This is the sixteenth 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 1992 letter weighs in at 11,200 words, a 23% increase from 9,130 words the prior year. Berkshire's gain in net worth during 1992 was $1.5 billion. Very little dilution accompanied the 377X increase in book value during the 28 years that Buffett had then been at the helm of Berkshire [which equates to a CAGR of 23.6%]. In fact, as Buffett notes, Berkshire's shares outstanding had only risen from 1,137,778 to 1,152,547 during that timeframe, or 1.3% in total.
LONG-TERM VERSUS SHORT-TERM THINKING
Unlike most commentators, who opine that only long-term thinking is desirable in capital allocation, Buffett clarifies that what was considered 'long-term' several years ago becomes 'long-term' eventually, in which case it is desirable to apply the measuring stick to today's results...
We do not, however, see this long-term focus as eliminating the need for us to achieve decent short-term results as well. After all, we were thinking long-range thoughts five or ten years ago, and the moves we made then should now be paying off. If plantings made confidently are repeatedly followed by disappointing harvests, something is wrong with the farmer. (Or perhaps with the farm: Investors should understand that for certain companies, and even for some industries, there simply is no good long-term strategy.) Just as you should be suspicious of managers who pump up short-term earnings by accounting maneuvers, asset sales and the like, so also should you be suspicious of those managers who fail to deliver for extended periods and blame it on their long-term focus. (Even Alice, after listening to the Queen lecture her about "jam tomorrow," finally insisted, "It must come sometimes to jam today.")
Thus, a capital allocator [whether a CEO or a portfolio manager] who consistently encourages those to whom he has a fiduciary duty to ignore recent poor financial results as being not sufficiently 'long-term' [and hence irrelevant as a yardstick against which to judge his or her performance] is just as guilty as one who consistently sacrifices long-term results for short-term gains. Yet in the financial press only the latter is typically called out as a bogeyman.
GROWTH INVESTING VERSUS VALUE INVESTING
Continuing to pop the balloons of conventional investing wisdom, Buffett goes on in the 1992 letter to discuss the commonly invoked dichotomy between so-called 'growth' investing and 'value' investing. He dismisses this as a distinction without a difference, since growth is always a determinant of value. The real dichotomy in Buffett's mind is not growth versus value, rather it is 'investing' [however labelled] versus 'speculation'...
In our opinion, the two approaches [of growth and value investing] are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value--in the hope that it can soon be sold for a still-higher price--should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).
The key to stock-picking, in Buffett's view, is selecting those securities that offer the highest expected present value of future cash flows versus the purchase price paid, and it doesn't matter whether these represent the common equity of low-growth old-economy 'smokestack' companies or senior secured bonds issued by the latest tech fads...
In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future "coupons." Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity "coupons." The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought. Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases. Though the mathematical calculations required to evaluate equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons." At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes. Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.
STOCK COMPENSATION IS DEFINITELY, CERTAINLY, NO-DOUBT-ABOUT-IT AN EXPENSE
Returning to a theme voiced in prior letters, Buffett engages in a relatively lengthy dissertation on why stock options granted to management are actual costs that should be deducted in the company's income statement. Previously, the business community had been relatively successful in excluding these obvious costs from the financial statements [which of course made the financials look better than they otherwise would have appeared]. Finally, the standards setters for GAAP rules closed this loophole, with Buffett's applause...
It seems to me [i.e, Buffett] that the realities of stock options can be summarized quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go? The accounting profession and the SEC should be shamed by the fact that they have long let themselves be muscled by business executives on the option-accounting issue. Additionally, the lobbying that executives engage in may have an unfortunate by- product: In my opinion, the business elite risks losing its credibility on issues of significance to society - about which it may have much of value to say - when it advocates the incredible on issues of significance to itself.
For the record, in 1992 Berkshire's stock was up 30%, beating the market by 22%, the Blue Jays beat the Braves in the World Series in six games, the Cowboys demolished the Bills 52-17 in Super Bowl XXVII and on May 18th the 27th Amendment to the Constitution, which was initially proposed way back in 1789, was enacted--representing the most recent amendment enacted up until the present. Next up, 1993, the first year of the Bill Clinton era [and a hugely explosive, perhaps even 'irrationally exuberant', stock market].