This is the tenth 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 1986 letter weighs in at slightly under 13,700 words, less than a 1% increase versus slightly under 13,600 words the prior year. Fortunately for shareholders, Berkshire's stock price was tied a bit more to earnings than the shareholder letter word count--and earnings in 1986 were a hefty $492.5 million, or 26.1% of beginning book value.
"A" PLAYERS VERSUS MICROMANAGEMENT
In the 1986 letter we find Buffett describing his role in managing Berkshire's affairs. Generally speaking, he was responsible for (A) selecting managers and (B) redeploying capital. With respect to point (A), however, what was most important was what he was not supposed to do--namely, get in his managers' way. In this respect, it is interesting to compare Buffett's approach to a few other famous investors/businessmen. For example, here is Buffett (in the 1986 letter) and Steve Jobs on choosing talent:
Buffett: Charlie and I know that the right players will make almost any team manager look good. We subscribe to the philosophy of Ogilvy & Mather’s founding genius, David Ogilvy: "If each of us hires people who are smaller than we are, we shall become a company of dwarfs. But, if each of us hires people who are bigger than we are, we shall become a company of giants." (Our prototype for occupational fervor is the Catholic tailor who used his small savings of many years to finance a pilgrimage to the Vatican. When he returned, his parish held a special meeting to get his first-hand account of the Pope. "Tell us," said the eager faithful, "just what sort of fellow is he?" Our hero wasted no words: "He’s a forty-four, medium.")
Steve Jobs: The Mac team was an attempt to build a whole team [with] A players. People said that they wouldn't get along, they'd hate working with each other. But I realized that A players like to work with A players, they just didn't like working with C players. At Pixar, it was a whole company of A players. When I got back to Apple, that's what I decided to try to do. You need to have a collaborative hiring process. When we hire someone, even if they're going to be in marketing, I will have them talk to the design folks and the engineers. My role model was J. Robert Oppenheimer. I read about the type of people he sought for the atom bomb project. I wasn't nearly as good as he was, but that's what I aspired to do.
Wth respect to delegation of authority, here is Buffett's view (again from 1986) contrasted with a description of how Sears operates under Eddie Lampert's leadership (I'll let the reader decide which approach makes the most sense):
Buffett: A by-product of our managerial style is the ability it gives us to easily expand Berkshire’s activities. We’ve read management treatises that specify exactly how many people should report to any one executive, but they make little sense to us. When you have able managers of high character running businesses about which they are passionate, you can have a dozen or more reporting to you and still have time for an afternoon nap. We intend to continue our practice of working only with people whom we like and admire. This policy not only maximizes our chances for good results, it also ensures us an extraordinarily good time. On the other hand, working with people who cause your stomach to churn seems much like marrying for money--probably a bad idea under any circumstances, but absolute madness if you are already rich.
Eddie Lampert's Management Style: Every year the presidents of Sears Holdings’ many business units trudge across the company’s sprawling headquarters in Hoffman Estates, Ill., to a conference room in Building B, where they ask Eddie Lampert for money. The leaders have made these solitary treks since 2008, when Lampert, a reclusive hedge fund billionaire, splintered the company into more than 30 units. Each meeting starts quietly: When the executive arrives, Lampert’s top consiglieri are there, waiting around a U-shaped table, according to interviews with a half-dozen former employees who attended these sessions. An assistant walks in, turns on a screen on the opposite wall, and an image of Lampert flickers to life. The Sears chairman, who lives in a $38 million mansion in South Florida and visits the campus no more than twice a year (he hates flying), is usually staring at his computer when the camera goes live, according to attendees.The executive in the hot seat will begin clicking through a PowerPoint presentation meant to impress. Often he’ll boast an overly ambitious target—“We can definitely grow 20 percent this year!”—without so much as a glance from Lampert, 50, whose preference is to peck out e-mails or scroll through a spreadsheet during the talks. Not until the executive makes a mistake does the Sears chief look up, unleashing a torrent of questions that can go on for hours... Lampert runs Sears like a hedge fund portfolio, with dozens of autonomous businesses competing for his attention and money. An outspoken advocate of free-market economics and fan of the novelist Ayn Rand, he created the model because he expected the invisible hand of the market to drive better results. If the company’s leaders were told to act selfishly, he argued, they would run their divisions in a rational manner, boosting overall performance. Instead, the divisions turned against each other—and Sears and Kmart, the overarching brands, suffered. [It's a] business that’s ravaged by infighting as its divisions battle over fewer resources.
