This is the second 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. For all the 1977-2015 letters, see here.
DISCUSSION OF OPERATING SUBSIDIARIES
The 1978 letter begins by noting that the financials of Blue Chip Stamps are now fully consolidated in Berkshire's financial statements due to the fact that Blue Chip became majority-owned by Berkshire. (Note to readers: Blue Chip was the entity that originally purchased See's Candies, one of Buffett's best investments ever. Purchased for just $25 million in 1972, as of 2014 See's had earned $1.9 billion pre-tax, with its growth having required added investment of only $40 million--see the 2014 shareholder letter, page 27.)
Buffett then discusses the continued suboptimal performance of Berkshire's textile division, noting that the main problem with commodity producers is an unrelenting "race to the bottom" with respect to product pricing (except for those fleeting periods when production capacity is constrained):
The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed.
We have seen this most recently with the oil industry. Only after nearly two years of price agony has OPEC finally decided to cut production. It remains to be seen whether the agreed-upon cuts will stick and/or whether the shale producers will simply ramp up their own production, thereby tethering the price of oil to cash breakeven levels for the foreseeable future.
DISCUSSION OF EQUITY INVESTMENTS--SAFECO
Moving past the discussion of Berkshire's insurance operations to that of its equity investment portfolio, it is interesting to note that as of year-end 1978, Berkshire's largest equity holding (based on original cost) was SAFECO Corporation. In the letter, Buffett issues the following paean regarding the company:
SAFECO probably is the best run large property and casualty insurance company in the United States. Their underwriting abilities are simply superb, their loss reserving is conservative, and their investment policies make great sense. SAFECO is a much better insurance operation than our own (although we believe certain segments of ours are much better than average), is better than one we could develop and, similarly, is far better than any in which we might negotiate purchase of a controlling interest. Yet our purchase of SAFECO was made at substantially under book value. We paid less than 100 cents on the dollar for the best company in the business, when far more than 100 cents on the dollar is being paid for mediocre companies in corporate transactions. And there is no way to start a new operation - with necessarily uncertain prospects - at less than 100 cents on the dollar.
Buffett's analysis of SAFECO was spot on. If one had purchased SAFECO at the beginning of 1979 and held until it was purchased by Liberty Mutual in September 2008, an investor would have realized 20X his or her original investment, not including dividends received (SAFECO's dividend yield typically ran in the 2-3% range); including dividends, this represents a ~13% CAGR (see SAFECO stock price history here). Time is indeed the friend of the wonderful business.
ARE DIVIDENDS REALLY DESIRABLE?
Finally, Buffett notes that whether an investor should prefer the issuance of dividends or the reinvestment of profits by his or her investee companies depends on whether the company's management can reinvest these amounts at high rates of return:
We are not at all unhappy when our wholly-owned businesses retain all of their earnings if they can utilize internally those funds at attractive rates. Why should we feel differently about retention of earnings by companies in which we hold small equity interests, but where the record indicates even better prospects for profitable employment of capital? (This proposition cuts the other way, of course, in industries with low capital requirements, or if management has a record of plowing capital into projects of low profitability; then earnings should be paid out or used to repurchase shares--often by far the most attractive option for capital utilization.)
Many retail investors simply assume that they need/want dividends, and therefore buy high yielding stocks to the exclusion of other options, without considering the distinctions Buffett makes above. This simplistic approach is not exactly rational, however, since an investor can "create" their own dividends by selling off a portion of their holdings periodically, even if the applicable company does not pay a dividend itself.
For the record, in 1978 Berkshire's stock was up 14.5%, beating the market by 8%, the Yankees beat the Dodgers in the 75th World Series four games to two, the Steelers edged out Dallas 35-31 in Super Bowl XIII and Argentina captured the World Cup 3-1 over the Netherlands. (OK, technically Super Bowl XIII actually took place in January 1979, for the persnickety.) So much for 1978. Next up, 1979, the final year of that wondrous decade the 70s, that gave birth to (among other things) bell bottoms, the Ford Pinto, Three's Company (RIP Jack Tripper), the Carter administration and (drumroll please) yours truly.