Intelligent Investor Club

Berkshire Annual Letter 1999 (Part 1)

The majority of Berkshire’s managers are wealthy, and work because they love their businesses. Even though the businesses are owned by Berkshire, these managers are given authority to run them as if they were their own.

Here’s a story of how one of their managers truly wanted their business to do well.

…Continue reading » A Managerial Story You Will Never Read Elsewhere

Berkshire Annual Letter 1995 (Part 7)

In 1995, there were three businesses in the Berkshire staple that underperformed.

The shoe business had depressed earnings but the problem was likely to be a cyclical one.

On the other hand, the industry trends for Berkshire’s newspaper business, The Buffalo News, are not good (This was also previously mentioned in the 1991 Annual Report). Newspapers are less economical attractive now compared to the days when they have a bullet-proof franchise.

Over time, Warren expects their competitive strength to gradually erode, but with many remaining years of being a fine business.

The most difficult problem was in World Book, which had increasingly difficult competition from CD-ROM and other online offerings.

As a result, it had to make major changes in the way it operates, with more electronic products and reduced overheads. Whether these efforts are sufficient remains to be seen.

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R.C. Willey Home Furnishings

R.c. Willey Home Furnishings was a business discovered by Irv Blumkin of Nebraska Furniture Mart while he was walking around.

Bill Child, CEO of R.C. Willey took over the company from his father-in-law in 1954 and grew the sales from $250,000 to $257 million in 1995.

The fact of it is that retailing is a tough business. During Warren Buffett’s investment career, he has seen a large number of retailers enjoy terrific growth and high ROE for a while, only to suddenly nosedive into bankruptcy.

This happens more often in retailing than in manufacturing or in the service industry. The reason is because a retailer is easily copied so he has to constantly come up with new ways to attract customers.

And shoppers are always faced with new merchants.

On the other hand, there are kinds of businesses whereby the owner only has to be smart once. By being early in the game, he can coast and still turn out pretty well.

A sidenote.

Just how many managers can Warren Buffett handle reporting to him? His answer:

“If I have one person reporting to me and he is a lemon, that’s one too many, and if I have managers like those we now have, the number can be almost unlimited.”

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Helzberg’s Diamond Shops

There is a popular technique called “management by walking around” (MBWA). Warren Buffet has his own technique which is called “acquisitions by walking around”(ABWA).

In May 1994, Warren Buffett was crossing the street when a man called Barnett Helzberg, Jr. told him that he owned a business that Berkshire might be interested in. When someone tells Warren that, the usual case is that they have a lemonade stand – with potential to grow quickly in the next Microsoft.

Anyway, the financial statements of Helzberg’s Diamond Shops were subsequently sent over to Warren Buffett and it turned out they were far from a lemonade stand.

Helzberg’s Diamond Shops was started in 1915 as a single store by Bernett’s grandfather and had grew into 134 stores with $282 million in sales. It was currently very well run by Jeff Comment, former President of Wanamaker’s.

The key to Helzberg’s excellent profits was that it had an average annual store sales of about $2 million, far more than their competitors.

The deal was appealing to Warren for two reasons. Firstly, the company was the kind of business that they wanted to own. Secondly, Jeff was the kind of manager they wanted. Without an outstanding manager running the show, they would not have bought the business.

The acquisition was completed using a tax-free exchange of stock, and Barnett shared quite a bit of his proceeds with a large number of his associates. When someone does that, a buyer will know that he will also be treated right.

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Purchase of Dexter Shoe

In 1991, Berkshire purchased H. H. Brown, a manufacturer of work shoe, boots and other footwear. At the end of 1992, they purchased Lowell Show, a long-established manufacturer of women’s and nurses’ shoes. This time in 1993, they acquired Dexter Shoe, which manufactures popular-priced men’s and women’s shoes.

Five years prior to these purchases, Warren Buffett had no thoughts that he would be getting the shoe business. That’s the way it works at Berkshire. They have no strategic plans about what businesses or industries they will enter in the future. Instead, they focus on the economic characteristics of businesses that they would like to own AND the personal characteristics of the managers running these businesses.

In fact, Warren Buffett feels that when a corporate giant embarks on new ventures because of some grand vision, it usually doesn’t work out too well for the shareholders.

For the case of Dexter Shoe, the owners Harold and Peter, was paid using Berkshire shares. So what they did was they traded 100% interest in a single terrific business for a smaller interest in a large group of terrific businesses. According to Warren, this was good for them (Harold and Peter) for various reasons:

1) They incurred no tax on this exchange.

2) They now own a security that can be easily used for charity, personal gifts or converted to cash. Compare this to complications that often arise when assets are concentrated in a private business and owners want to divest part of this asset.

3) Private companies often find it difficult to diversify outside their industries. By shifting their ownership to Berkshire, they solved a reinvestment problem.

4) Their investment results from owning shares of Berkshire will parallel exactly that of Warren, as the company does not issue him any restricted shares or stock options.

5) They still get to run Dextor Shoe as they did (and treated as partners) even though they only own non-controlling shares in Berkshire.

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See’s Candy Shops

On 3rd January 1972, Blue Chip Stamps (then an affiliate of Berkshire and later merged into it) bought control of See’s Candy Shops, a West Coast manufacturer and retailer of boxed-chocolates.

The sellers asked $40 million for 100% ownership of the company. But then the company had $10 million of excess cash, so the true offering price was really $30 million.

Back then, Charlie and Warren, were not yet fully appreciative of the value of an economic franchise. They looked at the company’s mere $7 million of tangible net worth and offered a maximum of $25 million for the company.

