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Good Business Economics

Buffett has a view 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.

Other than improvements to products, services, etc, which should be done, other major changes means chances for major errors. A fortress-like business franchise usually the key to sustained high returns, one which would be difficult to build with frequent changes.

Indeed a Fortune study of 25 top 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. Most of them 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).

Flexible Operating Budgets

Charlie Munger and Warren Buffett do not believe in flexible operating budgets, as in “Non-direct expenses can be X if revenues are Y, but must be reduced if revenues are Y – 5%.” Should the news hole at the Buffalo News, or the quality of product and service at See’s be cut, simply because profits are down during a given year or quarter? Or, conversely, should a staff economist, a corporate strategist, an institutional advertising campaign or something else that does Berkshire no good be added simply because the money is rolling in?

The adding of unneeded people or activities because profits are booming, or the cutting of essential people or activities because profitability is shrinking makes no sense and is neither business-like nor humane.

Purchase of Securities

Whenever Buffett buy common stocks for Berkshire’s insurance companies (leaving aside arbitrage purchases, discussed later), he approaches the transaction as if he was buying into a private business. He looks at the economic prospects of the business, the people in charge of running it, and the price that he must pay. There is neither a time or price for sale in mind. Indeed, he is willing to hold a stock indefinitely so long as he expects the business to increase in intrinsic value at a satisfactory rate.

When investing, he views himself as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts. While an active trading market would provide many opportunities, it is not essential.

Benjamin Graham 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. 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.

And Mr. Market 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.

Mr. Market is there to serve you, not to guide you. 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.

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.

As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give you the chance to buy more of a good thing at a bargain price.

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, Buffett will sell their holdings. Sometimes, also, he will sell a security that is fairly valued or even undervalued because he requires funds for a still more undervalued investment or one that he understands better.

Controlled Company

Owning a controlled company offers two advantages. The first is the ability to allocate capital. This point can be important because the heads of many companies are not skilled in capital allocation.

CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers (sometimes with unsatisfactory results). In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)

The second advantage of a controlled company over a marketable security has to do with taxes, a point which I will not elaborate here.

The disadvantages of owning marketable securities are sometimes offset by a huge advantage: Occasionally the stock market offers us the chance to buy non-controlling pieces of extraordinary businesses at truly ridiculous prices – dramatically below those commanded in negotiated transactions that transfer control.

An interesting accounting irony overlays a comparison of the reported financial results of controlled companies with those of the permanent minority holdings.

Accounting rules dictate that only the dividends that minority companies pay are considered as income. On the other hand, accounting rules provide that the carrying value of these holdings owned, as they are, by insurance companies – must be recorded on our balance sheet at current market prices. The result: GAAP accounting reflects the up-to-date net worth underlying values of the businesses that are partially own, but not their underlying earnings.

In the case of Berkshire’s controlled companies, just the opposite is true. Here, the full earnings is shown in the income account but not the asset values on the balance sheet, no matter how much the value of a business might have increased since the purchase.

The way to approach this accounting madness is to forget about GAAP figures and to focus solely on the future earning power of both our controlled and non-controlled businesses.

As this letter is particularly long, I will cover the rest in a second installment.

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This comes from the appendix of the 1986 letter. Looking at the accounts, which company do you think is more valuable?

  Company O Company N  

In case you haven’t realised, companies O and N are the same company – Scott Fetzer. The O column shows what the company’s 1986 GAAP earnings would have been if Berkshire had not purchased it. The N column shows the restated earnings.

In both statements, you are actually looking at exactly the same company. The difference came about because Scott Fetzer was purchased at a price above its stated net worth. Under GAPP, same a premium must be accounted for by “purchase-price adjustments” on the balance sheet.

Without going into details, this was done by adjustments to inventory costs, assets and liabilities with the balance going into Goodwill.

    Company O Company N

Because of the higher asset valuation, the depreciation every year will be higher. Combined with the amortization of Goodwill, the reported earnings for subsequent years will be lower.

