This is the eleventh 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 1987 letter weighs in at slightly under 12,500 words, a 9% decrease versus slightly under 13,700 words the prior year (note that the 1986 letter had an appendix). Berkshire's gain in net worth during 1987 was $464 million, or 19.5% of beginning book value. This compares with just $21.9 million in earnings ten years before; so earnings increased over 20X in that decade.
WHERE TO LOOK FOR GREAT BUSINESSES
Buffett, in his discussion of Berkshire's "Sainted Seven" operating subsidiaries, includes a discussion on where one is most likely to find truly exceptional businesses. The answer? Not where one would most expect (given the recent investor favoritism for companies such as TSLA, NFLX, AMZN, MBLY, SPLK, etc):
Severe change and exceptional returns usually don't mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today's business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be. Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.... But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.
The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000 companies met two tests of economic excellence - an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500. The Fortune champs may surprise you in two respects. First, most use very little leverage compared to their interest-paying capacity. Really good businesses usually don't need to borrow. Second, except for one company that is "high-tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane. Most sell non-sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.
While Netflix is today's darling, it could easily be tomorrow's goat. But a company such as Colgate-Palmolive (CL), a true compounder which engages in mundane activities such as selling toothpaste, is likely to outperform TSLA, NFLX or MBLY over the next 10 years (in our humble opinion). Here is CL's long-term record of rewarding shareholders--it is nearly a 24-bagger (not including dividends) over the past 30 years:
Anyone for toothpaste?
BERKSHIRE'S SECRET SAUCE IN INSURANCE
Further down in the 1987 letter, Buffett reveals how Berkshire manages to operate so effectively in the insurance business compared to peers. The secret, it turns out, lies in financial strength and temperament. First, Berkshire's financial strength comes in most handy at the precise time that insurance pricing is most attractive:
At Berkshire, we work to escape the industry's commodity economics in two ways. First, we differentiate our product by our financial strength, which exceeds that of all others in the industry. This strength, however, is limited in its usefulness. It means nothing in the personal insurance field: The buyer of an auto or homeowners policy is going to get his claim paid even if his insurer fails (as many have). It often means nothing in the commercial insurance arena: When times are good, many major corporate purchasers of insurance and their brokers pay scant attention to the insurer's ability to perform under the more adverse conditions that may exist, say, five years later when a complicated claim is finally resolved. (Out of sight, out of mind--and, later on, maybe out-of-pocket.) Periodically, however, buyers remember Ben Franklin's observation that it is hard for an empty sack to stand upright and recognize their need to buy promises only from insurers that have enduring financial strength. It is then that we have a major competitive advantage. When a buyer really focuses on whether a $10 million claim can be easily paid by his insurer five or ten years down the road, and when he takes into account the possibility that poor underwriting conditions may then coincide with depressed financial markets and defaults by reinsurer, he will find only a few companies he can trust. Among those, Berkshire will lead the pack.
Second, executives at Berkshire are perfectly fine not writing new policies when the pricing is not adequate (give-a-man-a-hammer syndrome is not evident at the company, as it would be in almost any other insurance operation):
Our second method of differentiating ourselves is the total indifference to volume that we maintain. In 1989, we will be perfectly willing to write five times as much business as we write in 1988--or only one-fifth as much. We hope, of course, that conditions will allow us large volume. But we cannot control market prices. If they are unsatisfactory, we will simply do very little business. No other major insurer acts with equal restraint.
THE (UN)TALENTED MR. MARKET
In the 1987 letter, Buffett for the first time in his Berkshire shareholder letters informs his readers of a curious fellow by the name of Mr. Market. Anyone reading this blog undoubtedly has heard of Mr. Market, and probably has even had a few encounters with the gentleman. Some view Mr. Market as an all-knowing oracle--when a stock price's changes significantly, then undoubtedly (such people claim) "somebody [Mr. Market] knows something". These worshippers of Mr. Market darkly warn others never to doubt him, as betting against him will likely prove disastrous (after all, he is Mr. Market, the Omniscient One).
Buffett, however, has a slightly less complimentary view of Mr. Market:
Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him. Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic- depressive his behavior, the better for you. But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."
When valuing companies, Buffett stresses that what is important is not the vicissitudes of their stock prices, but the underlying performance of their businesses:
Charlie and I let our marketable equities tell us by their operating results--not by their daily, or even yearly, price quotations--whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it.
INVESTMENTS IN CONTROLLED VERSUS NON-CONTROLLED COMPANIES
Buffett goes on to compare and contrast investments in Berkshire's controlled businesses (such as See's Candies) versus its investments in companies where it will never have too much of a say in management (Coca-Cola, for example). Investments in controlled companies have two main advantages:
(1) Buffett can direct how capital gets redeployed (thus hopefully preventing large-scale capital allocation mistakes):
[T]he heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.... [P]lenty of unintelligent capital allocation takes place in corporate America. (That's why you hear so much about "restructuring.")
(2) Taxes: "Berkshire, as a corporate holder, absorbs some significant tax costs through the ownership of partial positions that we do not when our ownership is 80% or greater."
However, investments in non-controlled business via the stock market have a huge potential advantage not evident in controlled companies: namely, that the aforementioned Mr. Market may offer up quality companies for a fraction of their true value (which opportunity would rarely, if ever, occur in a negotiated transaction for an entire business):
For example, we purchased our Washington Post stock in 1973 at $5.63 per share, and per-share operating earnings in 1987 after taxes were $10.30. Similarly, Our GEICO stock was purchased in 1976, 1979 and 1980 at an average of $6.67 per share, and after-tax operating earnings per share last year were $9.01. In cases such as these, Mr. Market has proven to be a mighty good friend.
Mighty good indeed.
$700 MILLION SALOMON BROTHERS PREFERRED INVESTMENT--OOPS!
Buffett in the 1987 letter makes his first mention of Berkshire's large investment in Salomon Brothers:
By far our largest - and most publicized - investment in 1987 was a $700 million purchase of Salomon Inc 9% preferred stock. This preferred is convertible after three years into Salomon common stock at $38 per share and, if not converted, will be redeemed ratably over five years beginning October 31, 1995. From most standpoints, this commitment fits into the medium-term fixed-income securities category. In addition, we have an interesting conversion possibility. We, of course, have no special insights regarding the direction or future profitability of investment banking.
The last sentence would soon prove prophetic, as shall be chronicled in our future blog posts.
For the record, in 1987 Berkshire's stock was up 4.6%, trailing the market by about 0.5% (the second consecutive year Berkshire stock had underperformed), the Twins beat the Cardinals in the World Series in seven games, the Redskins annihilated the Broncos 42-10 in Super Bowl XXII and on October 19th the Dow Jones declined over 22%, briefly putting all of American business on sale (not that anybody really appreciated the sale):
Where's the love for cheap merchandise folks??? Next up, 1988, the year a minor thing called the "Internet" came into being (not sure whatever happened to said "Internet"--must have been a flash in the pan).