.
In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There’s plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire. Though I’ve not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben’s; he had 1929-1932 to contend with.)
Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically-significant differential that might, conceivably, arouse one’s curiosity.
Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don’t talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.
Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - it’s an enormous advantage to have opponents who have been taught that it’s useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.
Top 4 portfolio positions at the end of 1988 (cost)
Coca-Cola 48%, Cap Cities/ABC 42%, Freddie Mac 8%, GEICO 4%
Top 4 portfolio positions at the end of 1988 (market)
Cap Cities/ABC 37%, GEICO 29%, Coca-Cola 22%, Wash Post 12
Top 4 non-insurance operating businesses:
Buffalo News $25.5M, See’s $19.7M, World Book $18.0M, Kirby $17.8M
1989 Lesson – Intrinsic Value/Discounted Cash Flow and 1 foot hurdles
What counts, however, is intrinsic value - the figure indicating what all of our constituent businesses are rationally worth. With perfect foresight, this number can be calculated by taking all future cash flows of a business - in and out - and discounting them at prevailing interest rates. So valued, all businesses, from manufacturers of buggy whips to operators of cellular phones, become economic equals.
************************
A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers. The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult. On occasion, tough problemsmust be tackled as was the case when we started our Sunday paper in Buffalo. In other instances, a great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO. Overall, however, we've done better by avoiding dragons than by slaying them.
Top 4 portfolio positions at the end of 1989 (cost)
Coca-Cola 61%, Cap Cities/ABC 31%, Freddie Mac 4%, GEICO 3%
Top 4 portfolio positions at the end of 1989 (market)
Coca-Cola 35%, Cap Cities/ABC 33%, GEICO 20%, Wash Post 9%
Top 4 non-insurance operating businesses:
Buffalo News $27.7M, See’s $20.6M, Scott Fetzer Mfg. $20.0M, Kirby $16.8M
1990 Lessons – Sloth, Contrarianism, and Independent Thinking
Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings.
*******
The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.
None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do."
In the final chapter of The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Forty-two years after reading that, I still think those are the right three words.
Top 4 portfolio positions at the end of 1990 (cost)
Coca-Cola 52%, Cap Cities/ABC 26%, Wells Fargo 18%, Freddie Mac 4%
Top 4 portfolio positions at the end of 1990 (market)
Coca-Cola 41%, Cap Cities/ABC 25%, GEICO 21%, Wash Post 6%
Top 4 non-insurance operating businesses:
Buffalo News $26.0M, See’s $23.9M, World Book $20.4M, Scott Fetzer Mfg. $18.5M
1991 Lesson – Franchises vs businesses
The
economic strength of once-mighty media enterprises continues to
erode as retailing patterns change and advertising and
entertainment choices proliferate. In the business world,
unfortunately, the rear-view mirror is always clearer than the
windshield: A few years back no one linked to the media business -
neither lenders, owners nor financial analysts - saw the economic
deterioration that was in store for the industry. (But give me a
few years and I'll probably convince myself that I did.)
The fact is that newspaper, television, and magazine
properties have begun to resemble businesses more than franchises
in their economic behavior. Let's take a quick look at the
characteristics separating these two classes of enterprise, keeping
in mind, however, that many operations fall in some middle ground
and can best be described as weak franchises or strong businesses.
An economic franchise arises from a product or service that:
(1) is needed or desired; (2) is thought by its customers to have
no close substitute and; (3) is not subject to price regulation.
The existence of all three conditions will be demonstrated by a
company's ability to regularly price its product or service
aggressively and thereby to earn high rates of return on capital.
Moreover, franchises can tolerate mis-management. Inept managers
may diminish a franchise's profitability, but they cannot inflict
mortal damage.
In contrast, "a business" earns exceptional profits only if it
is the low-cost operator or if supply of its product or service is
tight. Tightness in supply usually does not last long. With
superior management, a company may maintain its status as a low-
cost operator for a much longer time, but even then unceasingly
faces the possibility of competitive attack. And a business, unlike
a franchise, can be killed by poor management.
Top 4 portfolio positions at the end of 1991 (cost)
Coca-Cola 36%, Gillette 21%, Cap Cities/ABC 18%, Wells Fargo 10%
Top 4 portfolio positions at the end of 1991 (market)
Coca-Cola 42%, GEICO 15%, Gillette 15%, Cap Cities/ABC 14%
Top 4 non-insurance operating businesses:
See’s $25.6M, Kirby $22.6M, Buffalo News $21.8M, Scott Fetzer Mfg. $15.9M
1992 Lesson – On Value
Whether appropriate or not, the term "value investing" is
widely used. Typically, it connotes the purchase of stocks having
attributes such as a low ratio of price to book value, a low price-
earnings ratio, or a high dividend yield. Unfortunately, such
characteristics, even if they appear in combination, are far from
determinative as to whether an investor is indeed buying something
for what it is worth and is therefore truly operating on the
principle of obtaining value in his investments. Correspondingly,
opposite characteristics - a high ratio of price to book value, a
high price-earnings ratio, and a low dividend yield - are in no way
inconsistent with a "value" purchase.