If you value a business based on a certain multiple of earnings, what does all these mean to you? Does it make sense that a company would be worth significantly less the day after it was acquired?

A correct valuation of the “owner earnings” of a company should be based on (a) reported earnings plus (b) depreciation, depletion, amortization and certain other non-cash charges minus (c) average annual amount of capitalised plant and equipment that the business needs to fully maintain its long term competitive advantage and its unit volume.

Using such a method, you will be able to derive the same owner earnings for both company O and N.

Care must be taken in depending too much on the “cash flow” numbers. These numbers include (a) and (b) but do not substract (c). This number is meaningless for business such as manufacturing, retailing, utilities, because for them, (c) is significant.

A company may be able to defer spending in any given year, but over a 5 or 10 year period, they must make the capital investment.

Remember that accounting is but an aid to business thinking, never a substitute for it.

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At the end of Warren Buffett’s 1983 letter, there was an appendix discussing on economic and accounting goodwill.

When a business is purchased, accounting principles require that the purchase price first be assigned to the fair value of the identifiable assets that are acquired.

Frequently the sum of the fair values put on the assets (net of liabilities) is less than the total purchase price of the business. In that case, the difference is assigned to an asset account called “Goodwill”.

This accounting goodwill is then amortized (typically) over a period of 40 years to the earnings account.

For example, Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible assets. See’s was earning about $2 million after tax at the time. This works out to a very impressive 25% returns on assets.

Blue Chip’s purchase of See’s at $17 million over net tangible assets required that a Goodwill account of this amount be established as an asset on Blue Chip’s books and that $425,000 be charged to income annually for 40 years to amortize that asset.

Thus, instead of $2 million, earnings will be reflected as $1.575 million on the accounts.

If See had been bought at a price of $88 million, the amortization of $80 million over 40 years will be reflected by a net earnings of $0 on the accounts.

If you think about it, the economics of See’s business has not really changed even though the two purchase price were different. Yet, the income sheet tells a drastically a different story.

Different purchase dates and prices can give us vastly different asset values and amortization charges for two pieces of the same asset.

Consider another business B that is earning $2 million on assets of $18 million. Earning only 11% on required tangible assets, this mundane business would possess little or no economic Goodwill.

A business like B might been sold for the value of its net tangible assets, or for $18 million. In contrast, $25 million was paid for See’s, even though it had equal earnings and less net tangible assets!

Could less really be more?

The economic goodwill of See is much greater than B. If earnings of $4 million is to be achieved, See would require only an additional $8 million in capital while B would require a good $18 million.

See would now be worth $50 million (if valued on the same basis as originally). It would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.

B would be worth $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested.

Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

On another note, if an overexcited management purchases a business at a silly price, this silliness ends up showing up as Goodwill in the accounts. It remains on the books as an “asset” just as if the acquisition had been a sensible one!

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Operating Earnings
The percentage of operating earnings as a percentage of beginning equity capital dropped to only 9.8%. One reason was that for partially-owned (<20%), nonoperated businesses, accounting rules dictate that only the dividends received can be reported as earnings.

Even the earnings of 35% owned GEICO were not included. For accounting purposes, the company was treated as a less-than-20% holding as the voting rights had been assigned.

Thus, only the dividends received from GEICO in 1982 of $3.5 million after tax were included in the “accounting” earnings. An additional $23 million that represented Berkshire’s share of GEICO’s undistributed operating earnings for 1982 were totally excluded.

There’s accounting madness at work here. If GEICO had earned less money in 1982 but had paid an additional $1 million in dividends, reported earnings would have been larger despite the poorer business results. Conversely, if GEICO had earned an additional $100 million – and retained it all – reported earnings would have remained unchanged.

Warren prefers using a concept of “economic” earnings. This includes all undistributed earnings, regardless of ownership percentage. The point to bear in mind is that accounting numbers are the beginning, and not the end of business valuation.

