This is the thirteenth 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 1989 letter weighs in at 14,420 words, a 24% increase from 11,670 words the prior year. Berkshire's gain in net worth during 1989 was $1.515 billion, or 44% of beginning book value, up from a $569 million gain in 1988. Therefore 1989 represented the first year that net worth increased in excess of $1 billion for the company. This blog will cover all of the 1989 letter except the sections regarding the sections entitled "Zero Coupon Securities" and "Mistakes of the First 25 Years (A Condensed Version)" (to be covered in a subsequent blog).
COMPOUNDING $1 FOR 20 YEARS
In discussing Berkshire's deferred income tax line item on the balance sheet, Buffett demonstrates mathematically why compounding a single security is superior to compounding multiple securities sequentially at an identical CAGR--namely, because of the value of deferring tax payments:
Imagine that Berkshire had only $1, which we put in a security that doubled by yearend and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000. The sole reason for this staggering difference in results would be the timing of tax payments. Interestingly, the government would gain from Scenario 2 in exactly the same 27:1 ratio as we - taking in taxes of $356,500 vs. $13,000 - though, admittedly, it would have to wait for its money.
This math exercise can be extended as follows: the single fantastic investment that is held for 20 years can also be thought of as a disguised bond. If we assume that a security appreciates 15% per year on average during this timeframe, it would be the equivalent of owning a tax-exempt bond paying 15% coupons and into the principal of which the investor can reinvest all interest payments (alternatively, it is the equivalent of owning a re-investible taxable bond paying around 22%, i.e., 15% divided by 67%, assuming a 33% tax on interest payments). While virtually no sane investor would turn his or her nose up at a safe taxable bond paying 22% interest with a reinvestment privilege, investors often illogically prefer short-term trading or holding over owning truly outstanding compounding equities for decades. Admittedly, such equities are rare birds, but they are hardly impossible to find. Berkshire itself has been a 20% compounder over the past 50 years (thus identifying likely candidates for 15% compounders over the next 20 years is a much lower bar than identifying the next Berkshire).
One result of Buffett's math exercise, however, is that it produces the conclusion that buy-and-hold may not--from a mathematical expectation standpoint--necessarily produce the best returns. But by 1989 Buffett was rich and secure enough in his position at Berkshire to state that, well, he didn't care that much about obtaining the absolute highest possible returns:
We have not, we should stress, adopted our strategy favoring long-term investment commitments because of these mathematics. Indeed, it is possible we could earn greater after-tax returns by moving rather frequently from one investment to another. Many years ago, that's exactly what Charlie and I did. Now we would rather stay put, even if that means slightly lower returns. Our reason is simple: We have found splendid business relationships to be so rare and so enjoyable that we want to retain all we develop. This decision is particularly easy for us because we feel that these relationships will produce good--though perhaps not optimal--financial results.
INSURANCE UNDERWRITING AND THE UNDERWRITING OF INVESTMENTS
Buffett in discussing the suboptimal economics of the insurance industry (due to its commodity characteristics), makes the following point about how Berkshire approaches insurance underwriting generally:
We have no interest in writing insurance that carries a mathematical expectation of loss; we experience enough disappointments doing transactions we believe to carry an expectation of profit.... When rates carry an expectation of profit, we want to assume as much risk as is prudent.... [W]e simply don't care what earnings we report quarterly, or even annually, just as long as the decisions leading to those earnings (or losses) were reached intelligently.... This posture is one few insurance managements will assume. Typically, they are willing to write scads of business on terms that almost guarantee them mediocre returns on equity. But they do not want to expose themselves to an embarrassing single- quarter loss, even if the managerial strategy that causes the loss promises, over time, to produce superior results. We are willing to look foolish as long as we don't feel we have acted foolishly. [emphasis in original]
This principle can also be the underwriting of investments (although it rarely is). For example, an investor could restrict himself or herself to making only those investments that carry a "mathematical expectation of gain", preferably above a certain threshold. Yet how many investors, when making a stock purchase, ever reduce the decision to a mathematical expectation? Investments in any particular stock are made for various reasons, for instance because (i) the stock is going/has gone up recently, (ii) the stock is going/has gone down recently, (iii) the stock pays a dividend equal to X%, (iv) analysts recommend buying it, (iv) your neighbor made a large sum of money betting on it (e.g., TSLA), (v) your broker put you in it, (vi) it's part of an index and you are an index fund, (vi) the chart looks good, (vii) you have inside information, (viii) somebody wrote it up on an investing blog you happened to read, (ix) Cramer said it's a no-brainer, etc. None of these reduce the investment decision to one of a simple mathematical expectation of return ("I'm buying Ford at $13/share because it has a mathematical expectation of returning 15% per year (including dividends) before taxes over the next five years"), which is really the only rational and legal way to underwrite an investment. However, the fact that this approach is so rare is precisely the reason that markets often behave so irrationally.
