This is the twenty-third 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 1999 letter weighs in at 12,340 words, a 2.7% increase from 12,020 words the prior year. Berkshire's gain in net worth during 1999 was just $358 million, or 0.5% of beginning 1998 net worth.
EVEN G.O.A.T.S HAVE BAD YEARS
Buffett had an uncharacteristically poor year in 1999, with book value barely moving at all, despite the S&P 500 increasing by 21% on the year. Much of the stock euphoria on the years concerned 'new economy' and Internet stocks, as the market was approaching the zenith of the tech bubble, so this environment would naturally be expected to disfavor a company with old-economy holdings such as Berkshire. Nevertheless, Buffett had to assign himself a poor grade for the year overall...
The numbers on the facing page show just how poor our 1999 record was. We had the worst absolute performance of my tenure and, compared to the S&P, the worst relative performance as well. Relative results are what concern us: Over time, bad relative numbers will produce unsatisfactory absolute results.
Even Inspector Clouseau could find last year's guilty party: your Chairman. My performance reminds me of the quarterback whose report card showed four Fs and a D but who nonetheless had an understanding coach. "Son," he drawled, "I think you're spending too much time on that one subject."
My "one subject" is capital allocation, and my grade for 1999 most assuredly is a D. What most hurt us during the year was the inferior performance of Berkshire's equity portfolio -- and responsibility for that portfolio, leaving aside the small piece of it run by Lou Simpson of GEICO, is entirely mine. Several of our largest investees badly lagged the market in 1999 because they've had disappointing operating results. We still like these businesses and are content to have major investments in them. But their stumbles damaged our performance last year, and it's no sure thing that they will quickly regain their stride.
HOW TO EVALUATE AN INSURANCE COMPANY AS AN INVESTMENT
Buffett in the 1999 letter comes up with a simple approach to valuing an insurance company - just look at its cost of float, both currently and prospectively. If less than the going rate for long-term money, then the insurance company has a good business model; if more, it doesn't. In essence, Buffett is looking at an insurance company as a vehicle for borrowing money over time, with the float being the amount borrowed and its cost being the interest rate. Buffett explains as follows...
To begin with, float is money we hold but don't own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an "underwriting loss," which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money. [emphasis added]
A caution is appropriate here: Because loss costs must be estimated, insurers have enormous latitude in figuring their underwriting results, and that makes it very difficult for investors to calculate a company's true cost of float. Errors of estimation, usually innocent but sometimes not, can be huge. The consequences of these miscalculations flow directly into earnings. An experienced observer can usually detect large-scale errors in reserving, but the general public can typically do no more than accept what's presented, and at times I have been amazed by the numbers that big-name auditors have implicitly blessed. In 1999 a number of insurers announced reserve adjustments that made a mockery of the "earnings" that investors had relied on earlier when making their buy and sell decisions. At Berkshire, we strive to be conservative and consistent in our reserving. Even so, we warn you that an unpleasant surprise is always possible.
Needless to say, Berkshire's cost of float over the years has been outstanding. In 2015, for example, Berkshire was paid $1.837 billion for its $87.7 billion of float, and in 2016 things got even better, as the company earned $2.131 billion on $91.6 billion of float. This is equivalent to being paid 2.33% per annum in return for borrowing $91.6 billion for one year--try getting that deal at your local Wells Fargo or Citibank branch. For those scoring at home, float is calculated by adding net loss reserves, loss adjustment reserves, funds held under reinsurance assumed and unearned premium reserves, and then subtracting agents balances, prepaid acquisition costs, prepaid taxes and deferred charges applicable to assumed reinsurance.
ECONOMIC GOODWILL VERSUS ACCOUNTING GOODWILL
Buffett returns to the topic of accounting to discuss goodwill, particularly in the context of acquisitions. Most CEOs would prefer that investors ignore the amortization of goodwill that is put on a company's books due to mergers and acquisitions. This item is placed there when the consideration paid for an acquisition exceeds the then market value of its identifiable assets. Indeed, today many managers issue 'pro forma' earnings that specifically add-back such amortization charges for goodwill [usually using the spurious justification that these are 'non-cash' charges]. However, Buffett points out that most GAAP charges relate to some real cost. For example, depreciation represents the amount a company can be expected to spend over time in order to replace deteriorating asset [industrial plants wear out over time and need to be replaced, patents expire, etc.]. Some assets, however, actually appreciate over time--such as real estate generally [because dirt does not deteriorate due to the passage of time, although a parcel of land can become worth less if its location becomes less desirable to prospective buyers for exogenous reasons]. So investors need to differentiate between GAAP accounting charges that represent real costs and those which don't--but the default attitude should be to assume it is a real charge unless a compelling reason is produced to convince the investor otherwise.
Here is Buffett's summation on these points...
For accounting rules to mandate amortization that will, in the usual case, conflict with reality is deeply troublesome: Most accounting charges relate to what's going on, even if they don't precisely measure it. As an example, depreciation charges can't with precision calibrate the decline in value that physical assets suffer, but these charges do at least describe something that is truly occurring: Physical assets invariably deteriorate. Correspondingly, obsolescence charges for inventories, bad debt charges for receivables and accruals for warranties are among the charges that reflect true costs. The annual charges for these expenses can't be exactly measured, but the necessity for estimating them is obvious.
