This is the seventeenth 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 1993 letter weighs in at 11,030 words, a 1.5% increase from 11,200 words the prior year. Berkshire's gain in net worth during 1993 was $1.5 billion, or 14% of beginning 1993 net worth. During 1993 Berkshire issued 25,203 shares of stock for consideration of $478 million, or about $16,400 per share. Today those shares would be worth $263,200 each, or about 16X greater than in 1993. This means that the shares issued in 1993 have appreciated by approximately 12.5% per annum. Clearly, Berkshire's shareholders would have been better off if the company had raised the $478 million via debt offerings instead of stock offerings [or if the company could just have run a bit lower on cash for awhile]. Interestingly, Buffett in the 1993 letter reiterates his and Charlie Munger's goal of increasing Berkshire's intrinsic value by 15% per year; this means that they have either [x] failed to achieve their goal in the 24 years since then or [y] they have achieved their goal but Berkshire was somewhat overvalued in 1993 and/or somewhat undervalued today. Given that the stock price has appreciated by 21% per annum overall since 1964, whether intrinsic value has grown at 12.5% or 15% over the past quarter century doesn't change the fact that its growth rate has gone down dramatically since the first two decades of Buffett's stewardship [of course, Buffett predicted repeatedly that size would be an anchor on returns and time has proven him to be 100% correct on this point].
DEXTER SHOE - A POST-MORTEM
Buffett decided in 1993 to buy a company called Dexter Shoe of Dexter, Maine, which manufactured popular-priced men's and women's shoes. Of the purchase, Buffett confidently asserted that 'Dexter, I can assure you, needs no fixing: It is one of the best-managed companies Charlie and I have seen in our business lifetimes.' Buffett also made the following predictions regarding Berkshire's shoe manufacturing operations...
In 1994, we expect Berkshire's shoe operations to have more than $550 million in sales, and we would not be surprised if the combined pre-tax earnings of these businesses topped $85 million. Five years ago we had no thought of getting into shoes. Now we have 7,200 employees in that industry, and I sing "There's No Business Like Shoe Business" as I drive to work. So much for strategic plans.
So...how did the 'no business like shoe business' tagline work out? Pretty well, at least for one year, as in 1994 this business indeed made $85.5 million in pre-tax earnings. However, by 1995 this number had slipped to $58 million, with Buffett commenting as follows...
Our shoe business operated in an industry that suffered depressed earnings throughout last year, and many of our competitors made only marginal profits or worse. That means we at least maintained, and in some instances widened, our competitive superiority. So I have no doubt that our shoe operations will climb back to top-grade earnings in the future. In other words, though the turn has not yet occurred, we believe you should view last year's figures as reflecting a cyclical problem, not a secular one. [emphasis added]
In 1996, Berkshire's shoe business earned $62 million pre-tax, a marginal improvement over the prior year, but in 1997 this figure dropped to $49 million, in 1998 it dropped to $33 million and in 1999 it dropped even further to $17 million. By this point Buffett was no longer in the 'no doubt things will be fine' category, as he states in the 1999 shareholder letter...
Almost all of our manufacturing, retailing and service businesses had excellent results in 1999. The exception was Dexter Shoe, and there the shortfall did not occur because of managerial problems: In skills, energy and devotion to their work, the Dexter executives are every bit the equal of our other managers. But we manufacture shoes primarily in the U.S., and it has become extremely difficult for domestic producers to compete effectively. In 1999, approximately 93% of the 1.3 billion pairs of shoes purchased in this country came from abroad, where extremely low-cost labor is the rule.
Counting both Dexter and H. H. Brown, we are currently the leading domestic manufacturer of shoes, and we are likely to continue to be. We have loyal, highly-skilled workers in our U.S. plants, and we want to retain every job here that we can. Nevertheless, in order to remain viable, we are sourcing more of our output internationally. In doing that, we have incurred significant severance and relocation costs that are included in the earnings we show in the table.
By 2001 Berkshire's shoe operations were losing significant amounts of money and Buffett had to issue the following mea culpa....
Our shoe operations (included in "other businesses") lost $46.2 million pre-tax, with profits at H.H. Brown and Justin swamped by losses at Dexter. I've made three decisions relating to Dexter that have hurt you in a major way: (1) buying it in the first place; (2) paying for it with stock and (3) procrastinating when the need for changes in its operations was obvious. I would like to lay these mistakes on Charlie (or anyone else, for that matter) but they were mine. Dexter, prior to our purchase - and indeed for a few years after - prospered despite low-cost foreign competition that was brutal. I concluded that Dexter could continue to cope with that problem, and I was wrong.