To paraphrase the above Buffett quote, we would summarize intelligent investment underwriting as follows:
We have no interest in purchasing a stock at a price that carries a mathematical expectation of loss; we experience enough disappointments doing transactions we believe to carry an expectation of profit.... When stock prices generally carry an expectation of profit above 15% for a 5-year or longer time period, we want to invest as much as is prudent. We simply don't care the level of investment gains (or losses) we report quarterly, or even annually, just as long as the decisions leading to those gains (or losses) were reached intelligently. This posture is one few investors will assume. Typically, investors are willing to purchase stocks on terms that almost guarantee them mediocre returns. But they do not want to expose themselves to an embarrassing single-security loss, even if the strategy that causes the loss promises, over time, to produce superior results (in other words, the typical investor will prefer (whether consciously or unconsciously) a smooth 8% to a lumpy 15%).
CONVERTIBLE PREFERRED STOCK AND THE CIRCLE OF COMPETENCE
Buffett made the following remarks about the commitments Berkshire made in 1989 to the purchase of convertible preferred securities:
The proceeds from our bond sales, along with our excess cash at the beginning of the year and that generated later through earnings, went into the purchase of three convertible preferred stocks. In the first transaction, which took place in July, we purchased $600 million of The Gillette Co. preferred with an 8 3/4% dividend, a mandatory redemption in ten years, and the right to convert into common at $50 per share. We next purchased $358 million of USAir Group, Inc. preferred stock with mandatory redemption in ten years, a dividend of 9 1/4%, and the right to convert into common at $60 per share. Finally, late in the year we purchased $300 million of Champion International Corp. preferred with mandatory redemption in ten years, a 9 1/4% dividend, and the right to convert into common at $38 per share.... Gillette's business is very much the kind we like. Charlie and I think we understand the company's economics and therefore believe we can make a reasonably intelligent guess about its future. (If you haven't tried Gillette's new Sensor razor, go right out and get one.) However, we have no ability to forecast the economics of the investment banking business (in which we have a position through our 1987 purchase of Salomon convertible preferred), the airline industry, or the paper industry. [emphasis added]
It's interesting to note that of the four issues of converts that Berkshire purchased, two of the three that Buffett admits lay outside of his circle of competence (namely, USAir and Salomon) both proved to be near disasters. Below are relevant excerpts of contemporary news coverage, each mentioning Buffett's role as major company investor:
USAIR GROUP - From the Washington Post [source]:
USAIR GROUP FLIES INTO TURBULENCE - By Martha M. Hamilton September 3, 1990
"When the economy is growing, growth covers up a lot of sins."
Those words come from USAir Group Inc. Chairman Edwin I. Colodny, who has good reason lately to wish the economy were healthier.
After managing to build itself from a small regional airline into the country's sixth largest carrier, USAir is suffering through a year of record losses, layoffs and lower growth prospects.
