[Week 16 - 1980] Discussing A Berkshire Hathaway Shareholder Letter (Almost) Every Week

Full Letter:

https://theoraclesclassroom.com/wp-content/uploads/2019/09/1980-Berkshire-AR.pdf

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Key Passage 1

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Results for Owners

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.

High rates of inflation create a tax on capital that makes much corporate investment unwise - at least if measured by the criterion of a positive real investment return to owners. This “hurdle rate” the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners - has increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.

For example, in a world of 12% inflation a business earning 20% on equity (which very few manage consistently to do) and distributing it all to individuals in the 50% bracket is chewing up their real capital, not enhancing it. (Half of the 20% will go for income tax; the remaining 10% leaves the owners of the business with only 98% of the purchasing power they possessed at the start of the year - even though they have not spent a penny of their “earnings”). The investors in this bracket would actually be better off with a combination of stable prices and corporate earnings on equity capital of only a few per cent.

Explicit income taxes alone, unaccompanied by any implicit inflation tax, never can turn a positive corporate return into a negative owner return. (Even if there were 90% personal income tax rates on both dividends and capital gains, some real income would be left for the owner at a zero inflation rate.) But the inflation tax is not limited by reported income. 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.)

Of course, the two forms of taxation co-exist and interact since explicit taxes are levied on nominal, not real, income. Thus you pay income taxes on what would be deficits if returns to stockholders were measured in constant dollars.

At present inflation rates, we believe individual owners in medium or high tax brackets (as distinguished from tax-free entities such as pension funds, eleemosynary institutions, etc.) should expect no real long-term return from the average American corporation, even though these individuals reinvest the entire after-tax proceeds from all dividends they receive. The average return on equity of corporations is fully offset by the combination of the implicit tax on capital levied by inflation and the explicit taxes levied both on dividends and gains in value produced by retained earnings.

As we said last year, Berkshire has no corporate solution to the problem. (We’ll say it again next year, too.) Inflation does not improve our return on equity.

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. Of course, earnings and dividends per share usually will rise if significant earnings are “saved” by a corporation; i.e., reinvested instead of paid as dividends. But that would be true without inflation. A thrifty wage earner, likewise, could achieve regular annual increases in his total income without ever getting a pay increase - if he were willing to take only half of his paycheck in cash (his wage “dividend”) and consistently add the other half (his “retained earnings”) to a savings account. Neither this high- saving wage earner nor the stockholder in a high-saving corporation whose annual dividend rate increases while its rate of return on equity remains flat is truly 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.

We, of course, have a corporate policy of reinvesting earnings for growth, diversity and strength, which has the incidental effect of minimizing the current imposition of explicit taxes on our owners. However, on a day-by-day basis, you will be subjected to the implicit inflation tax, and when you wish to transfer your investment in Berkshire into another form of investment, or into consumption, you also will face explicit taxes.

Sources of Earnings

The table below shows the sources of Berkshire’s reported earnings. Berkshire owns about 60% of Blue Chip Stamps, which in turn owns 80% of Wesco Financial Corporation. The table shows aggregate earnings of the various business entities, as well as Berkshire’s share of those earnings. All of the significant capital gains and losses attributable to any of the business entities are aggregated in the realized securities gains figure at the bottom of the table, and are not included in operating earnings. Our calculation of operating earnings also excludes the gain from sale of Mutual’s branch offices. In this respect it differs from the presentation in our audited financial statements that includes this item in the calculation of “Earnings Before Realized Investment Gain”.