Similarly, business growth, per se, tells us little about
value. It's true that growth often has a positive impact on value,
sometimes one of spectacular proportions. But such an effect is
far from certain. For example, investors have regularly poured
money into the domestic airline business to finance profitless (or
worse) growth. For these investors, it would have been far better
if Orville had failed to get off the ground at Kitty Hawk: The more
the industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can
invest at incremental returns that are enticing - in other words,
only when each dollar used to finance the growth creates over a
dollar of long-term market value. In the case of a low-return
business requiring incremental funds, growth hurts the investor.
In The Theory of Investment Value, written over 50 years ago,
John Burr Williams set forth the equation for value, which we
condense here: The value of any stock, bond or business today is
determined by the cash inflows and outflows - discounted at an
appropriate interest rate - that can be expected to occur during
the remaining life of the asset. Note that the formula is the same
for stocks as for bonds. Even so, there is an important, and
difficult to deal with, difference between the two: A bond has a
coupon and maturity date that define future cash flows; but in the
case of equities, the investment analyst must himself estimate the
future "coupons." Furthermore, the quality of management affects
the bond coupon only rarely - chiefly when management is so inept
or dishonest that payment of interest is suspended. In contrast,
the ability of management can dramatically affect the equity
"coupons."
The investment shown by the discounted-flows-of-cash
calculation to be the cheapest is the one that the investor should
purchase - irrespective of whether the business grows or doesn't,
displays volatility or smoothness in its earnings, or carries a
high price or low in relation to its current earnings and book
value. Moreover, though the value equation has usually shown
equities to be cheaper than bonds, that result is not inevitable:
When bonds are calculated to be the more attractive investment,
they should be bought.
Leaving the question of price aside, the best business to own
is one that over an extended period can employ large amounts of
incremental capital at very high rates of return. The worst
business to own is one that must, or will, do the opposite - that
is, consistently employ ever-greater amounts of capital at very low
rates of return. Unfortunately, the first type of business is very
hard to find: Most high-return businesses need relatively little
capital. Shareholders of such a business usually will benefit if
it pays out most of its earnings in dividends or makes significant
stock repurchases.
Though the mathematical calculations required to evaluate
equities are not difficult, an analyst - even one who is
experienced and intelligent - can easily go wrong in estimating
future "coupons." At Berkshire, we attempt to deal with this
problem in two ways. First, we try to stick to businesses we
believe we understand. That means they must be relatively simple
and stable in character. If a business is complex or subject to
constant change, we're not smart enough to predict future cash
flows. Incidentally, that shortcoming doesn't bother us. What
counts for most people in investing is not how much they know, but
rather how realistically they define what they don't know. An
investor needs to do very few things right as long as he or she
avoids big mistakes.
Second, and equally important, we insist on a margin of safety
in our purchase price. If we calculate the value of a common stock
to be only slightly higher than its price, we're not interested in
buying. We believe this margin-of-safety principle, so strongly
emphasized by Ben Graham, to be the cornerstone of investment
success.
Top 4 portfolio positions at the end of 1992 (cost)
Coca-Cola 28%, Gillette 16%, Cap Cities/ABC 14%, Freddie Mac 11%
Top 4 portfolio positions at the end of 1992 (market)
Coca-Cola 34%, GEICO 19%, Cap Cities/ABC 13%, Gillette 12%
Top 4 non-insurance operating businesses:
Buffalo News $28.2M, See’s $25.6M, Kirby $22.8M, Buffalo News $28.2M, World Book $19.5M
1993 Lesson - Excessive diversification is madness
We believe that a policy of portfolio
concentration may well decrease risk if it raises, as it should,
both the intensity with which an investor thinks about a business
and the comfort-level he must feel with its economic characteristics
before buying into it. In stating this opinion, we define risk,
using dictionary terms, as "the possibility of loss or injury."
The primary factors bearing upon this evaluation
are:
1) The certainty with which the long-term economic
characteristics of the business can be evaluated;
2) The certainty with which management can be evaluated,
both as to its ability to realize the full potential of
the business and to wisely employ its cash flows;
3) The certainty with which management can be counted on
to channel the rewards from the business to the
shareholders rather than to itself;
4) The purchase price of the business;
Is it really so difficult to conclude that Coca-Cola and
Gillette possess far less business risk over the long term than,
say, any computer company or retailer? Worldwide, Coke sells about
44% of all soft drinks, and Gillette has more than a 60% share (in
value) of the blade market. Leaving aside chewing gum, in which
Wrigley is dominant, I know of no other significant businesses in
which the leading company has long enjoyed such global power.
