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Berkshire 1995 Shareholder Letter - Cliff's Notes Version

March 17, 2017

This is the nineteenth 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 1995 letter weighs in at 11,900 words, a 24% increase from 9,600 words the prior year. Berkshire's gain in net worth during 1995 was $5.3 billion, or 45% of beginning 1994 net worth.

 

MORE ON WHY ACQUISITIONS DESTROY ACQUIRERS' SHAREHOLDERS' WEALTH

 

Buffett in the 1995 letter explains how it is that intelligent acquirers often make incredibly foolish acquisitions. Basically it has to do with [1] the market they are choosing to play in [buying companies in negotiated transactions, where it is unlikely a seller will rashly or foolishly sell at too low a price], [2] the institutional imperative [some companies, for example AT&T, have entire divisions within their corporate ranks devoted to mergers and acquisitions, and to a man with a hammer everything tends to look like a nail], and [3] good ole animal spirits [CEOs tend to rise to the top of the corporate ladder due to this trait, which naturally leads to the desire to expand their empires]. Buffett expounds on this topic as follows....

 

In any case, why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, but instead keep in mind the story of the man with an ailing horse. Visiting the vet, he said: "Can you help me? Sometimes my horse walks just fine and sometimes he limps." The vet's reply was pointed: "No problem - when he's walking fine, sell him." In the world of mergers and acquisitions, that horse would be peddled as Secretariat. At Berkshire, we have all the difficulties in perceiving the future that other acquisition-minded companies do. Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale - a time when the business is likely to be walking "just fine." Even so, we do have a few advantages, perhaps the greatest being that we don't have a strategic plan. Thus we feel no need to proceed in an ordained direction (a course leading almost invariably to silly purchase prices) but can instead simply decide what makes sense for our owners. In doing that, we always mentally compare any move we are contemplating with dozens of other opportunities open to us, including the purchase of small pieces of the best businesses in the world via the stock market. Our practice of making this comparison - acquisitions against passive investments - is a discipline that managers focused simply on expansion seldom use. Talking to Time Magazine a few years back, Peter Drucker got to the heart of things: "I will tell you a secret: Dealmaking beats working. Dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work . . . dealmaking is romantic, sexy. That's why you have deals that make no sense." [emphasis added]

 

It seems that the shareholders of many public companies would be much better off if their management teams were to at least partially focus on acquiring stock of other companies on the open market, instead of solely attempting negotiated acquisitions. If it has worked at Bershire, there is no reason it couldn't work equally somewhere else. Perhaps poison pills and other entrenchment tactics are simply to prevalent today, which, despite their supposed rationales ['shareholder rights' plans, etc] hardly seem beneficial for public company stockholders. 

 

THE PERILS OF RETAILING

 

Buffett also issues a warning for those interested in investing in retail companies, indicating that most retailers have no real competitive moat - Buyer Beware...

 

Retailing is a tough business. During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy. This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses. In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants. In retailing, to coast is to fail. In contrast to this have-to-be-smart-every-day business, there is what I call the have-to-be-smart-once business. For example, if you were smart enough to buy a network TV station very early in the game, you could put in a shiftless and backward nephew to run things, and the business would still do well for decades. You'd do far better, of course, if you put in Tom Murphy, but you could stay comfortably in the black without him. For a retailer, hiring that nephew would be an express ticket to bankruptcy. [emphasis added]

 

GEICO MERGER

 

GEICO certainly appears to fall into the have-to-be-smart-once business category. The company at its outset came up with the business model of direct selling to policyholders, instead of selling through agents. This caused GEICO's costs to come in well below those of other insurance companies, which has proven to be an enduring competitive advantage, or moat around its corporate castle. Buffett relates his history with GEICO as follows...