The Arlington-based carrier announced last month that it plans to cut 3,600 jobs -- about 7 percent of its work force -- in what airline industry analysts said was likely to be the beginning of a round of major cost-cutting in the industry.
USAir's bumpy ride has been made worse by the costs of its merger one year ago with Piedmont Aviation Inc.
Just as the carrier was beginning to recover from service and operational problems that stemmed from that acquisition, along came a general plunge in the industry's profitability.
For USAir, the result was particularly dramatic: The company racked up losses of $63 million last year and $113 million in the first half of this year. Its stock has taken a nose dive along with its profit, dropping from a high of $54.75 the day before the merger to a low of $14.
For the first time, USAir's agenda is to minimize losses instead of planning for major expansion. As a result, the usually conservative airline finds itself in an unusual position -- looking like a trendsetter.
"I think they are doing something they had to do and that other folks are going to have to do," said Paul Turk of the aviation management firm Avmark Inc. "What's happening at USAir is just happening first."
Like other airlines, USAir has been hit by both dramatically rising fuel costs and intense fare competition that has made it hard to recoup increased costs. The slowdown in the economy has produced little or no growth in domestic airline traffic, leaving airlines with a choice of allowing expensive recently added airline capacity to fly empty or battling to fill seats with discount fares.
The whole airline industry is taking a pounding that may add up to a combined loss of $1 billion by the end of the year, according to the consulting firm Airline Economics.
In the case of USAir, however, the downturn has been particularly acute, in part because of the airline's mergers with Piedmont last year and Pacific Southwest Airlines the year before.
"Doing two mergers back to back in two years was a very difficult thing to do," Colodny said. "I guess we were guilty of assuming the economy was going to remain in a strong position while we did it."
But when the economy slowed instead, he said, "we had the timing problem of capturing the high cost of the mergers along with a slowdown in revenue and traffic growth."
USAir's difficulties also are compounded by regional recessions in most of its markets, intense competition on its West Coast routes, relentless discounting on the East Coast by bruised and financially ailing Eastern Air Lines, and a short-haul route structure that forces USAir to burn more fuel and absorb higher labor costs because of its frequent takeoffs and landings....
USAir also has delayed delivery of new aircraft and set a rapid schedule for eliminating some of its most costly, fuel inefficient Boeing 727s. Although the airline has a relatively large number of 727s, it has the second youngest fleet of any major airline, with an average aircraft age of 9.2 years.
As USAir struggles to slash costs, the airline has cut back flying at some hubs, including Dayton, Ohio, Syracuse, N.Y., and Baltimore-Washington International Airport, and has cut back the hours allocated to some of its 12 crew bases.
USAir also deferred the $27 million construction of a new maintenance facility in Tampa, which was planned in anticipation of expansion that has been postponed.
Some of the other savings are smaller: printing the company newspaper on newsprint instead of higher quality paper to save $100,000 a year and sending facsimiles with a stick-on label in place of a cover sheet, which the company expects to save it $200,000 a year.
"It blew my mind when I discovered we were not saving that amount of money when we should have been," Colodny said.
The company also is eliminating charitable contributions, which totaled $1.2 million last year, until better times.
The food-service budget has been under review for more than a year, but Colodny said the airline will look for savings that won't effect the quality of service.
The hardest costs to address are fuel and labor.
At the end of June, the carrier was paying 65.3 cents a gallon for jet fuel. Recently the cost of fuel went above 90 cents a gallon. Every penny increase in the cost of fuel adds $13 million to expenses at USAir, where the short-haul nature of its route system means higher fuel consumption because of the higher number of takeoffs and landings.
The airline is taking steps to save on fuel. In some markets, USAir is looking at using turbo-prop planes in place of jetliners. And pilots are sometimes taxiing with a single engine, a practice the FAA said does not compromise safety.
Although USAir and other major airlines imposed a 5.3 percent price increase on Aug. 30, many passengers were able to book flights at a discount before the increases took effect.
In any event, the 5.3 percent increase doesn't begin to recoup the higher fuel costs, industry officials said.
