Intelligent Investor Club

First of all, I have to apologise for the delay in this update. My computer broke down recently and it took a while before I managed to get it repaired.

This letter starts with a simplified lesson on accounting. For a subsidiary company that is more than 50% owned, the earnings, expenses, etc will be fully consolidated into the parent company’s accounts.

If the ownership lies between 20-50%, the earnings will simply be reflected as a one liner based on the percentage ownership of the company.

If the ownership is less than 20%, only dividends received will be reflected in the accounts.

Most of Berkshire’s holdings held by the insurance companies belong to the third category. Conventional acccounting will only allow a small proportion of Berkshire’s earnings to be reported, the rest of it will be hidden from view.

As an example, GEICO was purchased for $47 million in 1976. Based on the present dividends, reported earnings amount to only about $3 million annually. However, Berkshire’s share of their earnings is estimated to be about $20 million annually.

In Warren’s own words, “The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage.“

In the long run, the retained earnings of those non-controlled holdings will be translated into gains in market value.

In another accounting convention, insurance companies are allowed to carry their bond holdings at amortized cost, regardless of the market value. With the recent drop in bond prices, some companies could find even themselves in negative net worth if their bond holdings were valued at market.

It is strange that a significant drop in the stock portfolio of an insurance company will threaten it’s survival, yet a greater drop in bond prices produces no reaction at all. This can lead to a few negative effects:

1) Companies unwilling to sell off the bonds to ‘realise’ the losses even when there are superior ways to deploy the capital.

2) If money is required to pay off insurance claims, stock holdings might be sold off to raise the money instead. This is a case of selling the better assets and keeping the biggest losers.

3) Another way of raising the money to pay off insurance claims is to underwrite new business no matter what the potential underwriting losses are. Unfortunately, this is the preferred option and ultimately leads to suicidal underwriting among the different insurance companies.

Apart from his yearly AGMs, Warren Buffett hardly gives talks or seminars to the general public. However, there is one group of people that he will speak to even for free. And who are in this privileged group? Students.

Recently, Warren hosted a visit by a group of students from Medill’s Integrated Marketing Communications and school of journalism graduate programs.

This billionaire needed no entourage as he drove himself to a local country club in Omaha. Here are some snippets from his speech to the students.

Treat investing like journalism. Just as a reporter would want to find out something that most people don’t know about, you want to do the same for the companies you are analyzing. However, ninety-ninepercenty of the information out there is redundant.

You only have one life. If you have something or a job that you would like to do, do it today.

There must be a passion for the business you are in. There’s no such thing as retirement because work is play and play is work. If you look at the top managers in his companies, you will find most of them working even up to eighty or ninety plus years old.

Your inner scorecard is more important than your outer scorecard. Don’t worry about building a resume that you think others want to see.

Never get into something if you have the intention of someday wanting to get out of it.

A change in accounting has it that insurance companies have to quote their equity securities at their market value. Before this, these were quoted at the lower of aggregate cost or market value.

This means that an investment owned by Berkshire directly could be valued very differently if it was now owned by one of it’s insurance subsidiaries (even though the business owned is exactly the same!). Therefore, when reading the accounts, it is important to understand the accounting conventions used and interpret the numbers accordingly.

Warren feels that when measuring the operating performance (earnings), we should compare it with all securities measured at cost and not market value. This is because the market value might vary greatly in different years and this will distort the comparison.

A large decline in securities values might make medicore earnings look good. Conversely, successful equity investments might make operating performance look bad even if it’s not the case.

Warren again mentions that the earnings rate on equity employed should be used to measure performance rather than just the earnings per share as the latter will always rise on an expanding equity base even if the business performance stays the same.

As a example, assume a dormant savings account with $1000 that earns 10% interest every year. In the first year, the earnings (interest) will be $100. In the second year, the earnings will be $110. In the third year, the earnings will be $121. That’s a 10% increase in earnings every year, even for doing nothing. On the other hand, if you look at the earnings rate (compare interest to account balance), you will notice that the earnings (interest) are consistent at 10%. Nothing much has changed.

Also, when looking at any investment performance, we should always compare it to the inflation rate and tax rate. Warren calls this the investor’s misery index. The ultimate aim in any investment is to increase the purchasing power of the capital over time. This is achieved as long as the investment returns (minus tax) is higher than the inflation rate.

One interesting observation is that the book value of Berkshire at the end of 1969 would have bought one half ounce of gold. 15 years later, the book value (that has compounded at 20.5% annually) would have bought about the same amount of gold. A similar comparison can be made with Middle Eastern oil.

The government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.

The continuous (under)performance of the textiles unit leads Warren to conclude that capital would be much better employed in a good business purchased at a fair price, than in a poor business purchased at a bargain price. Always remember this!

There’s a short discussion on bonds as an extraordinary amount of money has been lost by the insurance industry in the bond area within the year.

In periods of high inflation and uncertain interest rates, many insurance companies have decided that a one-year auto policy is inappropriate. Six-month policies have been brought in as replacements.

It is ironic that they have then turned around, taken the proceeds from the sale of that six-month policy to purchase a bond for thirty or forty years.

The buyer of long term money has been able to obtain a firm price now for each year of its use while the buyer of just about any other product or service will never be able to do the same. In most other areas of commerce, parties to long-term contracts now either index prices in some manner, or insist on the right to review the situation every year or so.

Warren would never buy any straight thirty or forty year bonds as he has severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day.

However, convertible bonds provide an attractive alternative as the conversion option gives the bonds an earnings retention factor. They also have a shorter life than that implied by their maturity dates.

A note about quarterly reporting. There’s no narrative with Berkshire’s quarterly reports. The owners and managers both have very long time-horizons in regard to this business, and it is difficult to say anything new or meaningful each quarter about events of long-term significance.

On the other hand, you can (and should) expect to hear directly from the CEO on what’s happening in the annual reports.

A final note about trading activities in shares. It is puzzling why some managements seek high trading volume in their shares. In effect, such managements are saying that they want a good many of the existing shareholders continually to desert them in favor of new ones – because you can’t add new owners without losing former owners.

Warren much prefers owners who like their company and stay on as shareholders. This can be seen in low share turnovers among the owners, reflecting a constituency that understands their operation, approves of their policies, and shares their expectations.

The letter started with some notes about accounting. When a subsidiary of a company exceeds a certain percentage, it’s sales, expenses, receivables, inventories, debt, etc has to be fully consolidated into the company’s account.

Such a grouping of Balance Sheet and Earnings items – some wholly owned, some partly owned – is actually quite useless as it contains figures from many diverse businesses and does not enable investors to evaluate the performance of the individual businesses.

Thankfully, Berkshire still provides separate financial information and commentary on the various segments of the business.

There is a reminder that while capital gains or losses should not be used to evaluate the performance of a company over a single year, they are still an important component over the long term. It is also furtile to try to predict short term stock price movements.

The textiles continued to underperform. This only helped to reinforce the fact that producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage.

Back to the criteria for buying over businesses (as stated in the 1977 letter). It is often possible to find a few businesses fulfilling (1), (2) and (3), but (4) often prevents action.

Nevertheless, the stock market still offers an opportunity to obtain portions of outstanding businesses at prices that might be dramatically cheaper than the whole businesses bought over on negotiated sales.

If you were a net buyer of securities, would you prefer that prices go up or stay low? Many people get this part wrong.

A last note about retained earnings. If a company can utilize internally those funds at attractive rates, it makes sense for them to keep them. On the other hand, if management has a record of using capital for projects of low profitability; then earnings should be paid out or used to repurchase shares.