To further highlight this point, Berkshire’s share of undistributed earnings from four of their major non-controlled holdings came to well over $40 million in 1982. This number, which is totally unreflected in the earnings report, is much higher than the total reported earnings of $14 million in dividends received from these companies.

The gigantic auction arena of the stock market continues to offer value investors opportunities to purchase fractional portions of businesses at bargain prices. This is possible as long as the market is moderately priced.

For the investor, an over-priced purchase of an excellent company can undo the effects of even a subsequent decade of favorable business developments. Value investors want the market to be cheap, not expensive!

Insurance Industry Conditions
The insurance industry continued to bleed. It is a good example of an industry with substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc).

If prices or costs can be controlled, the ‘bleeding’ can be stopped. This can be carried out legally through government intervention, illegally through collusion, or “extra-legally” through OPEC-style foreign cartelization.

Unfortunately, for the great majority of industries selling “commodity” products, a depressing equation of business economics prevails: persistent over-capacity without controlled prices (or costs). This results in poor profitability.

Over-capacity may eventually self-correct, either as capacity drops or demand expands. When they finally occur, there usually follows an enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment.

What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years.

The insurance industry operates under substantial overcapacity as it can be instantly created by capital and an underwriter’s willingness to sign his name.

Since there can be no surge in demand for insurance policies comparable to one in copper or aluminum, the only way for it to return to profitably is to reduce the supply.

Unfortunately, major sources of insurance capacity are unlikely to turn their backs on very large chunks of business, thereby sacrificing market share and industry significance. Major capacity withdrawals will require a shock factor such as a natural or financial “megadisaster”.

Issuance of Equity
In a merger, the first choice of the buying company is to use cash or debt to fund the purchase. In cases where these are insufficient, the issuance of new equity might be used.

When this happens, you will have to take notice. Why?

Companies often sell in the stock market below their intrinsic business value. But when a company wishes to sell out completely in a negotiated transaction, it usually can receive full business value in whatever kind of currency the value is to be delivered.

If cash or debt is to be used in payment, the seller’s calculation of value received is quite straightforward. If stock of the buyer is to be the currency, the seller’s calculation is still relatively easy: just figure the market value in cash of what is to be received in stock.

If the buyer’s stock is selling in the market at full intrinsic value, using it as currency for the purchase doesn’t pose any problems.

But suppose it is selling at only half intrinsic value. In that case, the buyer will be using a substantially undervalued currency to fund the purchase of a company at full intrinsic business value.

The issuance of shares to make an acquisition amounts to a partial sale of the business. Using it to fund an acquisition means that you sell it at whatever value the market happens to be granting it at that time.

And if the market price is under-valuing the business, you will have to scrutinize the deal carefully no matter what ‘reasons’ the managers might give you.

However, there are three ways to avoid destruction of value for old owners when shares are issued for acquisitions.

One is to have a true business-value-for-business-value merger, with each receiving just as much as it gives in terms of intrinsic business value.

The second route presents itself when the acquirer’s stock sells at or above its intrinsic business value. In that situation, the use of stock may actually enhance the wealth of the acquiring company’s owners.

The third solution is for the acquirer to go ahead with the acquisition, but then subsequently repurchase a quantity of shares equal to the number issued in the merger. This essentially converts it to a “cash for stock” purchase.

Another variable in mergers that is given too much attention is the effects of dilution on earnings. There have been plenty of non-dilutive mergers that were instantly value destroying for the acquirer. And some mergers that have diluted current and near-term earnings per share have in fact been value-enhancing.

What really counts is whether a merger is dilutive or anti-dilutive in terms of intrinsic business value.

Finally, there is also a “double whammy” effect on the owners of the acquiring company when value-diluting stock issuances occur. A management that has a record of wealth-destruction through unintelligent share issuances will have a lower stock price for the company as the market accords a lower price/value ratio to them.

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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.

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.

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