This is the twelveth 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 1988 letter weighs in at 11,670 words, a 7% decrease from the slightly under 12,500 words the prior year. Berkshire's gain in net worth during 1988 was $569 million, or 20% of beginning book value, up from a $464 million gain in 1987.
A FEW THOUGHTS ON GAAP ACCOUNTING
Buffett in the 1988 letter begins with a few thoughts on GAAP accounting. First, he states that he wouldn't want the job of coming up with a better system of accounting from scratch. The point of accounting is to (hopefully) present a true and correct snapshot of a company's financial performance during the applicable time period. As Buffett explains, management should provide to investors all of the information (including, but not limited to, that required by GAAP) a reasonable person would require, but should not tweak or pervert the numbers in order to mislead (in short, it is a fine balancing act):
What needs to be reported is data--whether GAAP, non-GAAP, or extra-GAAP--that helps financially-literate readers answer three key questions: (1) Approximately how much is this company worth? (2) What is the likelihood that it can meet its future obligations? and (3) How good a job are its managers doing, given the hand they have been dealt? In most cases, answers to one or more of these questions are somewhere between difficult and impossible to glean from the minimum GAAP presentation. The business world is simply too complex for a single set of rules to effectively describe economic reality for all enterprises, particularly those operating in a wide variety of businesses, such as Berkshire. Further complicating the problem is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to overcome. Too often their accountants willingly assist them. (“How much,” says the client, “is two plus two?” Replies the cooperative accountant, “What number did you have in mind?”) Even honest and well-intentioned managements sometimes stretch GAAP a bit in order to present figures they think will more appropriately describe their performance. Both the smoothing of earnings and the “big bath” quarter are “white lie” techniques employed by otherwise upright managements. Then there are managers who actively use GAAP to deceive and defraud. They know that many investors and creditors accept GAAP results as gospel. So these charlatans interpret the rules “imaginatively” and record business transactions in ways that technically comply with GAAP but actually display an economic illusion to the world.
Unfortunately, human nature leads people to trust those in authority, such as CEOs and CFOs. After all, if titans of American industry cannot be trusted, who can? This trust presents an easy opportunity for the would-be charlatan to exploit for his own financial gain. Therefore, to all investors we say: caveat emptor (and don't blindly believe management--for in our view, the three most dangerous words in investing are "But management says...").
WHY IT'S EASIER TO FIRE A SECRETARY THAN A CEO
Buffett goes on to issue a general critique of chief executive officers, stating his low opinion of many:
The performance [of Berkshire's segment heads], which we have observed at close range, contrasts vividly with that of many CEOs, which we have fortunately observed from a safe distance. Sometimes these CEOs clearly do not belong in their jobs; their positions, nevertheless, are usually secure. The supreme irony of business management is that it is far easier for an inadequate CEO to keep his job than it is for an inadequate subordinate. If a secretary, say, is hired for a job that requires typing ability of at least 80 words a minute and turns out to be capable of only 50 words a minute, she will lose her job in no time. There is a logical standard for this job; performance is easily measured; and if you can’t make the grade, you’re out. Similarly, if new sales people fail to generate sufficient business quickly enough, they will be let go. Excuses will not be accepted as a substitute for orders. However, a CEO who doesn’t perform is frequently carried indefinitely. One reason is that performance standards for his job seldom exist. When they do, they are often fuzzy or they may be waived or explained away, even when the performance shortfalls are major and repeated. At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands. [emphases added]
What was true in 1988 seems even more true today. The fact is that CEOs today generally have an extremely cushy existence, complete with sycophantic subordinates, compliant boards, hired-gun attack-dog bankers and lawyers and, sadly, generally apathetic shareholders. The rise of indexing make the "agency problem" even worse. While "activists" are quick to be attacked by politicians as quick-buck artists who lack the ability to think "long term" (whatever that means), CEOs and others in the C-suite are virtually immune from outside criticism, while they quietly collect their millions (or tens of millions, depending on the size of the company) in yearly compensation. And if by chance a high-level corporate executive gets sued for mismanagement, they still have no consequences, since the company (meaning the shareholders) pick up the tab for their legal defense (of course, insurance companies pay the direct costs, but these are borne by all shareholders over time through D&O insurance premium increases).