"We are caught between the twin Scylla and Charybdis" of high fuel costs and the in ability to raise fares enough to recover the fuel costs, Colodny said.
Labor costs also have had a major financial impact. Contract agreements designed to give former Piedmont and Pacific Southwest workers parity with their counterparts at USAir have boosted the carrier's labor costs to 4.13 cents per available seat mile, compared with 3.57 cents before the merger, making them among the highest in the industry.
Although Colodny said he wishes he had been able to persuade the airline's unions to adopt a slower approach to pay parity, providing equal pay "had to be done," he said.
The airline is in mediation in an attempt to reach a new contract with its flight attendants, in negotiations with the International Association of Machinists on a new contract and looking toward negotiations with its pilots next year.
USAir also faces the prospect of a renewed Teamsters organizing drive because of a National Mediation Board decision that a previous union representation election was invalid.
Labor relations at USAir, which have been considered unusually good for the industry, have grown a little testier, first from the merger and now from the layoffs.
"I think people might have felt this was coming, but the way USAir handled it was quite poor," said Dee Maki, president of the flight attendants union at USAir. Many people first heard about the layoffs from the press, she said. Now morale is "kind of down," Maki said. "Nobody likes to see anyone laid off."
Most of the furlough notices will have been received by the end of this week. Because USAir had hired rapidly in the last year in anticipation of expanding its hubs and beefing up cross country routes linking its East and West Coast systems, most of the workers hit by the layoff are either probationary workers or workers with less than a year's seniority.
In departments that deliver customer services, many of the cuts will be in management, rather than at the delivery end of the department, said Colodny.
With the layoffs announced, USAir's remaining workers should have a cloud of uncertainty removed, said Colodny. "We have no intention of further cuts. We think we've done what we need to do," Colodny said.
Colodny is as accessible as he always has been, though perhaps not as ebullient. He is, however, confident that the mergers were the right choices for USAir, he said. As for the timing -- well, Colodny said that depended on circumstances beyond USAir's control, such as how long it took the other two airlines to agree to the merger.
"If things are in a good posture," it is Colodny's intent to retire next summer when he turns 65, following the general practice for the company's executives. If the board asks him to stay on, or if things are not in a good posture, his decision "will have to be reviewed," he said.
Despite the losses, the airline is "in good shape, but not as good as it needs to be. It needs to get back to earning a profit," Colodny said, adding that it may be awhile. "I sure hope by 1992, we've got the economy turned around," he said.
"There will be an airline industry, and there will be carriers that prosper, and USAir will be among them," said one of the airline's major investors, Berkshire Hathaway Chairman Warren E. Buffett. "But it's not going to be in 1990."
SALOMON BROTHERS - From the NY Times [source]:
UPHEAVAL AT SALOMON; Salomon Is Punished by Treasury, Which Partly Relents Hours Later By KURT EICHENWALD Published: August 19, 1991
In an extraordinary action, the Treasury Department yesterday suspended Salomon Brothers Inc., one of Wall Street's biggest trading and investment houses, from bidding in Treasury auctions, because of the scandal involving the firm's illegal bidding in that market. But hours later, the department partly reversed itself after a personal appeal to Nicholas F. Brady, the Treasury Secretary, by Warren E. Buffett, who was named chairman and chief executive of the scandal-torn firm at a dramatic board meeting yesterday. Mr. Buffett's appeal, made during the course of several telephone calls yesterday, did not succeed, however, in stopping the department from limiting Salomon's role in the auctions until the scandal is fully investigated. While Salomon will be permitted to bid in the auctions for itself, the firm will not be allowed to place orders for clients, a move that will drive that business to the firm's competitors and prevent Salomon from examining customer sentiment to make its own investment decisions. The actions by the Treasury came as the scandal at Salomon appeared to widen further. Mr. Buffett disclosed yesterday that records of the firm had been altered by some executives in what appeared to be an attempted cover-up of the illegal bidding. He also said the firm had committed one additional violation of the bidding rules that had not been previously disclosed, by failing to count the purchase of Treasuries by a subsidiary.
