This is the eighth 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 1984 letter (including the Appendix) weighs in at slightly over 12,600 words, a 10% increase versus the prior year. It begins with the observation that Berkshire's $133 gain in book value per share during the preceding year "sounds pretty good but actually it’s mediocre". If every stock I own increased in book value by that amount in 2017, there would be no more blog entries, as yours truly would be RETIRED for life. Sadly, the prospect of this happening is basically nil, so I trudge onwards.
SHARE REPURCHASES (AND GREENMAIL)
This being the 1980s, greenmail was a topic du jour. For anyone not familiar with the term, it refers to paying a corporate raider an above-market price for his shares so he'll go away and leave management alone (it has since been outlawed). Buffett includes the following classic (and amusing) summary of how greenmail works in the 1984 letter:
Our endorsement of repurchases is limited to those dictated by price/value relationships and does not extend to the “greenmail” repurchase--a practice we find odious and repugnant. In these transactions, two parties achieve their personal ends by exploitation of an innocent and unconsulted third party. The players are: (1) the “shareholder” extortionist who, even before the ink on his stock certificate dries, delivers his “your-money-or-your-life” message to managers; (2) the corporate insiders who quickly seek peace at any price--as long as the price is paid by someone else; and (3) the shareholders whose money is used by (2) to make (1) go away. As the dust settles, the mugging, transient shareholder gives his speech on “free enterprise”, the muggee management gives its speech on “the best interests of the company”, and the innocent shareholder standing by mutely funds the payoff.
The greenmail description comes within a larger discussion of share repurchases. In recent times, there has been some (in our humble opinion) misunderstanding of repurchase programs. They are often derided as being wasteful, contributing nothing to society, etc.--almost as if they were somehow un-American. See, for example, the following summary of criticism from the left during the presidential campaign:
Democratic presidential candidate Hillary Clinton and her progressive surrogates are making political hay out of the billions of dollars’ worth of share buybacks they say are made only to please “activist” hedge funds. In several speeches and in a bill introduced in the Senate in March, left-leaning Democrats are supporting Clinton’s message by repeating the theme that activist hedge funds are focused on their own wealth instead of on paying employees more and investing for long-term growth.
This type of criticism is irrational, however. A repurchase of stock is simply a trade of assets between two parties (the repurchasing company trades its cash for shares tendered by the exiting shareholders). Repurchases neither add to nor detract from the aggregate wealth of society (the shareholder that has sold his or her shares now has funds that were formerly retained by the company and can reinvest these funds into the broader economy). Repurchases certainly do not mean that employees won't get paid or that our society will have lower long-term growth. It is interesting indeed that politicians will gladly condemn repurchases as wasteful, yet would likely applaud a highly wealth-destructive (for the acquirer's shareholders) acquisition at an exorbitant price as a positive example of "investing for long-term growth". The bottom line is that any purchase of (or investment in) an asset (including shares of stock) is only intelligent if the acquired asset produces an adequate rate or return. Buffett has previously stated that he could "invest" by paying $10,000 per day to have his portrait painted every day, but this "investment" would add nothing of value to society.
Buffett, as usual, rationally assesses repurchases. What matters depends on one's perspective. If one is a remaining shareholder in a company that is repurchasing shares, such person should only care whether the shares being repurchased are trading below intrinsic value or not. If they are, it is good that the company is buying them back (since the company will be trading each $1 spent on repurchases for more than $1 worth of assets, i.e., it's own ownership interests); if they are not, however, the exiting shareholders are benefiting at the expense of the remaining shareholders:
The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding for two important reasons--one that is obvious, and one that is subtle and not always understood. The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended. The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are entirely rational. Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer.
NEWSPAPERS AS WONDERFUL BUSINESSES?
It's hard to imagine from the perspective of 2017, but 34 years ago one of the best businesses one could buy was...a newspaper. This was because in most cities the dominant newspaper was a natural monopoly. Buffett elucidates as follows:
The economics of a dominant newspaper are excellent, among the very best in the business world. Owners, naturally, would like to believe that their wonderful profitability is achieved only because they unfailingly turn out a wonderful product. That comfortable theory wilts before an uncomfortable fact. While first-class newspapers make excellent profits, the profits of third-rate papers are as good or better--as long as either class of paper is dominant within its community. Of course, product quality may have been crucial to the paper in achieving dominance.... Once dominant, the newspaper itself, not the marketplace, determines just how good or how bad the paper will be. Good or bad, it will prosper. That is not true of most businesses: inferior quality generally produces inferior economics. But even a poor newspaper is a bargain to most citizens simply because of its “bulletin board” value. Other things being equal, a poor product will not achieve quite the level of readership achieved by a first-class product. A poor product, however, will still remain essential to most citizens, and what commands their attention will command the attention of advertisers.
Today, however, you probably could not pay somebody enough to take a newspaper operation off your hands. The Internet has decimated many industries, but newspaper are probably at the top of the list of victims. There's even a Wikipedia page dedicated to the topic! And speaking of Wikipedia, I wonder what ever happened to the World Book encyclopedias that were popular when I was a kid? Ah, the creative destruction of capitalism.
