This is the fifteenth 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 1991 letter weighs in at 9,130 words, a 43% decrease from 16,020 words the prior year. Notwithstanding this shrinkage, Berkshire's gain in net worth during 1990 was $2.1 billion, or 39.6% of beginning book value, rebounding nicely from a 7.4% increase the prior year. Buffett notes that, as of the date of the writing of the letter, Berkshire maintained a goal of attaining a 15% average annual increase in Berkshire's intrinsic value per year. Thus, if Berkshire's growth in book value were to keep up with a 15% pace, the company would need to earn $22 billion during the ensuing decade. It is interesting to note that in the first 9 months of 2016 alone, Berkshire generated $11 billion in net income, or half of the target for the entire decade of the 1990s.
Another interesting fact is that approximately 70% of the $2.1 billion gain in 1991 net worth came from just two investments, Berkshire's holdings of Coca-Cola and Gillette. This shows how critical to Berkshire's success Buffett's stock-picking skills were even as late as the early 1990s. Today there is almost no chance that public equity investments could move the needle this much for the company. To put it in perspective, Berkshire's shareholder equity as of September 30, 2016 stood at $273 billion, versus just $5.3 billion at the beginning of 1991. Thus, book value is now over 50X greater, meaning that in order to achieve the same effect on Berkshire's book value in 2017 as the Coke and Gillette holdings had in 1991, Berkshire's stock portfolio would need to increase in value by $77 billion this year. Note that there is only a small universe of perhaps 100 or so public companies that even have a market cap of $77 billion or higher. Assuming realistically that [A] Berkshire would need to make a minimum $15 billion investment to really move the needle [or 5.5% of the most recent book value] and [B] the most Berkshire could buy in any single company would be 10% of the available public float, this means that Buffett is pretty much restricted to choosing from the 38 companies [other than Berkshire] that have market caps of $150 billion or higher [note that Berkshire already has large stakes in five of these, namely Apple, IBM, Bank of America, Wells Fargo and Coke]--the pool from which Buffett can choose has dramatically shrunken over the years.
A PORTFOLIO'S 'LOOK-THROUGH' EARNINGS
Buffett further discusses Berkshire's so-called 'Look Through' Earnings in the 1991 letter. These are the actual earnings of an investor's investee companies multiplied by such investor's percentage ownership interest in each such investee. Thus, if one owns 1% of Company A, and Company A's net income for the applicable year is $1 million, then one's 'look-through' earnings attributable to his or her ownership of Company A stock would be $10,000 [i.e., $1 million multiplied by 0.01]. One could calculate the 'look-through' earnings for each stock in one's portfolio for any given year and compare the total to the aggregate 'look-through' earnings for prior years. This would focus an investor's attention not on arbitrary and constantly fluctuating stock quotes, but rather on the actual operating performance of such person's investee companies. Of course, it would be necessary to take into consideration whether any truly unusual or extraordinary items skewed the results for any particular year, but this should theoretically give an investor a much better means of tracking the actual economic performance of his or her portfolio over time. Virtually no investors that I am aware actually do this, instead preferring to let the market be the judge of whether such investor's holdings are performing or not. But why outsource to a virtual opinion poll [the stock market] when one can actually review the hard numbers by spending a little time preparing an Excel file [showing 'look-through' earnings].
Buffett further explains this concept in the 1991 letter as follows...
We also believe that investors can benefit by focusing on their own look-through earnings. To calculate these, they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these. The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the highest possible look-through earnings a decade or so from now. An approach of this kind will force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results. It's true, of course, that, in the long run, the scoreboard for investment decisions is market price. But prices will be determined by future earnings. In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard.
DEFINING 'BUSINESSES' VERSUS 'FRANCHISES'
Buffett goes on to make a distinction between a 'business' and a 'franchise', with the latter being qualitatively superior to the former [and, hence, entitled to a higher valuation]...
An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage. In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.
