Berkshire 1996 Shareholder Letter - Cliff's Notes Version
This is the twentieth 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 1996 letter weighs in at 11,600 words, a 2.5% decrease from 11,900 words the prior year. Berkshire's gain in net worth during 1995 was $6.2 billion, or 36% of beginning 1995 net worth.
MUTUAL FUND FEES AND CORPORATE OVERHEAD COSTS - A TAX ON INVESTORS
Buffett in the 1996 letter points out why an investor should pay close attention to corporate fees and expenses, whether in the form of management fees for a mutual fund or in the form of general corporate overhead expenses for an individual stock holding. These fees and expenses siphon off money that would otherwise go to investors. He notes that Berkshire's after-tax headquarters expense amounted to less than two basis points (1/50th of 1%) measured against net worth during 1996, a shockingly low number. In comparison, if one adds up the compensation for 2015 for just the top five executives of GE, this totals over $75 million [per page 36 of GE's 2016 proxy statement], or ten basis points of GE's December 31, 2016 shareholders equity, a full 5X Berkshire's ratio for its entire HQ. Interestingly, GE trailed the S&P 500 by 84% in aggregate over the past 10 years. Perhaps it's no coincidence.
Buffett summarizes the main point as follows...
[C]osts matter. For example, equity mutual funds incur corporate expenses - largely payments to the funds' managers - that average about 100 basis points, a levy likely to cut the returns their investors earn by 10% or more over time. Charlie and I make no promises about Berkshire's results. We do promise you, however, that virtually all of the gains Berkshire makes will end up with shareholders. We are here to make money with you, not off you.
GEICO'S LOW-COST "VIRTUOUS CIRCLE"
Buffett goes on to explain the secret sauce of GEICO's success, which has continued in the 20 years since the 1996 letter was issued, as follows...
There's nothing esoteric about GEICO's success: The company's competitive strength flows directly from its position as a low-cost operator. Low costs permit low prices, and low prices attract and retain good policyholders. The final segment of a virtuous circle is drawn when policyholders recommend us to their friends. GEICO gets more than one million referrals annually and these produce more than half of our new business, an advantage that gives us enormous savings in acquisition expenses - and that makes our costs still lower.... GEICO's growth would mean nothing if it did not produce reasonable underwriting profits. Here, too, the news is good: Last year we hit our underwriting targets and then some. Our goal, however, is not to widen our profit margin but rather to enlarge the price advantage we offer customers. We expect new competitors to enter the direct-response market, and some of our existing competitors are likely to expand geographically. Nonetheless, the economies of scale we enjoy should allow us to maintain or even widen the protective moat surrounding our economic castle. [emphasis added]
Thus we find that a company that has the lowest costs can offer customers the best deal. And the company that offers customers the best deal delights such customers, who spread the news by word-of-mouth advertising. Of course, this kind of advertising is free, which lowers the company's costs even further, allowing even more benefits to flow to its customers, which in turns generates even more word-of-mouth advertising. And so on.
Today Costco appears to be another such beneficiary of this kind of virtuous circle. And Sears appears to be the victim of the reverse, suffering from negative word-of-mouth 'advertising' - it's free, but as a company you definitely don't want it. Over the past decade, COST is up 209% and SHLD is down 95% [the S&P 500 is up 71%], in each case excluding dividends. Bottom line - COST simply has a vastly better business model, an advantage which is virtually impossible to overturn. Somebody please alert Eddie Lampert to this news ASAP.
MAKING MONEY WHILE SNORING
Buffett expounds on the "Rip Van Winkle" approach to investing...
Our portfolio shows little change: We continue to make more money when snoring than when active. Inactivity [in investing] strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses? The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved. When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio.
This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor's take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.
In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek. [emphasis added]
ONCE AGAIN, FOR THE 328TH TIME - IT'S GREAT BUSINESSES, STUPID
Let's just get out of the way let the master speak...
Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.
Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected": You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.
Though it's seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders: Our look-through earnings have grown at a good clip over the years, and our stock price has risen correspondingly. Had those gains in earnings not materialized, there would have been little increase in Berkshire's value. The greatly enlarged earnings base we now enjoy will inevitably cause our future gains to lag those of the past. We will continue, however, to push in the directions we always have. We will try to build earnings by running our present businesses well - a job made easy because of the extraordinary talents of our operating managers - and by purchasing other businesses, in whole or in part, that are not likely to be roiled by change and that possess important competitive advantages.
To put the 'circle of competence' idea another way, an investor should know everything he or she can about what he or she is doing, and be willing to walk away if doubts persist about an investment. Simple as that.
For the record, in 1996 Berkshire's stock was up 6%, underperforming the S&P 500 by 17%, the Yankees beat the Braves in the World Series in six games, the Packers topped the Patriots 35-21 in Super Bowl XXXI and on August 26th Bill Clinton signed into law the welfare reform bill. Next up, 1997, the year the world said hello to Lonzo Ball of the famous Ball Brothers and goodbye to Biggie Smalls.