This is the seventh 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 1983 letter (including the Appendix) weighs in at slightly over 11,420 words, a 45.7% increase versus the prior year. Not to be outdone, Berkshire's stock price outpaced the S&P 500 that year by...46.6%. Coincidence? Personally, it smells like--to borrow a phrase--a "rigged" job...
In any event, I have to summarize and analyze it regardless of length, so let's proceed.
As Berkshire had just merged with Blue Chip Stamps (owner of, among other things, See's Candies), Buffett laid out the general owner-oriented principles that governed the company. For example, he viewed his shareholders not as suckers or annoyances (to be dealt with grudgingly), but as full partners with himself and vice chairman Charlie Munger (who just turned 93, incidentally), as if Berkshire were a private business. Quite interesting is the following quote: "We do not view the company itself as the ultimate owner of our business assets but, instead, view the company as a conduit through which our shareholders own the assets." In addition, what matters is increase in the intrinsic value of Berkshire over time on a per-share basis, not just in aggregate (many CEOs are happy to trumpet "record earnings" or "record revenues", but often forget that if these metrics do not increase per share, the shareholder's wealth does not either):
Our long-term economic goal (subject to some qualifications mentioned later) is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.... When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.... A managerial “wish list” will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.... We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.... We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance--not only mergers or public stock offerings, but stock for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company--and that is what the issuance of shares amounts to--on a basis inconsistent with the value of the entire enterprise.
Given the foregoing shareholder-friendly (shareholder-nirvana?) principles, it is slightly less to be wondered at that Berkshire's stock price appreciated 1,826,163% (no, that's not a typo, it was an 18,262-bagger) in the first 50 years under Buffett's leadership.
NEBRASKA FURNITURE MART
Buffett then discusses Berkshire's acquisition of Nebraska Furniture Mart and its founder Rose Blumkin. Since her rags-to-riches story has become part of Berkshire mythology, I will not repeat it here. What I find fascinating about the NFM acquisition is the sale contract--it was precisely two pages long! For a $55,350,000 acquisition. Here is the entire agreement (reproduced from Berkshire's 2013 annual report, pages 114-115):
So much for the utility of involving lawyers, investment bankers and other corporate "helpers" in an acquisition context.
THE LAW OF LARGE NUMBERS
Buffett makes the following observations regarding the future economic performance of Berkshire later in the letter:
During the 19-year tenure of present management, book value has grown from $19.46 per share to $975.83, or 22.6% compounded annually. Considering our present size, nothing close to this rate of return can be sustained. Those who believe otherwise should pursue a career in sales, but avoid one in mathematics.
Since year-end 1983, Berkshire's book value has climbed to $272.6 billion, or approximately $166,000/share (based on 1,644,000 outstanding equivalent A shares) as of the end of Q3 2016. This represents a CAGR in book value per share of 16.4% of the past 33.75 years, or 6.2% less than the CAGR for the first 19 years (1964-1983). Therefore Buffett's prediction was prescient; however, a 16.4% CAGR is considered outstanding under any long-term scenario (Bernie Madoff's investors were thrilled thinking they were making a mere 12-14%; perhaps they should have considered Berkshire stock instead).
SEE'S CANDIES--PORTRAIT OF A GREAT BUSINESS
Buffett discusses See's Candies, which is the definition of what he considers an outstanding business. See's has a wide moat, in the form of its extremely valuable brand and customer loyalty. Moreover, the business requires very little in the way of incremental capital to expand (mainly just raw ingredients and inventory). But most importantly, See's had (and has) the ability to raise prices--in Buffett's view the number one criterion for determining the quality of any business.
Here was the record of See's from the date of acquisition to 1983, as reproduced in the shareholder letter:
Buffett summarizes the case for See's as follows:
Despite the volume problem [note: See's had recently seen its unit volumes plateau temporarily], See’s strengths are many and important. In our primary marketing area, the West, our candy is preferred by an enormous margin to that of any competitor. In fact, we believe most lovers of chocolate prefer it to candy costing two or three times as much. (In candy, as in stocks, price and value can differ; price is what you give, value is what you get.) The quality of customer service in our shops--operated throughout the country by us and not by franchisees is every bit as good as the product. Cheerful, helpful personnel are as much a trademark of See’s as is the logo on the box. That’s no small achievement in a business that requires us to hire about 2000 seasonal workers. We know of no comparably-sized organization that betters the quality of customer service delivered by [CEO] Chuck Huggins and his associates.
Again we must note Munger's aphorism (see blog regarding 1982 letter): The way to get rich is to buy a few great companies and sit on your ass. Nuff said!
APPENDIX TO THE 1983 SHAREHOLDER LETTER
Buffett included an appendix to the shareholder letter for 1983 called "Goodwill and its Amortization: The Rules and The Realities". Buffett defines "economic goodwill" by reference to See's Candies as an example:
In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel. Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry. [emphasis added]
Hence economic goodwill is the value assigned by a rational investor to a business's intangible competitive moat (assuming the business has one), which permits the business to earn consistent above-average returns on tangible assets without the use of leverage.
Buffett then goes on to posit that economic goodwill tends to grow in line with inflation. To demonstrate this mathematically, assume two businesses: (1) a wonderful business that earnings $2 million on $8 million in tangible assets that is valued at $25 million (12.5X earnings and ~3X tangible book value); and (2) a mundane business that earns $2 million on $18 in tangible assets that is valued at $18 million (9X earnings and 1X book value). [Note that company (1) has significant "economic goodwill", as evidenced by its market valuation at 3X tangible assets, whereas company (2) has zero "economic goodwill" and hence trades at just the value of its tangible assets.]
Next assume that under inflationary conditions general price levels double in 5 years. Company (1) will have to (re)invest an additional $8 million in its business and at year 5 will be earning $4 million on $16 million in tangible assets; however, it will be valued at $50 million (12.5X earnings), meaning that the incremental $8 million investment will have resulted in a $25 million increase in the wealth of its shareholders. Company (2) will have had to (re)invest an additional $18 million in its business and will be earning $4 million on $36 million in tangible assets; however, it will only be valued at $36 million (or its book value), meaning that the incremental $18 million investment will have resulted in just a $18 million increase in value for its shareholders. While the shareholders of each business will see their equity stakes keep up with inflation (the value of each will double in 5 years, along with general prices), company (1) will have generated significant free cash (perhaps $6 million, or $16 million in earnings less the $8 reinvested) that it can distribute to its shareholders, while company will likely not have generated any free cash (all earnings will have to be plowed back into the business). Hence, only company (1)'s shareholders will have seen their purchasing power increase in real dollars over the 5-year period.
Buffett's conclusion? Under inflationary conditions, the best businesses are (counterintuitively) those that can generate high returns on equity with little in the way of tangible assets, not businesses that are asset-heavy:
Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least. And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.
For the record, in 1983 Berkshire's stock was up 69%, beating the market by 46% (but what's 46% between friends, right?), the Orioles beat the Phillies in the World Series in five games (Eddie and Cal, we miss you), the evil Raiders pummeled the Redskins 38-9 in Super Bowl XVIII (what was Theismann thinking???), and on May 25th the third episode of the original Star Wars trilogy, Return of the Jedi, opened in theatres to rave reviews and box office records (the more things change, the more they stay the same). Next up, 1984, the year that the world was introduced to the Macintosh personal computer.