 

You may think this odd, but I have kept copies of every tax return I filed, starting with the return for 1944. Checking back, I find that I purchased GEICO shares on four occasions during 1951, the last purchase being made on September 26. This pattern of persistence suggests to me that my tendency toward self-intoxication was developed early. I probably came back on that September day from unsuccessfully trying to sell some prospect and decided - despite my already having more than 50% of my net worth in GEICO - to load up further. In any event, I accumulated 350 shares of GEICO during the year, at a cost of $10,282. At yearend, this holding was worth $13,125, more than 65% of my net worth. You can see why GEICO was my first business love. Furthermore, just to complete this stroll down memory lane, I should add that I earned most of the funds I used to buy GEICO shares by delivering The Washington Post, the chief product of a company that much later made it possible for Berkshire to turn $10 million into $500 million. Alas, I sold my entire GEICO position in 1952 for $15,259, primarily to switch into Western Insurance Securities. This act of infidelity can partially be excused by the fact that Western was selling for slightly more than one times its current earnings, a p/e ratio that for some reason caught my eye. But in the next 20 years, the GEICO stock I sold grew in value to about $1.3 million, which taught me a lesson about the inadvisability of selling a stake in an identifiably-wonderful company.

 

GEICO, of course, must continue both to attract good policyholders and keep them happy. It must also reserve and price properly. But the ultimate key to the company's success is its rock-bottom operating costs, which virtually no competitor can match. In 1995, moreover, Tony and his management team pushed underwriting and loss adjustment expenses down further to 23.6% of premiums, nearly one percentage point below 1994's ratio. In business, I look for economic castles protected by unbreachable "moats." Thanks to Tony and his management team, GEICO's moat widened in 1995.

 

Later in the 1995 letter Buffett makes following prediction regarding GEICO's amount and cost of float...

 

Our acquisition of GEICO will immediately increase our float by nearly $3 billion, with additional growth almost certain. We also expect GEICO to operate at a decent underwriting profit in most years, a fact that will increase the probability that our total float will cost us nothing. Of course, we paid a very substantial price for the GEICO float, whereas virtually all of the gains in float depicted in the table were developed internally.

 

Indeed, on page 33 of Berkshire's 2016 Form 10-K we find that GEICO registered a pre-tax underwriting gain of $462 million during the year on a massively larger float.

 

BUYING A BASKET VERSUS BUYING A SINGLE SECURITY

 

Finally, in the 1995 letter Buffett lists the results of a basket of preferred securities he had purchased for Berkshire during the prior decade, as follows...

 

Company                           Dividend Rate   Year Purchased    Cost      Market Value ($ in millions)

Champion Int'l                            9 1/4%               1989              $300            $388(1)

First Empire State Corp.             9%                     1991                40               110

The Gillette Company                8 3/4%               1989                600            2,502(2)

Salomon Inc                                 9%                     1987              700               728(3)

USAir Group, Inc.                         9 1/4%              1989               358               215

 

(1) Proceeds from sale of common received through conversion in 1995.

(2) 12/31/95 value of common received through conversion in 1991.

(3) Includes $140 received in 1995 from partial redemption.

 

What is interesting about this table it that there was a single huge winner, Gillette, whereas the other four investments were collectively mediocre at best, with an aggregate cost of $1.398 billion and an aggregate fair value of $1.441 billion at year-end 1995, representing just a 3 percent overall gain. This shows that in investing it is usually better to concentrate on one's best ideas than to 'spread things around' to decrease risk. After all, if risk is properly defined as 'not knowing what you are doing', then diversification actually increases risk, since it requires putting money into ideas one knows less about than one's best idea. Even back in 1989, it is inconceivable that Buffett thought that the Champion and USAir investments were as attractive on a relative basis as the Gillette investment--yet, most likely in the name of diversification, he put money into these two inferior choices rather than concentrating everything into his best idea [note that he could have simply bought more Gillette common shares as well]. 

 

CONCLUSION

 

For the record, in 1995 Berkshire's stock was up 57%, beating the market by 20%, the Braves beat the Indians in the World Series in six games, the Cowboys topped the Steelers 27-17 in Super Bowl XXX and on October 16th the Million Man March was held in Washington DC. Next up, 1996, the year the world said hello to Major League Soccer and goodbye to 100-year-old George Burns.

 

 

 

 

 

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