This is the third 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.
A NOTE ON ACCOUNTING
The 1979 letter (weighing in at a whopping 6,650 words, a 52% increase over the prior year) notes at the outset that the accounting rules had changed such that Berkshire's equity securities held by its insurance subsidiaries would now have to been held on the balance sheet at period-end market values, rather than at cost. This artificially deflates Buffett's preferred financial performance metric, operating earnings divided by shareholder's equity, since the denominator would be higher due to unrealized gains on equity securities. Ironically, return on equity would be higher (and financial performance would appear better, at least judged by this metric) were Berkshire's equity holdings to drop precipitously in value, a nonsensical conclusion. Therefore Buffett states that "we will continue to report operating performance measured against beginning net worth, with securities valued at cost."
THE INVESTOR'S MISERY INDEX
After describing how Berkshire's book value had increased from $19.46 per share to $336 per share between 1964 and 1979, a 20.5% compound annual growth rate, Buffett notes the following:
[T]he inflation rate, coupled with individual tax rates [the combined effect of which Buffett later in the letter labels the "Investor's Misery Index"], will be the ultimate determinant as to whether our internal operating performance produces successful investment results - i.e., a reasonable gain in purchasing power from funds committed - for you as shareholders. If we should continue to achieve a 20% compounded gain - not an easy or certain result by any means - and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.
This discussion elucidates why low inflation is actually the investor's friend, while high inflation is the investor's enemy. This is contrary to much recent discussion that deflation is actually to be most feared and that the Fed desires higher inflation rates. While outright deflation is certainly harmful, low inflation (in the 1-3% range, similar to what we have been experiencing in recent years) actually seems to be ideal for equity holders, since it lowers bar needed to be cleared for an increase in an investor's purchasing power. Importantly, despite convention wisdom that inflation allows company's to raise prices, Buffett avers that "high inflation rates will not help us earn higher rates of return on equity" (one must keep in mind that inflation may reflect higher prices a company can obtain for its products, but it also reflects higher input costs).
TURNAROUNDS SELDOM TURN
Turning to the textile business, Buffett ruefully notes that a few years before he decided to buy an additional textile mill, due to it being offered at a bargain price. This, however, proved to be a mistake, leading Buffett to conclude 'that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price'.
LONG-TERM BONDS AND "RETURN-FREE RISK"
Later in the letter Buffett engages in a discussion of long-term bonds, the prices of which at the time had been decimated by rising inflation:
The very long-term bond contract has been the last major fixed price contract of extended duration still regularly initiated in an inflation-ridden world. The buyer of money to be used between 1980 and 2020 has been able to obtain a firm price now for each year of its use while the buyer of auto insurance, medical services, newsprint, office space - or just about any other product or service - would be greeted with laughter if he were to request a firm price now to apply through 1985.
This discussion is interesting in light of recent rock-bottom interest rates (in 2016, 30-year mortgage rates dropped to a minuscule 3.4%). If inflation were to pick up markedly, those investors purchasing long bonds over the past few years will be looking at substantial losses should they decide to sell prior to maturity. In our view long-term bonds currently are the definition of "return-free risk", since an investor will be receiving a return barely above (if not actually below) the combined effect of inflation and taxes for the next few decades (although it is true that certain bonds issued by the investor's state of residence, such as muni bonds, are exempt from federal and state income taxes); simultaneously, such an investor runs the risk of substantial capital losses even while receiving such a meagre return. Instead of putting money in long bonds, an investor today will almost certainly be better off in the long run choosing virtually any other asset class into which to put their money (whether equities, real estate, commodities or perhaps even collectibles such as baseball cards or works of art).
One way around this problem, however, if one simply must put money into bonds, may be to invest in convertible bonds that will appreciate if stock prices continue to rise (due to the conversion feature), but will still pay interest at a rate well above inflation:
We believe that the conversion options obtained, in effect, give that portion of the bond portfolio a far shorter average life than implied by the maturity terms of the issues (i.e., at an appropriate time of our choosing, we can terminate the bond contract by conversion into stock).
Finally, Buffett describes how he thinks about the relationship between management and shareholders. In essence, he views shareholders not as an annoyance to be ignored or shunted aside except for once a year at the annual meeting, but rather as business partners to whom he has certain inviolable obligations:
We feel that you, as owners, are entitled to the same sort of reporting by your manager as we feel is owed to us at Berkshire Hathaway by managers of our business units. Obviously, the degree of detail must be different, particularly where information would be useful to a business competitor or the like. But the general scope, balance, and level of candor should be similar.... In large part, companies obtain the shareholder constituency that they seek and deserve. If they focus their thinking and communications on short-term results or short-term stock market consequences they will, in large part, attract shareholders who focus on the same factors. And if they are cynical in their treatment of investors, eventually that cynicism is highly likely to be returned by the investment community.
Sadly, the rule (rather than the exception) in many public companies today is a combination of (1) a focus on short-term results and (2) a disdain for shareholder input or feedback on the performance of management. Hence the rise of "activist investors".
For the record, in 1979 Berkshire's stock was up a massive 102.5%, beating the market by 84% (that certainly beats inflation!), the Pirates beat the Orioles in the World Series in seven games (overcoming a 3-1 deficit, much like the Cubs this year), the Steelers repeated as NFL champs in Super Bowl XIV (beating the Rams 31-19 in Terry Bradshaw's final Super Bowl win) and President Jimmy Carter was attacked by a rabbit while fishing (it's true, check the link!).
So much for 1979. Next up, 1980, the first year of the glorious decade of the '80s, of which so much can (and will) be said in future posts.