This is the sixth 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 1982 letter weighs in at slightly over 7,840 words, an 18% increase versus the prior year. After a year of slacking off, Buffett set a new all-time high for word count in Berkshire's shareholder letters--bravo, Warren.
ECONOMIC [OR 'OWNER'] EARNINGS
Buffett introduced a new concept to his shareholder base in 1982, namely 'economic earnings', as opposed to GAAP earnings. He decided to insert this new form of earnings because Berkshire's intrinsic value had become much more anchored on its less-than-20%-owned investees. Under GAAP, earnings from such investees are not consolidated, only dividends received are; hence, if such a company is 19.99% owned by an investor and earns $100 million in GAAP profits but only pays out $1 million in dividends, then such an investor would only record $200 thousand in its GAAP income, even though it effectively 'owned' $20 million of the investee's earnings stream. Per Buffett:
We prefer a concept of “economic” earnings that includes all undistributed earnings, regardless of ownership percentage. In our view, the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used--and not by the size of one’s ownership percentage. If you have owned .01 of 1% of Berkshire during the past decade, you have benefited economically in full measure from your share of our retained earnings, no matter what your accounting system. Proportionately, you have done just as well as if you had owned the magic 20%.
As discussed in previous letters, if an investee company retains and reinvests its earnings on behalf of its investors, instead of paying them out as dividends, an investor should welcome this fact so long as each reinvested dollar produces an equivalent dollar (or preferably more than a dollar) in higher market value. To put it simply, if a company trades at $100 on January 1st and earns $10 during the subsequent calendar year, then an investor is better off not receiving any dividends if the company trades at $110 or greater on December 31st (assuming the company did not raise an equity capital during the year).
ACQUISITION FOLLIES OF 1982
Buffett then discusses how easy it is for a management team to destroy shareholder wealth via overpriced acquisitions, as was recently evident:
As we look at the major acquisitions that others made during 1982, our reaction is not envy, but relief that we were non-participants. For in many of these acquisitions, managerial intellect wilted in competition with managerial adrenaline. The thrill of the chase blinded the pursuers to the consequences of the catch. Pascal’s observation seems apt: “It has struck me that all men’s misfortunes spring from the single cause that they are unable to stay quietly in one room.”
The phenomenon of acquisitions-gone-wild in corporate America is usually not discussed much by financial journalists. They prefer to focus on the chase, and not so much on the the aftermath. Usually wealth-destroying acquisitions--for the acquirer's shareholders, that is--are not seen as such until quite a few years following consummation. By the time that a company realizes it has goofed up, the CEO has already been paid tens of millions in compensation (and will likely get a further golden parachute when politely asked to leave). One recent example is Caterpillar's 2011 acquisition of Bucyrous. [See also here]. Despite squandering billions of shareholder wealth, CEO Douglas Oberhelman, who recently decided to 'retire', made nearly $50 million in compensation in just the past three years--head's the CEO wins to an obscenely absurd extent, tail's the CEO wins to a slightly less obscene (but still absurd) extent. It's nice to be a Fortune 500 CEO.
Later in the letter Buffett proffers the following friendly advice to management teams on how to think about acquisitions correctly (and, hence, how to avoid blundering when making them). Of course, this advice has been infrequently heeded in the 34 years since it was issued, but that does not render the advice any less sage.
There have been plenty of mergers, non-dilutive in [the] limited sense [in which this term is typically used], that were instantly value destroying for the acquirer. And some mergers that have diluted current and near-term earnings per share have in fact been value-enhancing. What really counts is whether a merger is dilutive or anti-dilutive in terms of intrinsic business value (a judgment involving consideration of many variables). We believe calculation of dilution from this viewpoint to be all-important (and too seldom made).
A second language problem relates to the equation of exchange. If Company A announces that it will issue shares to merge with Company B, the process is customarily described as “Company A to Acquire Company B”, or “B Sells to A”. Clearer thinking about the matter would result if a more awkward but more accurate description were used: “Part of A sold to acquire B”, or “Owners of B to receive part of A in exchange for their properties”. In a trade, what you are giving is just as important as what you are getting. This remains true even when the final tally on what is being given is delayed. Subsequent sales of common stock or convertible issues, either to complete the financing for a deal or to restore balance sheet strength, must be fully counted in evaluating the fundamental mathematics of the original acquisition. (If corporate pregnancy is going to be the consequence of corporate mating, the time to face that fact is before the moment of ecstasy.)
Managers and directors might sharpen their thinking by asking themselves if they would sell 100% of their business on the same basis they are being asked to sell part of it. And if it isn’t smart to sell all on such a basis, they should ask themselves why it is smart to sell a portion. A cumulation of small managerial stupidities will produce a major stupidity - not a major triumph. (Las Vegas has been built upon the wealth transfers that occur when people engage in seemingly-small disadvantageous capital transactions.)