We have now placed the Dexter operation - which is still substantial in size - under the management of Frank Rooney and Jim Issler at H.H. Brown. These men have performed outstandingly for Berkshire, skillfully contending with the extraordinary changes that have bedeviled the footwear industry. During part of 2002, Dexter will be hurt by unprofitable sales commitments it made last year. After that, we believe our shoe business will be reasonably profitable.
By the 2015 letter Buffett mentions that the entire Dexter operation had at some point been shut down and its employees laid off, due to relentless foreign competition...
When low-cost competition drove shoe production to Asia, our once-prosperous Dexter operation folded, putting 1,600 employees in a small Maine town out of work. Many were past the point in life at which they could learn another trade. We lost our entire investment, which we could afford, but many workers lost a livelihood they could not replace. The same scenario unfolded in slow-motion at our original New England textile operation, which struggled for 20 years before expiring. Many older workers at our New Bedford plant, as a poignant example, spoke Portuguese and knew little, if any, English. They had no Plan B. [emphasis added]
So, in the end, Buffett issued 25,203 shares of Berkshire A stock for a company that eventually vanished completely, and which likely produced operating losses overall during the period Berkshire owned it. Meanwhile, the Berkshire shares issued to the former owners of Dexter in 1993 are today worth over $6.6 billion In essence, the sellers of Dexter Shoe made one of the greatest trades in stock market history. This discussion is included not to bash Buffett, since his overall record is obviously phenomenal, unmatched in the history of investing. Rather, it is included to demonstrate that [A] turnarounds seldom 'turn', [B] it can be disastrous to issue shares in an acquisition context if the target's shares are overvalued and the acquirer's shares undervalued [and the consequences of this problem only grow worse over time], [C] when in a leaking boat, effort is better directed at changing boats than fixing leaks, [D] the inherent quality of the business is more important than the inherent quality of management [or 'bet the horse, not the jockey'], and [E] even the greatest investors can make major capital allocation mistakes from time to time [note that at the point Buffett invested in Dexter, he had already racked up 50 years worth of investing experience].
A LESSON IN COMPOUNDING AND TAXES
Buffett includes a story about cartoon character L'il Abner to illustrate the superiority of making one great long-term investment versus a number of great short-term investments. If, every year, one can pick a stock that will double that year but not appreciate any further, this person [assuming he or she sells each such stock at the end of the applicable year] would need to do this for 27.5 consecutive years in order to turn $1 into $1 million [assuming a 35% tax rate, which is an approximation of the short-term capital gains tax rate applicable to such person's gains at the end of each year]; however, if the same person were to buy and hold a single investment that doubled every year, after the same 27.5 years this investment would be worth $200 million pre-tax or, after paying a $40 million tax in the final year [assuming a 20% long-term capital gains tax rate], about $160 million after-tax. So the long-term investor would be 160X better off than the equally-skilled short-term investor, all because of the effect of deferring capital gains taxes.
Examining the difference in compounding individual yearly investments at just 15% versus a single long-term investment that compounds at 15% annually, we find that, after capital gains taxes, the former would produce a 6.4X overall return [or a CAGR of 9.7%] over 20 years, while the latter would produce a 13.1X overall return [or a CAGR of 13.7%]. To put it another way, the short-term investor would actually need to consistently find investments with an expected return of 21% [or 13.7% divided by 0.65] just to equal the after-tax CAGR of the long-term investor who underwrites with an expected return of 15%. So the question would be whether it is easier to find many short-term [under 1 year] investments with expected IRRs over 20% versus just a few long-term investments with expected IRRs of approximately 15%. Given the fact that most investors appear to be hyper-focused on short-term events, it would seem that the latter category would be more fruitful than the former.
Buffett sums things up as follows...
What this little tale tells us is that tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate. But I suspect many Berkshire shareholders figured that out long ago.
PART TWO OF BLOG POST
The second part of this blog post regarding the 1993 letter [to be posted separately] will focus on Buffett's discussion regarding [A] the proper definition of 'risk' in equity investments and what level of diversification is appropriate given this definition and [B] corporate governance.