Berkshire Hathaway Inc. - Earnings Table (1980 vs. 1979)

| (in thousands of dollars) | Earnings Before Income Taxes (Total) 1980 | Earnings Before Income Taxes (Total) 1979 | Earnings Before Income Taxes (Berkshire Share) 1980 | Earnings Before Income Taxes (Berkshire Share) 1979 | Net Earnings After Tax (Berkshire Share) 1980 | Net Earnings After Tax (Berkshire Share) 1979 | |:---|:---:|:---:|:---:|:---:|:---:|:---:| | Total Earnings - all entities | $ 85,945 | $ 68,632 | $ 70,146 | $ 56,427 | $ 53,122 | $ 42,817 | | | | | | | | | | Earnings from Operations: | | | | | | | | Insurance Group: | | | | | | | | ... Underwriting | $6,738 |$ 3,742 | $6,737 |$ 3,741 | $3,637 |$ 2,214 | | ... Net Investment Income | 30,939 | 24,224 | 30,927 | 24,216 | 25,607 | 20,106 | | Berkshire-Waumbec Textiles | (508) | 1,723 | (508) | 1,723 | 202 | 848 | | Associated Retail Stores | 2,440 | 2,775 | 2,440 | 2,775 | 1,169 | 1,280 | | See’s Candies | 15,031 | 12,785 | 8,958 | 7,598 | 4,212 | 3,448 | | Buffalo Evening News | (2,805) | (4,617) | (1,672) | (2,744) | (816) | (1,333) | | Blue Chip Stamps - Parent | 7,699 | 2,397 | 4,588 | 1,425 | 3,060 | 1,624 | | Illinois National Bank | 5,324 | 5,747 | 5,200 | 5,614 | 4,731 | 5,027 | | Wesco Financial - Parent | 2,916 | 2,413 | 1,392 | 1,098 | 1,044 | 937 | | Mutual Savings and Loan | 5,814 | 10,447 | 2,775 | 4,751 | 1,974 | 3,261 | | Precision Steel | 2,833 | 3,254 | 1,352 | 1,480 | 656 | 723 | | Interest on Debt | (12,230) | (8,248) | (9,390) | (5,860) | (4,809) | (2,900) | | Other | 2,170 | 1,342 | 1,590 | 996 | 1,255 | 753 | | | | | | | | | | Total Earnings from Operations | $ 66,361 | $ 57,984 | $ 54,389 | $ 46,813 | $ 41,922 | $ 35,988 | | Mutual Savings and Loan - sale of branches | 5,873 | -- | 2,803 | -- | 1,293 | -- | | Realized Securities Gain | 13,711 | 10,648 | 12,954 | 9,614 | 9,907 | 6,829 | | | | | | | | | | Total Earnings - all entities | $ 85,945 | $ 68,632 | $ 70,146 | $ 56,427 | $ 53,122 | $ 42,817 |

Blue Chip Stamps and Wesco are public companies with reporting requirements of their own. On pages 40 to 53 of this report we have reproduced the narrative reports of the principal executives of both companies, in which they describe 1980 operations. We recommend a careful reading, and suggest that you particularly note the superb job done by Louie Vincenti and Charlie Munger in repositioning Mutual Savings and Loan. A copy of the full annual report of either company will be mailed to any Berkshire shareholder upon request to Mr. Robert H. Bird for Blue Chip Stamps, 5801 South Eastern Avenue, Los Angeles, California 90040, or to Mrs. Bette Deckard for Wesco Financial Corporation, 315 East Colorado Boulevard, Pasadena, California 91109.

As indicated earlier, undistributed earnings in companies we do not control are now fully as important as the reported operating earnings detailed in the preceding table. The distributed portion, of course, finds its way into the table primarily through the net investment income section of Insurance Group earnings.

We show below Berkshire’s proportional holdings in those non-controlled businesses for which only distributed earnings (dividends) are included in our own earnings.

Berkshire Hathaway Inc. - Common Stockholdings (1980)

| No. of Shares | Company | Cost ($000s) | Market ($000s) | |:---|:---|:---:|:---:| | 434,550 (a) | Affiliated Publications, Inc. | $2,821 | $12,222 | | 464,317 (a) | Aluminum Company of America | 25,577 | 27,685 | | 475,217 (b) | Cleveland-Cliffs Iron Company | 12