Illegalities Admitted--Previously, Salomon had admitted illegally purchasing more than its allowed share of 35 percent at several Treasury auctions by submitting bids in customers' names without their approval. In addition, the firm said it had mistakenly purchased $1 billion worth of the securities as the result of a practical joke. The disclosures capped a weekend of rapid developments in the unfolding scandal. Mr. Buffett yesterday selected Deryk C. Maughan, a vice chairman who only came to the New York office from Tokyo last month, to run the daily operations and help restore the shaken confidence of the firm. The appointment was made because of a vacuum in leadership caused by the scandal. John W. Meriwether, a vice chairman who has long been thought a possible leader for the firm, informed Mr. Buffett on Saturday that he would resign. In doing so, he joined John H. Gutfreund, the chairman and chief executive who built the firm into a bond-trading powerhouse, and Thomas W. Strauss, the president and Mr. Gutfreund's protege, both of whom announced Friday that they would resign.
Board Accepts Resignations--The resignations of all three men, who were told of an illegal bid in April but failed to inform the Government until this month, were accepted by the board at yesterday's meeting. The board yesterday also dismissed two senior executives whose activities are at the heart of the scandal. They are Paul Mozer, the head of Salomon's government bond trading desk, and Thomas Murphy, a top aide to Mr. Moser. Late last night, executives with the firm continued meetings to name new heads of trading desks vacated as a result of the resignations and dismissals. The result of the management upheaval is that Salomon, the firm which built itself into a Wall Street powerhouse on the back of its trading prowess, will now for the first time in its history not have a trader as chairman. In addition to making sweeping management changes, Mr. Buffett said yesterday at a news conference that he saw his role as making sure the firm cleaned itself up. "The job we have is to come clean in an appropriate way with whatever regulatory authorities believe we may not have behaved in an appropriate way," Mr. Buffett said. "It is in our interest and it is certainly in the market's interest to find out what has been done."
Interim Changes in Procedure--The firm yesterday released a copy of interim changes to its Treasury auction procedure. The four-page, single-spaced document contains some surprising new rules; for example, the trading desk is now not permitted to withhold order confirmation slips to customers without written approval. At the news conference, Mr. Buffett disclosed a number of new details about the widening scandal. As part of the illegal bidding, records of the firm were altered by executives in what Mr. Buffett said he "would characterize as a cover-up" of the illicit transactions. Mr. Buffett said that none of the senior executives who resigned knew anything of the cover-up, adding that the firm was examining the role of the dismissed executives. Mr. Buffett said he did not have sufficient information to provide more details. But other executives with the firm said that order tickets, which are filled out after bids are placed, were altered in what appeared to be an effort to hide the scheme from Salomon's compliance department. In at least one additional violation of the rules, Mr. Buffett also disclosed that Phibro Energy, Salomon's oil refining and trading operation, had submitted a bid for $104 million of Treasury securities at the May auction, with that bid not being reported by the government bond trading desk as part of Salomon's full position. Mr. Buffett also provided new details about how Mr. Gutfreund and other executives first learned of the illegal bidding and about actions the firm took when it concluded there was something seriously wrong at the desk. While shedding more light on the episode, the additional details also created more questions, about the actions of both the firm and Government regulators. Mr. Gutfreund and two other senior executives learned of one illegal bid in April, Mr. Buffett said, when Mr. Mozer showed them a copy of a letter the Treasury had sent to a Salomon client asking about a bid the client was said to have made in the February auction. The bid turned out to have been entered by Salomon in the client's name but without that client's knowledge or request. Mr. Buffett added that, while the letter was not accusatory, "it was obviously going to lead to something if you answered it truthfully."