Moreover, both Coke and Gillette have actually increased their
worldwide shares of market in recent years. The might of their
brand names, the attributes of their products, and the strength of
their distribution systems give them an enormous competitive
advantage, setting up a protective moat around their economic
castles. The average company, in contrast, does battle daily
without any such means of protection. As Peter Lynch says, stocks
of companies selling commodity-like products should come with a
warning label: "Competition may prove hazardous to human wealth."
In many industries, of course, Charlie and I can't determine
whether we are dealing with a "pet rock" or a "Barbie." We
couldn't solve this problem, moreover, even if we were to spend
years intensely studying those industries. Sometimes our own
intellectual shortcomings would stand in the way of understanding,
and in other cases the nature of the industry would be the
roadblock. For example, a business that must deal with fast-moving
technology is not going to lend itself to reliable evaluations of
its long-term economics. Did we foresee thirty years ago what
would transpire in the television-manufacturing or computer
industries? Of course not. (Nor did most of the investors and
corporate managers who enthusiastically entered those industries.)
Why, then, should Charlie and I now think we can predict the
future of other rapidly-evolving businesses? We'll stick instead
with the easy cases. Why search for a needle buried in a haystack
when one is sitting in plain sight?
On the other hand, if you are a know-something investor, able
to understand business economics and to find five to ten sensibly-
priced companies that possess important long-term competitive
advantages, conventional diversification makes no sense for you.
It is apt simply to hurt your results and increase your risk.
Top 4 portfolio positions at the end of 1993 (cost)
Coca-Cola 28%, Gillette 16%, Cap Cities/ABC 14%, Freddie Mac 11%
Top 4 portfolio positions at the end of 1993 (market)
Coca-Cola 34%, GEICO 19%, Cap Cities/ABC 13%, Gillette 12%
Top 4 non-insurance operating businesses:
Buffalo News $29.7M, Shoe Group $28.8, Kirby $25.6M, See’s $24.4M
1994 Lesson - Forget about the macro stuff, and just keep learning about individual businesses
We will continue to ignore political and economic forecasts,
which are an expensive distraction for many investors and
businessmen. Thirty years ago, no one could have foreseen the
huge expansion of the Vietnam War, wage and price controls, two
oil shocks, the resignation of a president, the dissolution of
the Soviet Union, a one-day drop in the Dow of 508 points, or
treasury bill yields fluctuating between 2.8% and 17.4%.
But, surprise - none of these blockbuster events made the
slightest dent in Ben Graham's investment principles. Nor did
they render unsound the negotiated purchases of fine businesses
at sensible prices. Imagine the cost to us, then, if we had let
a fear of unknowns cause us to defer or alter the deployment of
capital. Indeed, we have usually made our best purchases when
apprehensions about some macro event were at a peak. Fear is the
foe of the faddist, but the friend of the fundamentalist.
Top 4 portfolio positions at the end of 1994 (cost)
Coca-Cola 29%, AXP 16%, Gillette 13%, PNC 11%
Top 4 portfolio positions at the end of 1994 (market)
Coca-Cola 37%, Gillette 13%, GEICO 12%, Cap Cities/ABC 12%
Top 4 non-insurance operating businesses:
Shoe Group $55.8, Buffalo News $31.7M, See’s $28.2M, Kirby $27.7M,
1995 Lesson - On retailing
Retailing is a tough business. During my investment career,
I have watched a large number of retailers enjoy terrific growth
and superb returns on equity for a period, and then suddenly
nosedive, often all the way into bankruptcy. This shooting-star
phenomenon is far more common in retailing than it is in
manufacturing or service businesses. In part, this is because a
retailer must stay smart, day after day. Your competitor is
always copying and then topping whatever you do. Shoppers are
meanwhile beckoned in every conceivable way to try a stream of
new merchants. In retailing, to coast is to fail.
In contrast to this have-to-be-smart-every-day business,
there is what I call the have-to-be-smart-once business. For
example, if you were smart enough to buy a network TV station
very early in the game, you could put in a shiftless and backward
nephew to run things, and the business would still do well for
decades. You'd do far better, of course, if you put in Tom
Murphy, but you could stay comfortably in the black without him.
For a retailer, hiring that nephew would be an express ticket to
bankruptcy.
Top 4 portfolio positions at the end of 1995 (cost)
AXP 24%, Coca-Cola 23%, Gillette 10%, WFC 7%
Top 4 portfolio positions at the end of 1995 (market)
Coca-Cola 34%, Gillette 11%, Cap Cities/ABC 11%, GEICO 10%
Top 4 non-insurance operating businesses:
Shoe Group $37.5, Kirby $32.1M, See’s $29.8M, Buffalo News $27.3M
Thanks for reading Part 2. Look for a couple installments over the next couple weeks.
