This is the fifth 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 1981 letter weighs in at slightly over 6,600 words, a 13% decrease versus the prior year, the first such decease we have seen in our series. So, for at least one blog post, yours truly will have some easier lifting.
After recapping the prior year's discussion of retained earnings, Buffett talks about the criteria Berkshire uses for acquisitions, off the bat noting that "we try to avoid small commitments--'If something’s not worth doing at all, it’s not worth doing well'". He then states something that should be obvious to most corporate management teams, but which all-too-often gets ignored, namely that the point of making an acquisition is to increase the wealth of the shareholders, not to build an empire for the CEO to preside over (or some other suspect motivation):
Our acquisition decisions will be aimed at maximizing real economic benefits, not at maximizing either managerial domain or reported numbers for accounting purposes. (In the long run, managements stressing accounting appearance over economic substance usually achieve little of either.)
In corporate America today, how many acquisitions are actually done for the right reasons? In our humble opinion, not too many. One great example of a smart acquisition in recent years was Constellation Brands' acquisition of the 50% interest in Grupo Modelo's U.S. beer operations that it did not already own. If you look hard enough you might be able to discern a slight uptick in STZ's stock price since the announcement of the acquisition in June 2012:
In Buffett's view, acquisitive managements all too often believe they have the ability to conjure magical performance from heretofore underperforming companies:
Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T(arget). Such optimism is essential. Absent that rosy view, why else should the shareholders of Company A(cquisitor) want to own an interest in T at the 2X takeover cost rather than at the X market price they would pay if they made direct purchases on their own? In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite. We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses - even after their corporate backyards are knee-deep in unresponsive toads. [emphasis added]
The clear lesson, which applies to both corporate acquirers of whole businesses as well as individual acquirers of fractional ownership stakes in business (i.e., retail investors), is to focus on princes rather than toads. Ironically, Buffett learned the lesson himself the hard way by buying Berkshire Hathaway:
We have tried occasionally to buy toads at bargain prices with results that have been chronicled in past reports. Clearly our kisses fell flat. We have done well with a couple of princes - but they were princes when purchased. At least our kisses didn’t turn them into toads. And, finally, we have occasionally been quite successful in purchasing fractional interests in easily-identifiable princes at toad-like prices.
Buffett then amusingly describes how, even if an investor is focused on supposed princes, things can still go haywire for various reasons, to wit:
We expect that undistributed earnings from [our equity investee] companies will produce full value (subject to tax when realized) for Berkshire and its shareholders. If they don’t, we have made mistakes as to either: (1) the management we have elected to join; (2) the future economics of the business; or (3) the price we have paid. We have made plenty of such mistakes - both in the purchase of non-controlling and controlling interests in businesses. Category (2) miscalculations are the most common. Of course, it is necessary to dig deep into our history to find illustrations of such mistakes--sometimes as deep as two or three months back. For example, last year your Chairman volunteered his expert opinion on the rosy future of the aluminum business. Several minor adjustments to that opinion - now aggregating approximately 180 degrees - have since been required.
MORE ON THE BANE OF HIGH INFLATION AND INTEREST RATES
Buffett next launches into a further lengthy discussion on how inflation, and hence high interest rates, destroys investors' returns. It had gotten to the point in 1981, that with long-term yields at a staggering 16%, American businesses had become worth far less than their aggregate book value. This is because companies then were earning only 14% on equity, before deducting for taxes, leading to the following logical conclusion:
Assume an investor in a 50% tax bracket; if our typical company pays out all earnings, the income return to the investor will be equivalent to that from a 7% tax-exempt bond. And, if conditions persist--if all earnings are paid out and return on equity stays at 14%--the 7% tax-exempt equivalent to the higher-bracket individual investor is just as frozen as is the coupon on a tax-exempt bond. Such a perpetual 7% tax-exempt bond might be worth fifty cents on the dollar as this is written. [emphasis added]
With the book value of the S&P 500 at $765 as of the end of Q2 2016, this means that its price-to-book ratio is currently approaching 3X (the index closed at 2,250 as of the date of this post). Were it to decline to 1X, for example in a period of significantly higher inflation, either book value would need to increase 200%, or (more ominously) the S&P would need to decline ~67% (most likely, however, a combination of the two would occur). For those investors out there hoping for higher inflation or thinking that higher inflation will be beneficial for their stock porfolios, be careful what you wish for.
A NOTE ON HUMILITY
Most humans, especially those managing money for third parties, are loath to admit error or bad judgment. Apparently the thinking is that the admission of mistakes equals weakness and might lead to the loss of client confidence and, hence, redemptions. However, in his shareholder letters Buffett seems to go out of his way to rub his own nose in his mistakes and to redirect praise from himself to his managers (omitting to mention that he selected said managers). Just witness the following admissions from the 1977 to 1981 letters alone.
1977 letter - 'In aggregate, the insurance business has worked out very well. But it hasn’t been a one-way street. Some major mistakes have been made during the decade, both in products and personnel.' 'One of the lessons your management has learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds.'
1978 letter - 'Some of our expansion efforts [in insurance]--largely initiated by your Chairman--have been lackluster, others have been expensive failures.' 'SAFECO is a much better insurance operation than our own..., is better than one we could develop and, similarly, is far better than any in which we might negotiate purchase of a controlling interest.'
1979 letter - 'Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment... But the purchase was a mistake. While we labored mightily, new problems arose as fast as old problems were tamed.' 'You do not adequately protect yourself by being half awake while others are sleeping. It was a mistake to buy fifteen-year bonds, and yet we did; we made an even more serious mistake in not selling them (at losses, if necessary) when our present views began to crystallize.'
1980 letter - 'But lest we get too puffed up, we remind ourselves that our asset and liability maturities still are far more mismatched than we would wish and that we, too, lost important sums in bonds because your Chairman was talking when he should have been acting.' 'Operations at Waumbec Mills have been terminated, reluctantly but necessarily. Some equipment was transferred to New Bedford but most has been sold, or will be, along with real estate. Your Chairman made a costly mistake in not facing the realities of this situation sooner.'
1981 letter - 'Your Chairman, unfortunately, does not qualify for Category 2 [i.e., managers that can conjure outstanding performance from mediocre companies]' '“Forecasts”, said Sam Goldwyn, “are dangerous, particularly those about the future.” (Berkshire shareholders may have reached a similar conclusion after rereading our past annual reports featuring your Chairman’s prescient analysis of textile prospects.)'
Despite all of these so-called 'mistakes', however, Berkshire's stock price from 1977 through 1981 increased 496%, representing a CAGR of 43%. Over the same period, the overall market (including dividends) was up 48%, a respectable CAGR of 8%. Thus, warts and all, Berkshire shareholders saw their wealth increase (percentage-wise) more than 10 times that of those simply invested in the broader market. Perhaps the willingness--or even eagerness--to admit mistakes is a sign of intellectual strength rather than weakness.
For the record, in 1981 Berkshire's stock was up 32%, beating the market by 37% (ho hum, life as Berkshire shareholder sure was tough back in the day), the Dodgers beat the Yankees in the World Series in six games (overcoming a 0-2 deficit), Joe Montana led the 49ers to a 26-21 win over the Bengals in Super Bowl XVI, and on September 25th our country--then in its 193rd year as a republic--finally appointed a female Supreme Court justice. Next up, 1982, the year a great football team with a non-P.C. name won the Super Bowl over a group of fish (er, water-dwelling mammals).