This is the ninth 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 1985 letter weighs in at slightly under 13,600 words, an 8% increase versus slightly over 12,600 words the prior year. Berkshire earned $613.6 million in 1985, so the company made $45,118 on an "earnings-per-word" (or EPW) basis (note that this figure has not been adjusted for any non-cash, unusual, non-recurring or otherwise generally annoying amounts). This represents an increase of 530% from the $7,170 in EPW in 1977, representing a CAGR of 26%. Pick whatever metric you like, ole Warren sure knows how to compound!
GENERAL FOODS BUYOUT
More than half of the $614 million yearly gain in net worth was composed of $338 million in capital gains from Berkshire's investment in General Foods, which was bought in 1985 by Phillip Morris:
Buffett had bought slightly over 4 million shares of General Foods in 1980 at an average cost of $37/share. If one adds to the $338 million in capital gains the $22 million received in 1984 from a company tender offer for a portion of Berkshire's shares, then Buffett's investment netted an aggregate profit of $360 million on a $150 million investment. This represents a CAGR of approximately 28%; include a 2% annual dividend (a conservative guess as to what General Food's was yielding at the time) and Berkshire likely realized an overall CAGR before taxes of about 30% on the investment over a 5-year period. Clearly an advertisement for not "taking profits" when one's sees one's investment in an outstanding company climb 40% or 50%.
Buffett summarized the lessons of the General Foods investment as follows:
We benefited from four factors: a bargain purchase price, a business with fine underlying economics, an able management concentrating on the interests of shareholders, and a buyer willing to pay full business value. While that last factor is the only one that produces reported earnings, we consider identification of the first three to be the key to building value for Berkshire shareholders. In selecting common stocks, we devote our attention to attractive purchases, not to the possibility of attractive sales.
CHANGING BOATS AND PATCHING LEAKS
Berkshire finally exited its textile business operations in 1985 after more than 20 years of struggle. Buffett concludes in the letter that the original investment he made in Berkshire Hathaway (then solely a textile company) in 1964 as questionable at best. Interesting is his discussion of the recurring temptation for management to try to "fix" a struggling business with additional capital expenditures:
Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses. But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic. [emphasis added]
This illustrates that while a manager's rationale to "reinvest" in the business may sound tempting to shareholders, such decisions should not be endorsed without an clear view of the competitive dynamics in the industry in which the applicable company operates. The prisoner's dilemma presented to such a management team (who may myopically not recognize that further capital investments will prove futile in the end) should be recognized by directors and shareholders and (hopefully) communicated to management before wasteful commitments are made.
This existential question (to be or not to be, to reinvest in a failing business or to just give up) is further illustrated by the example of Burlington Industries, a textile competitor to Berkshire at the time. Buffett describes Burlington's plight as follows:
For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at $60 at the end of 1964; ours was $13. Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington’s basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational. Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at $34--on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.
Post-script: Berkshire's stock now trades at over $240,000 per A share (a modest increase from its $13 level of 1964) and Burlington now trades at zero (a 100% decrease from its $60+ level of 1964). Burlington's ultimate fate was tragic yet (if one had been a regular reader of our Chairman's letters) predictable:
Buffett's general conclusions:
A. Changing boats > patching leaks: "Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."
B. Great businesses > great management (although it's preferable to have both): "When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”
C. Book value can be highly deceptive:
The equipment sold [in the liquidation of Berkshire's textile operations in 1985] (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost [Berkshire] about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million. Gross proceeds from [Berkshire's] sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, [Berkshire's] net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.
THE EFFECT OF STOCK OPTIONS AND COMPOUNDING ON MANAGEMENT WEALTH
Buffett next goes on to discuss how management can (and often does) fleece shareholders through the use of long-dated stock options. This occurs when management reinvests earnings into a business rather than distributing them to the owners of the business (the shareholders), while at the same time hiving off a portion of the this ever increasingly valuable business for themselves through the grant of options. Similar to a dormant savings account, which will pay more and more interest each year as prior interest payments are "reinvested" into the account, a company's income should steadily increase due to the compounding effect of reinvested earnings, thereby creating a windfall for management at the expense of shareholders:
When returns on capital are ordinary, an earn-more-by-putting-up-more record is no great managerial achievement. You can get the same result personally while operating from your rocking chair. Just quadruple the capital you commit to a savings account and you will quadruple your earnings. You would hardly expect hosannas for that particular accomplishment. Yet, retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign--with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest. If the widget company consistently earned a superior return on capital throughout the period, or if capital employed only doubled during the CEO’s reign, the praise for him may be well deserved. But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be withheld. A savings account in which interest was reinvested would achieve the same year-by-year increase in earnings--and, at only 8% interest, would quadruple its annual earnings in 18 years.
