This is the first in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters, beginning with the 1977 letter and (hopefully) ending with last year's letter in about a month or two from now, just in time for the issuance of 2016 letter in late February. Prior to 1977, the letters were more straightforward and less philosophical and/or educational, so they won't be covered in this series; moreover, they aren't available on Berkshire Hathaway's website (for all the 1977-2015 letters, see here).
The 1977 letter runs a mere 3,050 words. In comparison, the 2015 letter is over 15,000 words, or 5 times as long. It appears that Buffett has, similar to more than a few older gentlemen, become a bit more verbose with age (Buffett was a spry 47 when the first letter ran, while the 2015 letter was issued half way through his ninth decade on the planet--he was born a mere 10 months after the 1929 stock market crash). The letter is thus a model of succinctness.
HOW TO DEFINE 'SUCCESS'
The letter begins by laying out the relevant results for Berkshire's various operating subsidiaries (textiles bad, banking as expected, insurance good). Buffett then goes on to make a salient point about the financial metric earnings-per-share (EPS), stating that growth in EPS, which CEO's routinely tout as evidence of their managerial brilliance, is not everything it is cracked up to be:
"Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding."
I must confess that in all of the earnings conference calls that I have listened to over the past few years, I have yet to hear one CEO or CFO make this rather obvious point about "record earnings per share" they are announcing.
As Buffett point outs in the letter, the relevant metric should be Return on Equity (ROE) employed in the business, not EPS, because ROE accounts for the compounding effect of retained earnings. We won't hold our breath here at Seven Corners Capital waiting for management teams across the country to change their preferred metrics, however. That would be like an NFL head coach downplaying a 45-14 win because his team was playing the Cleveland Browns instead of the Patriots--hey, a blowout's a blowout, right?
DISCUSSION OF OPERATING RESULTS
Moving on to a more detailed look at Berkshire's operating results, Buffett issues a mea culpa regarding Berkshire's textile operations:
"The textile business again had a very poor year in 1977. We have mistakenly predicted better results in each of the last two years. This may say something about our forecasting abilities, the nature of the textile industry, or both."
It appears that Buffett, having gone "all in" on Berkshire in 1964 in order to spite the then CEO Seabury Stanton (who had reneged on a tender offer handshake deal for Buffett's shares of Berkshire), maintained certain illusions about his ability to resuscitate the textile business. This despite 12 years of relatively consistent futility up until that point. It took Buffett nearly another decade to finally shut down the textile operations for good (see the 1985 letter for details). Clearly, Buffett's textile travails were instrumental in the formulation of one of his more famous investment theses: Time is the friend of the wonderful business, the enemy of the mediocre.
In his analysis of Berkshire's insurance operations, Buffett elucidates precisely this idea, as the insurance business was (and is) clearly a wonderful business, at least in Buffett's hands:
"It was early in 1967 that we made our entry into [the insurance] industry through the purchase of National Indemnity Company and National Fire and Marine Insurance Company (sister companies) for approximately $8.6 million. In that year their premium volume amounted to $22 million. In 1977 our aggregate insurance premium volume was $151 million. No additional shares of Berkshire Hathaway stock have been issued to achieve any of this growth."
Buffett notes that this explosive growth occurred despite "significant problems" in various aspects of the business over the years and concludes that this is the type of business you want to own (one that grows like a weed in spite of significant issues cropping up from time to time). The lesson, then, is the following:
"[What we have] learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds."
Thus, one key question an investor should ask before making a stock purchase is whether the industry he or she will be vicariously participating in will benefit from secular tailwinds or be penalized going forward from secular headwinds. In other words, it's probably wiser as a general proposition to buy a company that will benefit from the growth in wireless data usage (for example, T-Mobile), than to buy the stock of a print media company (for example, Time Inc).
BUFFETT AS GROWTH INVESTOR
When Buffett moves on to discuss Berkshire's equity holdings, he makes a great point about how to look at an investment, or, more precisely how not to look at an investment:
"A little digression illustrating this point [i.e., that one should not focus on short-term results or prospects when judging a business] may be interesting. Berkshire Fine Spinning Associates and Hathaway Manufacturing were merged in 1955 to form Berkshire Hathaway Inc. In 1948, on a pro forma combined basis, they had earnings after tax of almost $18 million and employed 10,000 people at a dozen large mills throughout New England. In the business world of that period they were an economic powerhouse. For example, in that same year earnings of IBM were $28 million (now $2.7 billion), Safeway Stores, $10 million, Minnesota Mining, $13 million, and Time, Inc., $9 million. But, in the decade following the 1955 merger aggregate sales of $595 million produced an aggregate loss for Berkshire Hathaway of $10 million. By 1964 the operation had been reduced to two mills and net worth had shrunk to $22 million, from $53 million at the time of the merger. So much for single year snapshots as adequate portrayals of a business."
We have thus completed our précis of the 1977 Berkshire shareholder letter--only 38 more to go! Next up, the 1978 letter, which at 4,360 words, marks a whopping 43% increase over 1977--our work will definitely not be getting any easier.