Finally, a word should be said about the “double whammy” effect upon owners of the acquiring company when value-diluting stock issuances occur. Under such circumstances, the first blow is the loss of intrinsic business value that occurs through the merger itself. The second is the downward revision in market valuation that, quite rationally, is given to that now-diluted business value. For current and prospective owners understandably will not pay as much for assets lodged in the hands of a management that has a record of wealth-destruction through unintelligent share issuances as they will pay for assets entrusted to a management with precisely equal operating talents, but a known distaste for anti-owner actions. Once management shows itself insensitive to the interests of owners, shareholders will suffer a long time from the price/value ratio afforded their stock (relative to other stocks), no matter what assurances management gives that the value-diluting action taken was a one- of-a-kind event.
GEICO - THE GIFT THAT KEEPS GIVING (AND GIVING (AND GIVING))
Buffett gives a special shoutout to GEICO in the 1982 letter--and with good reason. While Berkshire's operating earnings for the year amounted to just 9.8% of its beginning equity capital, Berkshire's stock price levitated a smart 38.4% on the year. A large part of the increase can be explained by the $79 million uptick in the value of Berkshire's GEICO stake during the year, which more than doubled the entire dollar amount of Berkshire's 1982 GAAP operating earnings (note that GEICO, despite being over 20% owned by Berkshire, was not consolidated into Berkshire's financials due to the fact that Berkshire did not have full voting rights with respect to its shares). Buffett made the brilliant decision to back GEICO's equity raise in 1976; this investment has proven the proverbial 'gift that keeps on giving' for Berkshire shareholders right down to the present day. This demonstrates the truth in Charlie Munger's aphorism that the best way to get rich is to 'buy a few great companies and sit on your ass'.
Buffett had laid out his thoughts on GEICO in a letter to the head of reinsurance at Berkshire subsidiary National Indemnity Company contemporaneously to making the 1976 investment [source here]:
July 22nd, 1976
Mr. George D. Young,
National Indemnity Company,
3024 Harney Street,
Omaha, Nebraska. 68131
Thanks very much for your memo of July 19th regarding GEICO which I believe summarizes well the problems attendant to the specific property treaty we are discussing, as well as the general problems associated with reinsurance of any type at GEICO. I still am willing to explore further the GEICO property treaty—if they subsequently decide that it fits their needs—and today committed to [GEICO CEO] Jack Byrne that we would take a 1% quota share of their entire book. This increase from .8 of 1% was pursuant to his request in order to help him attain the 25% mark by the shareholders meeting tomorrow.
I consider the overall quota share to be an acceptable—but not exciting—piece of business. Under normal conditions we would take nothing like 1%, obviously, since that makes it by far the largest reinsurance treaty on our books, and involves substantial risks along with a limited prospect of profit. I also do not like the feature that provides for a credit to GEICO for interest earnings on funds held by us. In effect, we are making this contract number one in size for the reinsurance department, whereas the contractual terms make it less attractive than most of our other contracts.
However, I have three reasons for taking this unusually large portion of the quota share arrangement, and these same reasons also apply to my interest in the property treaty.
I hope it is not a governing factor in any way, but I do have some sentimental reasons for wishing GEICO to survive. GEICO has enumerated all of the hard-headed reasons, such as the State Financial Guaranty funds, etc. I just have pulled out of the bottom drawer of my desk a statement of my net worth at the end of 1951 when I was 21 years old. I showed net assets of $19,737, of which $13,125 was in GEICO stock. That was the year when I first started selling securities, and I told everyone who would listen to me that they should put every cent they could scrape together into GEICO. A number of friends and relatives did so, and enjoyed a significant change in their financial fortunes because of this. It provided the first big boost to my own small savings, as well as an even more important boost to my reputation in the Omaha investment community. During those early years, when I followed the company, the people involved couldn’t have been nicer. Leo Goodwin was running things then and was helpful. Even more so was L. A. Davidson. He was personally encouraging and forthcoming with information regarding the business, which enabled me to develop a depth of conviction which I have felt few times since about any security.
At that time I felt that GEICO possessed an extraordinary business advantage in a very large industry that was going to continue to grow. Since that time they never have lost that advantage—the ability to give the policyholder back in losses a greater percentage of the premium dollar than any other auto insurance company in the country, while still providing a profit to the company. I always have been attracted to the low cost operator in any business and, when you can find a combination of (i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation. That situation prevailed twenty-five years ago when I first became interested in the company, and it still prevails.