If a management team grants itself long-term options, then it has every incentive to seek out this type of compounding, potentially at great expense of the shareholders, who may benefit much more from dividends or the intelligent use of stock repurchases. Buffett points out that a CEO would never in a million years grant to a third party a fixed-price, long-term option to purchase his or her company, especially if that company were reinvesting its earnings, yet that same CEO will gladly (greedily?) grant himself or herself and his or her fellow occupants of the C-suite options to buy small pieces of the exact same company on exactly the same terms.
Not only that, these same executives will often couch these grants in terms of "alignment of interests with those of the shareholders", when in fact the exact opposite situation prevails:
Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I’ll be happy to accept a lottery ticket as a gift--but I’ll never buy one.)
Occasionally corporate executives will even re-price their already generous options lower if the company's stock price has fallen considerably since the date of the original grants (just more "alignment of interests", folks, nothing to see here). And please don't ask management to do something crazy like actually buying shares of their company's stock on the open market, the same as everybody else--that would clearly be unthinkable (much better to get stock for free--free to them, that is). Do unto others? Not in corporate America. (Buffett concludes wryly: "Negotiating with one’s self seldom produces a barroom brawl.").
WASHINGTON POST LOLLAPALOOZA
Finally, Buffett discusses Berkshire's 1.73 million share investment in the Washington Post Company (WPC), which had appreciated in value from just under $10 million when purchased in 1973 to $205 million by the end of 1985. This investment demonstrates Ben Graham's old maxim that "In the short run, the market is a voting machine but in the long run, it is a weighing machine":
We bought all of our WPC holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage, rather, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.
Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value--and even thought, itself--were of no importance in investment activities. (We are enormously indebted to those academics: what could be more advantageous in an intellectual contest--whether it be bridge, chess, or stock selection--than to have opponents who have been taught that thinking is a waste of energy?)
Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by year-end 1974 our WPC holding showed a loss of about 25%, with market value at $8 million against our cost of $10.6 million. What we had thought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.
You know the happy outcome. Kay Graham, CEO of WPC, had the brains and courage to repurchase large quantities of stock for the company at those bargain prices, as well as the managerial skills necessary to dramatically increase business values. Meanwhile, investors began to recognize the exceptional economics of the business and the stock price moved closer to underlying value. Thus, we experienced a triple dip: the company’s business value soared upward, per-share business value increased considerably faster because of stock repurchases and, with a narrowing of the discount, the stock price outpaced the gain in per-share business value. [emphasis added]
The "triple dip" was made possible due to what Charlie Munger has labelled the"lollapalooza effect" (when multiple psychological factors come together to cause an extreme outcome, in this case a massive, logic-defying undervaluation of the Washington Post Company). One can count the following (among others) of Munger's "Causes of Human Misjudgment" inherent in the undervaluation:
(1) Open outcry auction mechanism (i.e., the stock market itself and the echo-chamber effect of the financial media);
(2) Social proof (investors acting like brain-dead lemmings, especially during conditions inducing either fear or greed);
(3) Commitment bias (once sold at a loss (or from seeing others sell at a loss), an investor hates to repurchase a security lower, even though a lower price is safer to buy, all other things being equal); and
(4) Bias from disliking someone or something (investors dislike a stock because it's "been going down"--and hence is transformed into "a falling knife"--whereas if it "is going up" it is magically determined to be "safe to buy").
Munger concludes his discussion of the causes of human misjudgment by asking: "What happens when these standard psychological tendencies combine? What happens when the situation, or the artful manipulation of man, causes several of these tendencies to operate on a person toward the same end at the same time? The clear answer is the combination greatly increases power to change behavior, compared to the power of merely one tendency acting alone."
And hence you can at times buy a great business in the stock market for a fraction of its actual worth.
For the record, in 1985 Berkshire's stock was up 94%, beating the market by a pedestrian 62% (did it ever get old for Berkshire shareholders?), the Royals beat the Cardinals in the World Series in seven games, Refrigerator Perry and the Da Bears demolished the Patriots in Super Bowl XX (man, that was a serious whuppin') and on April 23rd the Coca-Cola Company came out with New Coke, thereby either engaging in the absolute worst or the absolute most diabolically brilliant (depending on whether one is a conspiracy theorist or not) marketing move in history. Next up, 1986, the year of the Hand of God and the nascence of Stefani Germanotta (events not connected as far as I am aware, I might add).