In contrast, economic goodwill does not, in many cases, diminish. Indeed, in a great many instances -- perhaps most -- it actually grows in value over time. In character, economic goodwill is much like land: The value of both assets is sure to fluctuate, but the direction in which value is going to go is in no way ordained. At See's, for example, economic goodwill has grown, in an irregular but very substantial manner, for 78 years. And, if we run the business right, growth of that kind will probably continue for at least another 78 years.
Note the qualifier 'if we run the business right'. Buffett states that economic [as opposed to accounting] goodwill often increases. However, a company must still spend money to produce this effect. Coca-Cola must spend on advertising to increase the value of its trademarks. Amazon must continually invest in warehouses to maintain the loyalty and thereby increase the value of its base of customers. Very little comes free in life or business, despite what C-suite executives may claim in earnings press releases, investor slide decks or on conference calls. IN SHORT, BEWARE OF 'NON-CASH' ADD-BACKS, FOLKS - CAVEAT EMPTOR.
DIVERSIFICATION VERSUS DIWORSIFICATION
One of the central tenets of modern investing is that investors should maintain adequate diversification in their portfolios. For active investors [as opposed to the vast majority of passive investors], however, Buffett preaches the opposite, stating that diversification is a huge mistake. Rather, he believes that one should concentrate one's capital only one's absolute best ideas--see, e.g., his '20 Punches' rule of investing [discussed further here]. Thus, for active investors, Buffett equates diversification with, in Peter Lynch's word, 'diworsification', from his seminal book 'One Up On Wall Street'...
Indeed, if we look at Berkshire's stock portfolio at the end of 1999, Buffett was practicing what he preached. The following are the concentrations of Berkshire's portfolio in its 2, 3 and 5 largest holdings, each as a percentage of the overall equity portfolio...
Top 2 Stocks [Coca-Cola and American Express] - $20.05 billion, or 54.2% of the total portfolio.
Top 3 Stocks [KO, AXP and Gillette] - $23.97 billion, or 64.8% of the total portfolio.
Top 5 Stocks [KO, AXP, Gillette, Freddie Mac and Wells Fargo] - $29.20 billion, or 78.9% of the total portfolio.
Note that the total portfolio also includes stocks picked by Lou Simpson, then the portfolio manager at GEICO [see more info about him here], so these numbers would be even more concentrated if Simpson's stock picks were excluded from the calculations.
A corollary to having a concentrated portfolio is that an investor's large bets must be right. And the key way to achieve this happy outcome is to stay within one's 'circle of competence', as Buffett explains...
If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries -- and seem to have their claims validated by the behavior of the stock market -- we neither envy nor emulate them. Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it's almost certain there will be opportunities from time to time for Berkshire to do well within the circle we've staked out. [emphasis added]
BUFFETT ON SHARE REPURCHASES
Finally, in the 1999 letter Buffett includes a relatively lengthy discussion of share repurchases, specifically under what circumstances they are appropriate or not. We include a long quote without further comment, as the Master is speaking, so let's just listen...
There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.
The business "needs" that I speak of are of two kinds: First, expenditures that a company must make to maintain its competitive position (e.g., the remodeling of stores at Helzberg's) and, second, optional outlays, aimed at business growth, that management expects will produce more than a dollar of value for each dollar spent (R. C. Willey's expansion into Idaho).
When available funds exceed needs of those kinds, a company with a growth-oriented shareholder population can buy new businesses or repurchase shares. If a company's stock is selling well below intrinsic value, repurchases usually make the most sense. In the mid-1970s, the wisdom of making these was virtually screaming at managements, but few responded. In most cases, those that did made their owners much wealthier than if alternative courses of action had been pursued. Indeed, during the 1970s (and, spasmodically, for some years thereafter) we searched for companies that were large repurchasers of their shares. This often was a tipoff that the company was both undervalued and run by a shareholder-oriented management.
That day is past. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.
Charlie and I admit that we feel confident in estimating intrinsic value for only a portion of traded equities and then only when we employ a range of values, rather than some pseudo-precise figure. Nevertheless, it appears to us that many companies now making repurchases are overpaying departing shareholders at the expense of those who stay. In defense of those companies, I would say that it is natural for CEOs to be optimistic about their own businesses. They also know a whole lot more about them than I do. However, I can't help but feel that too often today's repurchases are dictated by management's desire to "show confidence" or be in fashion rather than by a desire to enhance per-share value.
Sometimes, too, companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This "buy high, sell low" strategy is one many unfortunate investors have employed -- but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully.
Of course, both option grants and repurchases may make sense -- but if that's the case, it's not because the two activities are logically related. Rationally, a company's decision to repurchase shares or to issue them should stand on its own feet. Just because stock has been issued to satisfy options -- or for any other reason -- does not mean that stock should be repurchased at a price above intrinsic value. Correspondingly, a stock that sells well below intrinsic value should be repurchased whether or not stock has previously been issued (or may be because of outstanding options).
For the record, in 1999 Berkshire's stock was down 20%, underperforming the S&P 500 by 40% [YIKES], the Yankees swept the Braves 4-0 in the World Series, the Rams topped the Titans 23-16 in Super Bowl XXXIV and on June 11th the war in Kosovo ended. Next up, 2000, the year America couldn't figure out who the heck won the Presidential election [two words - 'hanging chads'].