Regarding point (B) above [Capital Allocation], Buffett makes the point that this skill is much more important for the CEO of a company earning a 23% return on equity and reinvesting all cash flow (as Berkshire was at the time) than that of a company earning 10% and distributing half of its cash flow to shareholders as dividends. In the former case, such a company will reinvest an amount equal to its total shareholder's equity in just 3 and 1/3 years (1.23^3.35=2), whereas in the latter case it would take approximately 14 years. Of course, with respect to a company such as a REIT that pays out nearly all of its cash flow as dividends, the capital allocation skills of the CEO mean virtually nothing. Many investors pay strict attention to current earnings and cash flow numbers, but totally overlook how a company's cashflows are being reinvested, even though (1) CEOs tend not to be great capital allocators, even if good business operators and (2) for low payout companies, in the long run capital allocation is just as important as the current performance of a company's base business.
BERKSHIRE JUMPS THE SHARK--THE INDEFENSIBLE/INDISPENSABLE CORPORATE JET
In 1986, Buffett and Berkshire officially jumped the shark, albeit a small ($850,000) shark. Note the small type face used in making the official announcement:
GAAP VERSUS NON-GAAP ACCOUNTING
In the appendix to the 1986 letter, Buffett compares two companies, Company O and Company N. See if you can guess which is more valuable:
Of course, this is a trick question. Company O[ld] and Company N[ew] are the same company, Scott Fetzer, with its financials shown first using historical accounting figures [Old] and second using purchase accounting [New] (Berkshire had recently acquired the company). Here is contemporary news coverage of the deal announcement:
Buffett's point is that GAAP accounting, while the best available system to reflect the financial performance of an entity, is not perfect. Under historical accounting, net income for 1986 would have been 40% higher than actually reflected in Berkshire's consolidated numbers. The main differences result from increased depreciation and amortization, as certain of Scott Fetzer's assets were written up to fair value upon acquisition by Berkshire. Company O at 12X earnings would be valued at $483 million whereas Company N at 12X earnings would be valued at $343 million, quite a wide disparity.
To remedy the conundrum, Buffett introduces us to the concept of "owner earnings":
What does all this mean for owners? Did the shareholders of Berkshire buy a business that earned $40.2 million in 1986 or did they buy one earning $28.6 million? Were those $11.6 million of new charges a real economic cost to us? Should investors pay more for the stock of Company O than of Company N? And, if a business is worth some given multiple of earnings, was Scott Fetzer worth considerably more the day before we bought it than it was worth the following day?
If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)
Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess--and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes--both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes's observation: "I would rather be vaguely right than precisely wrong."
The approach we have outlined produces "owner earnings" for Company O and Company N that are identical, which means valuations are also identical, just as common sense would tell you should be the case. This result is reached because the sum of (a) and (b) is the same in both columns O and N, and because (c) is necessarily the same in both cases.
Not a few management teams and investment bankers in recent years have forgotten that the key to presenting proper "earnings" figures is the "owner" part. If a company's "cash flow" or "earnings" belong to somebody other than the shareholders (such as debt holders or the company's capital expenditure counterparties), then they don't really count as "earnings" at all, since they will never end up in the "owner's" (shareholder's) pocket. Yet the term "earnings" is abused today just as much as it was in 1986. Buffett explains why as follows:
Why, then, are "cash flow" numbers so popular today? In answer, we confess our cynicism: we believe these numbers are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable (and thereby to sell what should be the unsalable). When (a) --that is, GAAP earnings--looks by itself inadequate to service debt of a junk bond or justify a foolish stock price, how convenient it becomes for salesmen to focus on (a) + (b). But you shouldn't add (b) without subtracting (c); though dentists correctly claim that if you ignore your teeth they'll go away, the same is not true for (c). The company or investor believing that the debt-servicing ability or the equity valuation of an enterprise can be measured by totaling (a) and (b) while ignoring (c) is headed for certain trouble. "Cash Flow", true, may serve as a shorthand of some utility in descriptions of certain real estate businesses or other enterprises that make huge initial outlays and only tiny outlays thereafter. A company whose only holding is a bridge or an extremely long-lived gas field would be an example. But "cash flow" is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment--or the business decays.
We need look no further than the example given above, Eddie Lampert and Sears Holdings, to see how true Buffett's words are. Sears and Kmart been starved of capital since Lampert took over and, as a consequence, SHLD's stock price has been in an inexorable decline for the past decade, with no end to the carnage in sight:
For the record, in 1986 Berkshire's stock was up 14%, trailing the market by about 4.5% (everyone is entitled to an off year now and again), the Mets beat the Red Sox in the World Series in seven games, the Giants killed the Broncos 39-20 in Super Bowl XXI and on April 21st Geraldo Rivera unsealed Al Capone's vaults in a 2-hour live TV special, revealing...exactly nothing. Way to go, Geraldo! I will never get those 2 hours of my life back. :( Next up, 1987, the year Prozac was introduced and Tim Tebow sprang to life (I'm sure something good happened that year, but I haven't been able to find it yet).