They were lucky that the seller agreed to it.

See’s candy sales in the same period increased from $29 million to $196 million from 1972 to 1991. The profits grew even faster than sales, from $4.2 million pre-tax in 1972 to $42.4 million in 1991.

In order to evaluate this increase in profits properly, we must look at the incremental capital investment required to produce these additional profits.

In 1991, the company has a net worth of $25 million. This means that only $18 million of earnings had to be reinvested in the company. During the 20 or so years, about $410 million of pre-tax profits were distributed to Blue Chip/Berkshire.

What did Warren see in See’s?

They saw that the business had untapped pricing power.

Add to that Chuck Huggins, a person of utmost capability and integrity, then See’s executive vice-president, whom they instantly put in charge, and they had a winner.

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A Change in Media Economics

In my previous post, I talked about the difference between a franchise and a business.

Buffett is of the view that newspaper, television, and magazine properties have begun to resemble businesses more than franchises in their economic behavior.

This is because of the changes in retailing pattern and also an significant increase in other entertainment and advertising choices.

Previously, media properties possessed the three characteristics of a franchise and therefore could both price aggressively and be managed loosely.

Nowadays, consumers looking for information and entertainment have so many choices and the supply is simply much more than demand.

The result is that competition has intensified, markets have fragmented, and the media industry has lost some – though far from all – of its franchise strength.

In light of this phenomenal, let us look at the impact on the value of media properties.

In the past, a newspaper, television or magazine property would forever increase its earnings at 6% or so annually. This would be done without additional capital, as depreciation charges would roughly match capital expenditures and working capital requirements would be minor.

Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings. This meant that ownership of a media property is like owning a perpetual annuity set to grow at 6% a year.

Using a discount rate of 10% to determine the present value of that earnings stream, one could then calculate that it was appropriate to pay $25 million for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25 translates to a multiplier on pre-tax earnings of about 16.)

Back to the present, assume that this $1 million represents “normal earning power” and that earnings will stay around this level instead.

This is true of most businesses, whose income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings).

Under our revised assumption, $1 million of earnings, discounted by the same 10%, translates to a $10 million valuation. A modest shift in assumptions reduces the property’s valuation to 10 times after-tax earnings (or about 6 1/2 times pre-tax earnings).

This simple example shows that valuations can change dramatically when there is just a minor change in expectations!

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The Difference Between a Franchise and a Business

Warren Buffett mentions that 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.

If all three conditions are present, the company will be able to increase its prices regularly and earn higher rates of return on capital. This can be achieved even without requiring additional capital.

A franchise is also more tolerant of inept management. They can reduce the franchise’s profitablity, but they are unlikely to kill the franchise.

For a business, Buffett is of the opinion that it will be able to earn exceptional profits only if it is a low-cost operator or if supply of its product or service is tight.

And in the real world, tightness in supply usually does not last long.

If management is good, a company might be able to keep costs low for a much longer time, but they will always face the possibility of a competitive attack.

And unlike a franchise, poor management can kill a business.

Based on these reasons, a franchise and a business should be valued differently.

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About Banking Business

For most banking business, assets are commonly twenty times of equity. Thus, mistakes that involve only a small portion of assets can destroy a major portion of equity.

Because of this 20:1 leverage, any managerial strengths or weaknesses will be greatly magnified. Warren Buffett has no interest in purchasing shares of a poorly-managed bank at a “cheap” price. Instead, he prefers buying into well-managed banks at fair prices.

Attitude Towards Investments

What attitude should investors hold towards market fluctuations? If you will be buying businesses – or small parts of businesses, called stocks – year in, year out for as long as you live, declining prices for businesses benefit you, and rising prices hurt you.

Pessimism in a certain company or industry is one of the most common causes of low prices. This is a good time to buy stocks, because of the price it produces. Optimism, on the other hand, is the enemy of the rational buyer.

However, care has to be taken as a stock purchase is not necessary intelligent just because it is unpopular. A contrarian approach can be just as foolish as a follow-the-crowd approach.

At the end of the day, independent thinking is key.

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As I read the summary of the performance of the various non-insurance operations like Borsheim, Nebraska Furniture Mart, See’s Candy, Fechheimer, Scott Fetzer and Buffalo News for the umpteen time, I was given the reason by Buffett why these companies continue to do well.

Whatever the reason for their performance, when you invest in a stock, at the end of the day you are looking at the quality of the business. If the company has a good business model and stand above your competitors, then your stock will do well.

Measuring Insurance Performance

The combined ratio represents total insurance costs (losses incurred plus expenses) compared to revenue from premiums: A ratio below 100 indicates an underwriting profit, and one above 100 indicates a loss.

Typical property-casualty insurers can have a ratio of 107-111% and still be profitable because of investment returns from the insurance funds (float).

Exceptions include insurance covering losses to crops (which produce no float at all) and malpractice insurance which has a higher tolerance due to delayed payment caused by lengthy litigation.

Most analysts and managers look to the combined ratio when measuring an insurance business; however Buffett has another method.

He looks at the underwriting loss to float developed ratio (over an extended period of time) and then treats that as the “cost of funds developed from insurance.”

If this cost (including the tax penalty) is higher than that applying to alternative sources of funds, then it’s a poor business. If the cost is lower, it is a good business – and if the cost is significantly lower, the insurance business qualifies as a very valuable asset.

To put it simply, insurance is a place where you can generate funds for investment. If the cost of these funds (after deducting all expenses) are lower than what you pay outside, then you have a good business!

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