This is the fourth in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2015. For all of the prior shareholder letters, see here.
The 1980 letter weighs in at almost 7,500 words, a 12% increase over the prior year and a "yuge" 145% increase over the 1977 letter (the subject of our first blog post in this series). Much like Berkshire's stock price and book value, the word count in Berkshire's letters trends in one direction over time, up.
INTRINSIC VALUE, RETAINED EARNINGS AND STOCK REPURCHASES
So much for the important stuff; now, what's in the letter itself? Buffett opens by noting that much of Berkshire's intrinsic, or true, underlying value is represented by its equity holdings, which are accounted for under the equity method of accounting (as Berkshire holds under 20% of the outstanding shares of such entities). This means that these entities' financials are not consolidated into Berkshire's financials, except to the extent of dividends received. However, Buffett states that the value of these holdings should not be ignored when determining Berkshire's valuation:
We impose this short - and over-simplified - course in accounting upon you because Berkshire’s concentration of resources in the insurance field produces a corresponding concentration of its assets in companies in that third [equity method] (less than 20% owned) category. Many of these companies pay out relatively small proportions of their earnings in dividends. This means that only a small proportion of their current earning power is recorded in our own current operating earnings. But, while our reported operating earnings reflect only the dividends received from such companies, our economic well-being is determined by their earnings, not their dividends. 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. [emphasis in original]
The key takeaway is that it is preferable to have an equity investee reinvest its earnings at a high rate of return than to have such earnings paid out in dividends, unless the investor receiving those dividends has the ability to reinvest the proceeds (after taking into consideration the payment of appropriate taxes) at a higher overall rate. And the concept of "reinvestment of earnings" by the investee company includes share repurchases, when appropriate:
One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price?
Conversely, if a company repurchases its shares when those shares are selling for a price above intrinsic value, then the company is destroying the wealth of its remaining holders, not increasing it. This is because it is exchanging every $1 in cash used in such repurchases for $0.90 or $0.80 (or perhaps even $0.50) in intrinsic value in stock, depending on how overvalued the company's shares are when repurchased.
INFLATION AS THE INVESTOR'S BANE
Buffett next engages in a further discussion of how high inflation wipes out an investor's gains in real terms, further to the discussion in the 1979 letter. He again notes that Berkshire has no answer to this problem. Basically, he concludes that in an inflation ravaged world an investor will ideally seek out a relatively capital-light company that has pricing power (which of course would be attractive--albeit to a lesser extent vis-a-vis a capital-intensive company--even in a low-inflation environment such as we have recently been experiencing):
For capital to be truly indexed [to inflation], return on equity must rise [along with inflation], i.e., business earnings consistently must increase in proportion to the increase in the price level without any need for the business to add to capital - including working capital - employed. (Increased earnings produced by increased investment don’t count.) Only a few businesses come close to exhibiting this ability. And Berkshire Hathaway isn’t one of them.
Interestingly, as indicated in the equity holdings table further down in the letter, Berkshire was then investing in commodity names such as Cleveland Cliffs, Alcoa and Kaiser Aluminum & Chemical Company.
Buffett then discusses Berkshire's investment in GEICO, which continues to the present day. At the time, Berkshire owned 33% of GEICO (whereas today it is a wholly-owned subsidiary). Buffett uses the discussion of GEICO to demonstrate his preference for a passive investment in an equity-method investee when that investee has the ability to reinvest profits at high rates of return (much the same way a retail investor ideally should think):
We should emphasize that we feel as comfortable with GEICO management retaining an estimated $17 million of earnings applicable to our ownership as we would if that sum were in our own hands. In just the last two years GEICO, through repurchases of its own stock, has reduced the share equivalents it has outstanding from 34.2 million to 21.6 million, dramatically enhancing the interests of shareholders in a business that simply can’t be replicated. The owners could not have been better served.