Questions on Letter--That information suggests that if the client told Treasury that it had not made such a bid, the Government could have known as early as April that something had gone wrong -- possibly even illegal bidding. Treasury Department officials did not offer further comment on the letter or say what they had learned from the client or even who the client was. Mr. Buffett's statements also raised new questions about actions taken by the firm in recent months and by its lawyers, Wachtell, Lipton, Rosen & Katz. The new chairman said that in early July, the firm was so concerned about questionable activities on its government trading desk that it hired Wachtell, Lipton to conduct an inquiry. Mr. Maughan said that Wachtell, Lipton was hired because "senior management had come to believe they were not getting the whole story" from its traders. Weeks of Silence Even as Salomon brought in lawyers to conduct the inquiry, it still apparently did not report these suspicions to regulators until weeks later, on Aug. 9, one day after it had participated in the Government's huge quarterly refinancing. It is not clear whether Wachtell, Lipton pressed Salomon to make a report any earlier. "Wachtell, Lipton's response was to report to senior management," Mr. Maughan said of the action by the law firm. A telephone call to Martin Lipton, a partner at the firm, was not returned late yesterday. All of the questions surrounding the Salomon scandal will be part of the investigations currently being conducted by the Government. In addition to the Treasury inquiry, civil and criminal investigations of the affair are being conducted by the Federal Reserve, the Securities and Exchange Commission and the Justice Department.
Impact on Bottom Line--But the action taken by Treasury yesterday, even though it was less severe than it might have been, will have an impact on the firm's bottom line. Stanley Shopkorn, a vice chairman at the firm, said the action would "make things a little more difficult" for the firm at Treasury auctions. "The less inquiries you see, the less flow you see," Mr. Shopkorn said, referring to market activity. "The less flow you see, the more you have to act on intuition." This additional obstacle to doing business will come as the very character of Salomon Brothers is put under a microscope by its new management. In his statements, Mr. Buffett made clear that there would be changes in the culture and character of Salomon Brothers perhaps as significant as those made by Mr. Gutfreund, who over the last decade molded the firm into one of the biggest, most successful and most aggressive investment banking houses on Wall Street.
'Macho and Cavalier'--Mr. Buffett said the scandal at Salomon, also known as one of the toughest and most arrogant financial firms, was in part fueled by what he described as the firm's "macho and cavalier" culture. "The culture did, in some way, contribute to a couple of people's behavior," he said, adding that he viewed changing that culture as an important part of his job. "I have seen cultures change," Mr. Buffett said, referring to other companies, adding that "the behavior and goals of the top people will have a lot to do with" a change at Salomon. Although Mr. Buffett said he had long admired Mr. Gutfreund, he made clear yesterday that he was extremely distressed by the actions of the former management. "The failure to report is, in my view, inexplicable and inexcusable," he said. Moreover, Mr. Buffett said that employees who did not understand that Salomon had entered a new era would be dealt with harshly. "If they don't get the message, and act in a way that is harmful to our goals, they will be out," Mr. Buffett said.
Painful Period Expected--Executives with other Wall Street firms predict that this is going to be a painful period for Salomon. A firm that has, by temperament and history, been led by traders, will now be under the control of a long-term investor and an investment banker. With Mr. Buffett holding his post on only an interim basis, much of the focus will be on Mr. Maughan, the new chief of operations. While Mr. Maughan has been seen as a rising star at the firm for more than a year, he has not yet had a chance to make much of an impression on Wall Street. Indeed, two senior Wall Street executives in administrative positions at other firms said yesterday that they could not comment on Mr. Maughan's appointment simply because they had never heard of him. But Mr. Maughan's colleagues, many of whom praised his appointment yesterday, had expected him to rise to the top. At his going-away party in Tokyo, when he was moving to New York to take over the investment banking job after many years in Japan, his coworkers joked that he should not worry about the change because he would be running the firm in two years.
Lesson = Bet on the horse, not the jockey.
[Remainder of the 1989 letter to be covered with Part 2 of this blog...]