INSURANCE RESERVING--BURIED IN A RENTED SUIT
Buffett, in discussing the tendency for insurance under-reserving to be the "debacle that keeps (unfortunately) giving (and giving)" uses the following parable (also known as the cockroach theory in investing):
I heard a story recently that is applicable to our insurance accounting problems: a man was traveling abroad when he received a call from his sister informing him that their father had died unexpectedly. It was physically impossible for the brother to get back home for the funeral, but he told his sister to take care of the funeral arrangements and to send the bill to him. After returning home he received a bill for several thousand dollars, which he promptly paid. The following month another bill came along for $15, and he paid that too. Another month followed, with a similar bill. When, in the next month, a third bill for $15 was presented, he called his sister to ask what was going on. “Oh”, she said. “I forgot to tell you. We buried Dad in a rented suit.” If you’ve been in the insurance business in recent years--particularly the reinsurance business--this story hurts. We have tried to include all of our “rented suit” liabilities in our current financial statement, but our record of past error should make us humble, and you suspicious. I will continue to report to you the errors, plus or minus, that surface each year.
VIEWING A BOND AS A BUSINESS
Next Buffett describes Berkshire's $139 million investment in certain high-yield bonds issued by the Washington Public Power Supply System (WPPSS) in late-1983 through mid-1984 by analogizing to the acquisition of a business. In this case the "business" (i.e., the bonds) "earns" (via interest payments) $22.7 million per year, or a 16% "return on equity" (22.7/139). Note that since these bonds are tax-advantaged, 100% of the interest payments represent actual "net income" for the holder. Buffett states that any real business earning nearly $23 million in net income and a 16% on equity would only be available for an amount far in excess of the $139 million paid by Berkshire for this WPPSS "bond business":
We are unable to buy operating businesses with economics close to [the WPPSS "bond business"]. Only a relatively few businesses earn the 16.3% after tax on unleveraged capital that our WPPSS investment does and those businesses, when available for purchase, sell at large premiums to that capital. In the average negotiated business transaction, unleveraged corporate earnings of $22.7 million after-tax (equivalent to about $45 million pre- tax) might command a price of $250 - $300 million (or sometimes far more). For a business we understand well and strongly like, we will gladly pay that much. But it is double the price we paid to realize the same earnings from WPPSS bonds. However, in the case of WPPSS, there is what we view to be a very slight risk that the “business” could be worth nothing within a year or two. There also is the risk that interest payments might be interrupted for a considerable period of time. Furthermore, the most that the “business” could be worth is about the $205 million face value of the bonds that we own, an amount only 48% higher than the price we paid.
This ceiling on upside potential is an important minus. It should be realized, however, that the great majority of operating businesses have a limited upside potential also unless more capital is continuously invested in them. That is so because most businesses are unable to significantly improve their average returns on equity--even under inflationary conditions, though these were once thought to automatically raise returns. (Let’s push our bond-as-a-business example one notch further: if you elect to “retain” the annual earnings of a 12% bond by using the proceeds from coupons to buy more bonds, earnings of that bond “business” will grow at a rate comparable to that of most operating businesses that similarly reinvest all earnings. In the first instance, a 30-year, zero-coupon, 12% bond purchased today for $10 million will be worth $300 million in 2015. In the second, a $10 million business that regularly earns 12% on equity and retains all earnings to grow, will also end up with $300 million of capital in 2015. Both the business and the bond will earn over $32 million in the final year.)
Our approach to bond investment--treating it as an unusual sort of “business” with special advantages and disadvantages--may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.
If an investor had been business-minded enough to think in those terms--and that was the precise reality of the bargain struck--he would have laughed at the proposition and walked away. For, at the same time, businesses with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, or 15% after tax on book. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. [emphasis added]
Similar, although less extreme, conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards. (In what I think is by far the best book on investing ever written - “The Intelligent Investor”, by Ben Graham - the last section of the last chapter begins with, “Investment is most intelligent when it is most businesslike.” This section is called “A Final Word”, and it is appropriately titled.)
In mid-2016, 10-year Treasury bonds were yielding 1.5%. Investors clearly weren't thinking with the above-elucidated "bond as a business" mindset. What was then viewed as "safe" (what's "safer" than putting one's money into Treasuries, right?) should in reality have been viewed as an investment a "terrible business" (one with a permanently anemic 1.5% return on equity).
TO DIVIDEND OR NOT TO DIVIDEND (FREE CASH FLOW)
Finally, Buffett launches into an extensive discussion regarding whether (and when) a company should pay out its free cash flow to shareholders. To sum up, a company should pay out free cash as dividends unless (and only to the extent that) management has the ability to reinvest the funds at a higher rate of return than generally available to investors:
Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level, the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.
With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO’s business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5%--and market rates are 10%--he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company.
Thus, if a company has $100 in free cash for the year and has three different operating subsidiaries (earning 20%, 10% and 5% on equity, respectively) while the S&P 500's return on equity is 15% (and assuming the S&P 500 then trades at book value), then the $100 should only be invested to the extent that the subsidiary earning 20% on equity can benefit from incremental capital. In other words, if the CEO could only invest $50 in the 20% ROE subsidiary and $50 in the 10% ROE subsidiary (and not all $100 in the former, due to limited opportunities for profitable reinvestment), then $50 should be returned to shareholders via dividends, even though the CEO could truthfully claim to invest--in aggregate--all $100 at the market rate of return (15%) on a blended basis. Of course, many companies never engage in these type of deliberations, preferring instead the easier path of mindless repetition (duplicating capital allocation decisions made in prior years) or imitation (copying capital allocation decisions made by peers).
For the record, in 1984 Berkshire's stock was down 2.7% (that's not a typo), trailing the market by almost 9%, the Tigers beat the Padres in the World Series in five games, Joe Montana and the 49ers topped the Dolphins in Super Bowl XIX and on July 22nd Vanessa Williams was forced to resign as Miss America due to a nude photo scandal (and, yes, there is a Wiki page dedicated to this subject - long live Wikipedia!). Next up, 1985, the year an iconic consumer products company made probably the dumbest (or, perhaps, smartest?) marketing move in history.