Buffett continues with the critique as follows:
Another important, but seldom recognized, distinction between the boss and the foot soldier is that the CEO has no immediate superior whose performance is itself getting measured. The sales manager who retains a bunch of lemons in his sales force will soon be in hot water himself. It is in his immediate self-interest to promptly weed out his hiring mistakes. Otherwise, he himself may be weeded out. An office manager who has hired inept secretaries faces the same imperative. But the CEO’s boss is a Board of Directors that seldom measures itself and is infrequently held to account for substandard corporate performance. If the Board makes a mistake in hiring, and perpetuates that mistake, so what? Even if the company is taken over because of the mistake, the deal will probably bestow substantial benefits on the outgoing Board members. (The bigger they are, the softer they fall.) Finally, relations between the Board and the CEO are expected to be congenial. At board meetings, criticism of the CEO’s performance is often viewed as the social equivalent of belching. No such inhibitions restrain the office manager from critically evaluating the substandard typist.
Ironically, right after this spiel, Buffett dedicates a few words to praising Salomon CEO John Gutfreund, soon to be embroiled in a gigantic controversy that almost destroyed his firm (and Buffett's $700 million investment therein):
The close association we have had with John Gutfreund, CEO of Salomon, during the past year has reinforced our admiration for him. But we continue to have no great insights about the near, intermediate or long-term economics of the investment banking business: This is not an industry in which it is easy to forecast future levels of profitability. We continue to believe that our conversion privilege could well have important value over the life of our preferred. However, the overwhelming portion of the preferred’s value resides in its fixed-income characteristics, not its equity characteristics.
Yikes. Well, at least he got the last sentence correct.
HOW TO MAKE 50% A YEAR VIA RISK ARBITRAGE
Buffett next discusses Berkshire's arbitrage activities in 1988, which produced a nifty pre-tax gain was about $78 million on average invested funds of about $147 million (ho hum, a >50% return, just another day at the office). He reminisces about his 1954 cocoa bean arbitrage (part of Buffett lore which I won't bother repeating here--one can read about in the 1988 letter and in greater detail at this link). Buffett summarizes how risk arbitrage works thusly:
To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire--a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?
He then goes on to describe the Arcata Corp. arbitrage, which culminated in a huge payday in 1988, even though it began 7 years earlier. Basically it involved the value of a legal claim of the shareholders of Arcata against the government for an eminent domain taking. Based on the above 50%+ referenced arbitrage results in 1988, one would (correctly) guess that the legal claim paid off massively when it was finally decided:
The trial judge appointed two commissions, one to look at the timber’s value, the other to consider the interest rate questions. In January 1987, the first commission said the redwoods were worth $275.7 million and the second commission recommended a compounded, blended rate of return working out to about 14%. In August 1987 the judge upheld these conclusions, which meant a net amount of about $600 million would be due Arcata. The government then appealed. In 1988, though, before this appeal was heard, the claim was settled for $519 million. Consequently, we received an additional $29.48 per share, or about $19.3 million. We will get another $800,000 or so in 1989.
[Note that the original arbitrage investment had a cost basis of $23 million. Note also that the original $23 million was not tied up for the seven years it took to decide the eminent domain case, since Berkshire got this amount (plus a 7.4% profit) back in mid-1982 when the buyout of Arcata was consummated.]
DISPROVING THE EFFICIENT MARKET THEORY
Buffett also points out how his and Graham-Newman's arbitrage activities conclusively disprove the efficient market theory (or EMT):
The preceding discussion about arbitrage makes a small discussion of [the EMT] also seem relevant. This doctrine became highly fashionable--indeed, almost holy scripture--in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day. In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There’s plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire. Though I’ve not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben’s; he had 1929-1932 to contend with.) All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63- year record; (2) the results are not skewed by a few fortunate experiences; (3) we did not have to dig for obscure facts or develop keen insights about products or managements - we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identified universe - they have not been selected by hindsight. [emphasis added]
For the record, in 1988 Berkshire's stock was up over 59%, beating the market by nearly 43% (don't call it a comeback, Lil' Buffey never left!), Kirk Gibson heroically led the Dodgers over the As in the World Series in five games, the 49ers edged the Bengals 20-16 in Super Bowl XXIII and on October 5th Senator Lloyd Bentsen kindly informed a confused Senator Dan Quayle that he was in fact not JFK. Next up, 1989, the most recent year, when written in Roman numerals, to have an "L" (the next such year is 2040) (and no, I did not just make that up).