One would clearly label Google's principal search business as a franchise, as it is needed, has no close substitute [sorry, Bing, you just aren't good enough] and is not subject to price regulation. Unsurprisingly, Google's economic performance has been stellar ever since it went public in the early 2000s. One would also clearly label Exxon's operations a business, because although oil and gas is obviously needed and not subject to price regulation, it is unfortunately undifferentiated [nobody cares whether they buy oil from Exxon versus any other oil producer, they simply want the lowest price]. However, Exxon has prospered as a business over the years since it possesses competitive advantages due to its massive scale and vertically integrated structure.
Buffett states that a franchise's superior valuation derives from its ability to consistently increase earnings year after year. Thus, if over the long term one expects a franchise to grow its earnings at a 6% CAGR and one discounts this earnings stream back to a net present value [NPV] using a 10% discount rate, then the proper multiple to apply to the most recent 'normalized' earnings of the company would be 25X [1 divided by 4% [i.e., 10% minus 6%]]. Conversely, if over the long term one expects a business [as opposed to a franchise] to have earnings that 'bob around' a certain level [never straying too far away from that level over time] and one discounts this earnings stream back to an NPV using a 10% discount rate, then the proper multiple to apply to the most recent 'normalized' earnings of this company would be 10X [1 divided by 10%]. Theoretically, then, a 50X multiple could be justified for a truly great franchise if one could realistically predict an 8% earnings growth CAGR over the long term [50 = 1 divided by 2% [10% minus 8%]]; a business that can grow its earnings at this pace for decades, however, would truly be a rare find.
To take one example of a company thought to possess a great franchise [at least in retrospect], Coca-Cola, in 1991 the company earned $1.62 billion in net income on $11.6 billion of revenues. By 2016, Coke increased its net income to $6.51 billion on revenues of $41.8 billion, representing CAGRs of 5.7% and 5.3%, respectively [of course, actual EPS has gone up more than 5.7% per annum due to share repurchases]. In addition, dividends have increased from a split-adjusted $0.12/share with a payout ratio of 40% to today's level of $1.40/share with a payout ratio of 94%, representing a CAGR of 10% [this CAGR is higher than the CAGR for actual net income due to the substantial increase in the payout ratio, as well as share repurchases]. If one believes that Coca-Cola retains the ability to continue this type of performance over the next 25 years, one would logically apply to the company a multiple of around 23X [1 divided by 4.3% [or 10% minus 5.7%]]. In fact, KO currently trades at 28X last year's actual EPS of $1.49/share and 22X last year's supposed 'adjusted' or 'comparable' EPS of $1.91/share. Thus it appears that either the market is crediting the 'comparable' EPS number as the company's 'real' economic earnings [versus the lower GAAP EPS number] and/or it is applying a discount rate below 10% to the future expected earnings stream, perhaps because it expects generally lower prevailing interest rates over the next 25 years versus the prior 25 years. For example, if the market only expects 3% earnings growth for KO instead of 5.7%, but settles on a discount rate of 7% instead of 10% due to 3% lower expected interest rates in the future, then the proper multiple of 'earnings' [whether GAAP or non-GAAP] should still be 25X [1 divided by 4% [7% minus 3%]]. Thus it appears that a company could conceivably evolve from a 'franchise' to a mere 'business' without any shrinkage in its P/E multiple, due to declining interest rates. Conversely, a company could see its P/E multiple shrink even as it widens its competitive moat if market participants adjust their views regarding future interest rates to higher expected levels [something that happened in the 1970s, when P/E multiples shrank drastically across the board].
EVEN G.O.A.T.S MAKE MISTAKES - THE H.H. BROWN PURCHASE
In the 1991 letter Buffett proudly described Berkshire's purchase of the H.H. Brown shoe company, a purchase which seemed to hinge more than anything else on Buffett's appreciation of the CEO rather than the underlying business...