The company managed to nullify this advantage—and even more than nullify it—by inadequate recognition of loss costs through poor techniques of loss reserving. This led to improper pricing of product with the result that a product which *could* have been sold at a profit *was* sold at a loss.But the important point to note is that the company had not lost its position as a low cost operator; they merely had mismanaged their loss information which caused the product to be priced inadequately. I believe the advantages of a 13% acquisition cost ratio are as important as ever. I also believe that practically no other companies are going to achieve costs near that figure in the future. Therefore, GEICO, properly managed, should prosper if they can pull themselves back from the financial precipice. I like very much what Jack Byrne says about reducing policies in force. It seems to me that such an approach a rather than an obsession with growth is very likely to reconstruct the situation whereby they can give the policyholder an unusually high percentage of the dollar back in losses and still make good profits for themselves.
The crucial factor, then, becomes whether they can get past their present financial difficulties. Much of the press –witness Time last week—assumes that they can’t. Until recently, I was unclear myself as to their possibilities in this regard. If they had been at all wishy-washy in obtaining rate increases or biting the bullet generally, I don’t think they would have made it. However, the size of the rate increases they have instituted, along with the underwriting results they have published for April and May, have convinced me that their combined ratio will come down to tolerable limits within a fairly short time.
Even this would not have been enough if [the Washington D.C. superintendent of insurance] Wallach were inclined to put them into receivership because of the unwillingness of the industry to accept his 40% plan. When he did not move to do so after the June 23rd deadline, it convinced me that he was not going to act precipitously to terminate a business that fundamental economic logic still dictated had a bright future ahead of it. When he did not bow his back over the non-subscription to his 40% plan, I believe the company’s future became assured. I decided then to buy stock, which is the most tangible evidence I can give you as to my assessment of the Company’s chances for survival. [emphasis added]
Therefore, George, I will take the responsibility for making the decision that GEICO survives as a business entity. You should make any underwriting judgments that you wish, with this as the premise—if I am wrong about their survival, it will be my fault and not yours. I do not want to go overboard because of sentiment, but I certainly want us to make every effort to come up with proposals that make business sense to us and are useful to them. I do not want more of the overall quota share because I consider the terms too disadvantageous to the reinsurer, all things considered. But, if a property treaty can be put together with a prospect of gain that more than balances the risk of loss, let’s proceed.
Warren E. Buffett
Later on, in the equity holdings summary in the letter, it states that in six years the $47 million original GEICO investment made by Buffett had appreciated to $310 million, representing a CAGR of 37%.
Finally, one side note regarding GEICO. The CEO of GEICO who Buffett references above, Jack Byrne, was the father of Overstock.com founder and current CEO Patrick Byrne. For anyone in search of an entertaining corporate earnings conference call, OSTK's CEO will not disappoint.
COMMODITY COMPANIES: DANGEROUS TO SHAREHOLDER WEALTH
Buffett, in the discussion of Berkshire's insurance operations, engages in a lengthy dissertation on why commodity companies, to put it delicately, pretty much suck for shareholders (anyone holding oil producer stocks over the past two years can attest to this fact). Rather than slicing and dicing it, it's worth just reproducing the discussion in whole:
Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles. These may be escaped, true, if prices or costs are administered in some manner and thereby insulated at least partially from normal market forces. This administration can be carried out (a) legally through government intervention (until recently, this category included pricing for truckers and deposit costs for financial institutions), (b) illegally through collusion, or (c) “extra- legally” through OPEC-style foreign cartelization (with tag-along benefits for domestic non-cartel operators).
If, however, costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous. Hence the constant struggle of every vendor to establish and emphasize special qualities of product or service. This works with candy bars (customers buy by brand name, not by asking for a “two-ounce candy bar”) but doesn’t work with sugar (how often do you hear, “I’ll have a cup of coffee with cream and C & H sugar, please”).
In many industries, differentiation simply can’t be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent. For the great majority of companies selling “commodity”products, a depressing equation of business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability.
Of course, over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success.
What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal. (It seems as if the most recent supply-tight period in our textile business--it occurred some years back--lasted the better part of a morning.) In some industries, however, capacity-tight conditions can last a long time. Sometimes actual growth in demand will outrun forecasted growth for an extended period. In other cases, adding capacity requires very long lead times because complicated manufacturing facilities must be planned and built.
For the record, in 1982 Berkshire's stock was up 38%, beating the market by 17%, the Cardinals beat the Brewers in the World Series in seven games, Joe Theismann (rhymes with Heisman) led the Washington [Football Team, name sounds like 'Deadspins'] to a 27-17 victory over the Dolphins in Super Bowl XVII, and on January 30th the first ever computer virus was discovered on an Apple II computer. Next up, 1983, the year a great football team with a non-P.C. name lost the Super Bowl to Marcus Allen (basically single-handedly)--it was indeed a black day for yours truly, then aged 10.