Buffett also notes that GEICO is an exception to his "turnarounds seldom turn" rule (as discussed in the 1979 letter):
[T]he fundamental business advantage that GEICO had enjoyed - an advantage that previously had produced staggering success - was still intact within the company [when it almost went bankrupt in 1976], although submerged in a sea of financial and operating troubles. GEICO was designed to be the low-cost operation in an enormous marketplace (auto insurance) populated largely by companies whose marketing structures restricted adaptation. Run as designed, it could offer unusual value to its customers while earning unusual returns for itself. For decades it had been run in just this manner. Its troubles in the mid-70s were not produced by any diminution or disappearance of this essential economic advantage. GEICO’s problems at that time put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true “turnaround” situation in which the managers expect - and need - to pull off a corporate Pygmalion. [emphasis added]
WATERING THE INSURANCE WEEDS
Buffett goes on to note that when inflation is rampant, insurance companies are loath to sell their bond holdings, since they would likely have large realized losses. Avoiding such losses means that their assets don't shrink (since the bonds aren't marked to market). Perversely, insurance companies are thus forced to keep writing insurance regardless of the adequacy of rates, so as to maintain a premium stream that is adequate to support their asset holdings:
But the full implications flowing from massive unrealized bond losses are far more serious than just the immobilization of investment intellect. For the source of funds to purchase and hold those bonds is a pool of money derived from policyholders and claimants (with changing faces) - money which, in effect, is temporarily on deposit with the insurer. As long as this pool retains its size, no bonds must be sold. If the pool of funds shrinks - which it will if the volume of business declines significantly - assets must be sold to pay off the liabilities. And if those assets consist of bonds with big unrealized losses, such losses will rapidly become realized, decimating net worth in the process. Thus, an insurance company with a bond market value shrinkage approaching stated net worth (of which there are now many) and also faced with inadequate rate levels that are sure to deteriorate further has two options.
One option for management is to tell the underwriters to keep pricing according to the exposure involved - “be sure to get a dollar of premium for every dollar of expense cost plus expectable loss cost”. The consequences of this directive are predictable: (a) with most business both price sensitive and renewable annually, many policies presently on the books will be lost to competitors in rather short order; (b) as premium volume shrinks significantly, there will be a lagged but corresponding decrease in liabilities (unearned premiums and claims payable); (c) assets (bonds) must be sold to match the decrease in liabilities; and (d) the formerly unrecognized disappearance of net worth will become partially recognized (depending upon the extent of such sales) in the insurer’s published financial statements. The second option is much simpler: just keep writing business regardless of rate levels and whopping prospective underwriting losses, thereby maintaining the present levels of premiums, assets and liabilities - and then pray for a better day, either for underwriting or for bond prices.... Of course you know which option will be selected.
Should inflation ever pick up, it will be interesting to see how disciplined insurance companies will be; however, based on history it doesn't look promising (human nature doesn't change much over time). This demonstrates Berkshire's inherent competitive advantage in the insurance field: when everyone else is behaving perversely / irrationally, Berkshire has the freedom to act rationally--for one reason, because Berkshire won't be stuck holding an inordinate amount of long-term bonds, given Buffett's relatively recent admonitions against them as poor investments as current price levels.
A WARNING FOR HOLDERS OF TSLA AND NFLX SHARES
Lastly, one can't help but connect (i) the following observation from Buffett at the end of the 1980 letter about his preference for cashflowing companies with (ii) the recent mania for shares of companies such as Tesla and Neflix, which consume massive amounts of cash but which nevertheless have been stockholder favorites. Forewarned is forearmed:
Our acquisition preferences run toward businesses that generate cash, not those that consume it. As inflation intensifies, more and more companies find that they must spend all funds they generate internally just to maintain their existing physical volume of business. There is a certain mirage-like quality to such operations. However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.
For the record, in 1980 Berkshire's stock was up 33%, beating the market by 0.5%, the Phillies beat the Royals in the World Series in six games, the Raiders topped the Eagles in Super Bowl XV by a score of 27-10, and on November 21st the world finally found out Who Shot J.R. (I won't spoil it for those who still have the episode on DVR and haven't had time to watch it over the past 36 years). Next up, 1981, the year yours truly discovered football (not coincidentally the same year this guy took over his home team's head coaching duties).