We made a sizable acquisition in 1991--the H. H. Brown Company. Frank [Rooney, the CEO of H.H. Brown, was previously] CEO of Melville Shoe (now Melville Corp.). During his 23 years as boss, from 1964 through 1986, Melville's earnings averaged more than 20% on equity and its stock (adjusted for splits) rose from $16 to $960. And a few years after Frank retired, Mr. Heffernan [former head of H.H. Brown], who had fallen ill, asked him to run Brown. After Mr. Heffernan died late in 1990, his family decided to sell the company--and here we got lucky. I had known Frank for a few years but not well enough for him to think of Berkshire as a possible buyer. He instead gave the assignment of selling Brown to a major investment banker, which failed also to think of us. But last spring Frank was playing golf in Florida with John Loomis, a long-time friend of mine as well as a Berkshire shareholder, who is always on the alert for something that might fit us. Hearing about the impending sale of Brown, John told Frank that the company should be right up Berkshire's alley, and Frank promptly gave me a call. I thought right away that we would make a deal and before long it was done.
Brown (which, by the way, has no connection to Brown Shoe of St. Louis) is the leading North American manufacturer of work shoes and boots, and it has a history of earning unusually fine margins on sales and assets. Shoes are a tough business--of the billion pairs purchased in the United States each year, about 85% are imported--and most manufacturers in the industry do poorly. The wide range of styles and sizes that producers offer causes inventories to be heavy; substantial capital is also tied up in receivables. In this kind of environment, only outstanding managers like Frank and the group developed by Mr. Heffernan can prosper.
Fast forward to last May and we find an article attempting to trace the ultimate fate of H.H. Brown, which seems to have disappeared into the larger Berkshire Hathaway corpus with virtually no remaining trace today...
Dexter, which Buffett later called his worst purchase, closed factories in ensuing years and was later folded into H.H. Brown, as was Lowell, now going by the name Sofft. In 2001 the shoe businesses [of Berkshire] incurred a $46 million loss... Since then, shoes have been discussed sporadically in Buffett’s letter[s], mostly in reference to Brooks. No one knows what H.H. Brown, maker of Carolina work boots and Nurse Mates nursing shoes, contributes to earnings or soaks up in capital. “Buffett has held some of these companies for a long time,” said Russ Kaplan, chief of Omaha’s Russ Kaplan Investments, a value investing shop modeled on the style Buffett learned in the 1950s at Columbia University from professor Ben Graham. “Perhaps some of it is nostalgia.”
ONCE AGAIN--IT'S GREAT BUSINESSES, STUPID
Picking up again on the thread that runs throughout his letters regarding his preference for concentrating his funds in exemplary businesses with exemplary managers, Buffett in the 1991 letter explains exactly what to look for and how to look for it...
We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-oriented managements. This focus doesn't guarantee results: We both have to buy at a sensible price and get business performance from our companies that validates our assessment. But this investment approach--searching for the superstars--offers us our only chance for real success. Charlie and I are simply not smart enough, considering the large sums we work with, to get great results by adroitly buying and selling portions of far-from-great businesses. Nor do we think many others can achieve long-term investment success by flitting from flower to flower. Indeed, we believe that according the name "investors" to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic. If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long- term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products? (I was tempted to say "the real thing.") Our motto is: "If at first you do succeed, quit trying." John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F. C. Scott, on August 15, 1934 that says it all: "As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. . . . One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence." [emphasis added]
So, Rule 1 of investing is to search for great businesses with great managers. Rule 2 is if you deviate from Rule 1, you will end up feeling pretty stupid. Got it? Good.
For the record, in 1991 Berkshire's stock was up 36%, beating the market by 5%, the Twins beat the Braves in the World Series in seven games [with Jack Morris pitching a 10-inning shutout in the final game], the Redskins stomped the Bills 37-24 in Super Bowl XXVI and on February 28th the first Gulf War officially ended. Next up, 1992, the year the first President Bush had a pretty downright embarrassing incident in Japan [long live Wikipedia].