[Week 15 - 1979] Discussing A Berkshire Hathaway Shareholder Letter (Almost) Every Week

Full Letter:

https://theoraclesclassroom.com/wp-content/uploads/2019/09/1979-Berkshire-AR.pdf

· · · · · · · · · · · · · · · · · · · · · · · · · · · · · ·

Key Passage

· · · · · · · · · · · · · · · · · · · · · · · · · · · · · ·

Long Term Results

In measuring long term economic performance - in contrast to yearly performance - we believe it is appropriate to recognize fully any realized capital gains or losses as well as extraordinary items, and also to utilize financial statements presenting equity securities at market value. Such capital gains or losses, either realized or unrealized, are fully as important to shareholders over a period of years as earnings realized in a more routine manner through operations; it is just that their impact is often extremely capricious in the short run, a characteristic that makes them inappropriate as an indicator of single year managerial performance.

The book value per share of Berkshire Hathaway on September 30, 1964 (the fiscal yearend prior to the time that your present management assumed responsibility) was $19.46 per share. At yearend 1979, book value with equity holdings carried at market value was $335.85 per share. The gain in book value comes to 20.5% compounded annually. This figure, of course, is far higher than any average of our yearly operating earnings calculations, and reflects the importance of capital appreciation of insurance equity investments in determining the overall results for our shareholders. It probably also is fair to say that the quoted book value in 1964 somewhat overstated the intrinsic value of the enterprise, since the assets owned at that time on either a going concern basis or a liquidating value basis were not worth 100 cents on the dollar. (The liabilities were solid, however.)

We have achieved this result while utilizing a low amount of leverage (both financial leverage measured by debt to equity, and operating leverage measured by premium volume to capital funds of our insurance business), and also without significant issuance or repurchase of shares. Basically, we have worked with the capital with which we started. From our textile base we, or our Blue Chip and Wesco subsidiaries, have acquired total ownership of thirteen businesses through negotiated purchases from private owners for cash, and have started six others. (It’s worth a mention that those who have sold to us have, almost without exception, treated us with exceptional honor and fairness, both at the time of sale and subsequently.)

But before we drown in a sea of self-congratulation, a further - and crucial - observation must be made. 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.

Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives, a business earning 20% on capital can produce a negative real return for its owners under inflationary conditions not much more severe than presently prevail.

If we should continue to achieve a 20% compounded gain - not an easy or certain result by any means - and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.

That combination - the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) - can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.

One friendly but sharp-eyed commentator on Berkshire has pointed out that our book value at the end of 1964 would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce. A similar comparison could be drawn with Middle Eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.

We intend to continue to do as well as we can in managing the internal affairs of the business. But you should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.

· · · · · · · · · · · · · · · · · · · · · · · · · · · · · ·

In this passage Buffet zooms out as this is his 15th year of owning the company, the book value per share increased from $19.46 per share to $335.18 per share. A 20.5% CAGR. But due to inflation and taxes he says the purchasing power of the book value hasn’t really changed much. It would still buy about as much gold and oil as it would 15 years ago and if he had just bought and sat on gold he would be better off. This was during the 1979 Iran’s Revolution caused an oil crisis and stagflation leading to gold and oil prices surging. Here is an oil graph and a gold graph so it is picking a bit of a bubble in both assets to make this measurement.

|Metric|1964|1979|2026 (Est.)| |:---|:---|:---|:---| |BK Book Value (Per Share)|$19.46|$335.85|$717,400.00| |Gold Price (Per oz)|$35.35|$512.00|$4,630.00| |Oil Price (Per bbl)|$3.00|$32.50|$114.22| |Gold oz Purchased|0.55 oz|0.65 oz|154.94 oz| |Oil bbl Purchased|6.48 bbl|10.33 bbl|6,280.86 bbl|

As can be seen from this table, the book value ended up outperforming oil and gold very much in the long run, this was more of a temporary oddity from a period of high inflation and some years of poor performance for Berkshire and the Economy.

· · · · · · · · · · · · · · · · · · · · · · · · · · · · · ·

Key Passage 2

· · · · · · · · · · · · · · · · · · · · · · · · · · · · · ·

Textiles and Retailing

The relative significance of these two areas has diminished somewhat over the years as our insurance business has grown dramatically in size and earnings. Ben Rosner, at Associated Retail Stores, continues to pull rabbits out of the hat - big rabbits from a small hat. Year after year, he produces very large earnings relative to capital employed - realized in cash and not in increased receivables and inventories as in many other retail businesses - in a segment of the market with little growth and unexciting demographics. Ben is now 76 and, like our other “up-and-comers”, Gene Abegg, 82, at Illinois National and Louis Vincenti, 74, at Wesco, regularly achieves more each year.

Our textile business also continues to produce some cash, but at a low rate compared to capital employed. This is not a reflection on the managers, but rather on the industry in which they operate. 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.

We can speak from experience, having tried the other route. Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment. By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing. But the purchase was a mistake. While we labored mightily, new problems arose as fast as old problems were tamed.

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. Although a mistake, the Waumbec acquisition has not been a disaster. Certain portions of the operation are proving to be valuable additions to our decorator line (our strongest franchise) at New Bedford, and it’s possible that we may be able to run profitably on a considerably reduced scale at Manchester. However, our original rationale did not prove out.

· · · · · · · · · · · · · · · · · · · · · · · · · · · · · ·

Some more burns from the cigarette butts. Both have been wrapped together into this single section, in particular he laments the previous decision to buy a second failing textile company which has once again proven to be more of a headache than it is worth. He seems happy with diversified retailing but the lack of any mention of the underlying business in this or last letter is worrying.

Anot