This is the thirty-eighth in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2016. For all of the prior shareholder letters, see here.
The 2014 letter weighs in at 20,560 words, a 60% increase from 12,890 words the prior year. Berkshire's $18 billion increase in net worth during the year was 8.3% of beginning 2014 net worth.
THE POWER OF COMPOUNDING OVER 50 YEARS
2014 marked the 50th anniversary of Buffett's takeover of Berkshire Hathaway. Buffett includes in the 2014 letter for the first time a record of Berkshire's stock price appreciation during that five decade period (in all prior letters, only the change in Berkshire's book value per year had been included, the idea being that the annual change in book value would be a roughly equivalent measure to the change in the company's intrinsic value). Buffett states that since in recent years Berkshire had been acquiring businesses outright, rather than making open market stock purchases, book value had begun to lag intrinsic value. Including the appreciation of market appreciation in Berkshire's shares had thus become a more accurate indication of Berkshire's intrinsic value appreciation over the long term. Buffett explains as follows:
During our tenure, we have consistently compared the yearly performance of the S&P 500 to the change in Berkshire’s per-share book value. We’ve done that because book value has been a crude, but useful, tracking device for the number that really counts: intrinsic business value.
In our early decades, the relationship between book value and intrinsic value was much closer than it is now. That was true because Berkshire’s assets were then largely securities whose values were continuously restated to reflect their current market prices. In Wall Street parlance, most of the assets involved in the calculation of book value were “marked to market.”
Today, our emphasis has shifted in a major way to owning and operating large businesses. Many of these are worth far more than their cost-based carrying value. But that amount is never revalued upward no matter how much the value of these companies has increased. Consequently, the gap between Berkshire’s intrinsic value and its book value has materially widened.
So what does the stock market metric show us? Over the 1964-2014 period, the S&P 500 had appreciated by 112X, or 9.9% annually. Quite an impressive record indeed--every dollar invested in 1964 had turned into $112 by 2014 (assuming dividends were reinvested). However, Berkshire's stock had a much more shocking upward trajectory: it had appreciated 18,262X, or 21.6% annually. By outperforming the S&P by just 11.6% per year, Berkshire shareholders ended up 163X richer than a holder of the S&P 500 during the same 50-year period. To put it another way, had a 30-year-old in 1964 invested $10,000 in the S&P, by turning 80 in 2014 that person would have attained wealth equal to $1.1 million. Not bad. But had the same person instead bought $10,000 in Berkshire shares in 1964 and held them until turning 80, such person would have attained wealth equal to $183 million(!) Such is the power of compounding money at a high level over a long period of time.
CASH IS TRASH
Picking up on a theme from the 2011 letter, Buffett elucidates on why holding cash (and, consequently, securities with values tied to cash, such as government bonds) is far more dangerous to an investor's health than owning stocks:
The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.
It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.
For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.
To summarize: cash is the absolute least volatile asset to own--its value never wavers (a $1 bill will always be worth $1). However, cash is virtually certain to depreciate over time, thereby rendering it an extremely risky asset to hold over time in terms of long-term purchasing power.
CIGAR BUTTS CAN BE (EXTREMELY) FINANCIALLY FATTENING
Buffett includes a section in the 2014 letter describing how and why he initially bought into Berkshire Hathaway, which was then a failing textile manufacturer:
On May 6, 1964, Berkshire Hathaway, then run by a man named Seabury Stanton, sent a letter to its shareholders offering to buy 225,000 shares of its stock for $11.375 per share. I had expected the letter; I was surprised by the price.
Berkshire then had 1,583,680 shares outstanding. About 7% of these were owned by Buffett Partnership Ltd. (“BPL”), an investing entity that I managed and in which I had virtually all of my net worth. Shortly before the tender offer was mailed, Stanton had asked me at what price BPL would sell its holdings. I answered $11.50, and he said, “Fine, we have a deal.” Then came Berkshire’s letter, offering an eighth of a point less. I bristled at Stanton’s behavior and didn’t tender.
That was a monumentally stupid decision.
Berkshire was then a northern textile manufacturer mired in a terrible business. The industry in which it operated was heading south, both metaphorically and physically. And Berkshire, for a variety of reasons, was unable to change course.
That was true even though the industry’s problems had long been widely understood. Berkshire’s own Board minutes of July 29, 1954, laid out the grim facts: “The textile industry in New England started going out of business forty years ago. During the war years this trend was stopped. The trend must continue until supply and demand have been balanced.”
About a year after that board meeting, Berkshire Fine Spinning Associates and Hathaway Manufacturing – both with roots in the 19th Century – joined forces, taking the name we bear today. With its fourteen plants and 10,000 employees, the merged company became the giant of New England textiles. What the two managements viewed as a merger agreement, however, soon morphed into a suicide pact. During the seven years following the consolidation, Berkshire operated at an overall loss, and its net worth shrunk by 37%.
Meanwhile, the company closed nine plants, sometimes using the liquidation proceeds to repurchase shares. And that pattern caught my attention.
I purchased BPL’s first shares of Berkshire in December 1962, anticipating more closings and more repurchases. The stock was then selling for $7.50, a wide discount from per-share working capital of $10.25 and book value of $20.20. Buying the stock at that price was like picking up a discarded cigar butt that had one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected.
Berkshire thereafter stuck to the script: It soon closed another two plants, and in that May 1964 move, set out to repurchase shares with the shutdown proceeds. The price that Stanton offered was 50% above the cost of our original purchases. There it was – my free puff, just waiting for me, after which I could look elsewhere for other discarded butts.
Instead, irritated by Stanton’s chiseling, I ignored his offer and began to aggressively buy more Berkshire shares.
By April 1965, BPL owned 392,633 shares (out of 1,017,547 then outstanding) and at an early-May board meeting we formally took control of the company. Through Seabury’s and my childish behavior – after all, what was an eighth of a point to either of us? – he lost his job, and I found myself with more than 25% of BPL’s capital invested in a terrible business about which I knew very little. I became the dog who caught the car.
Because of Berkshire’s operating losses and share repurchases, its net worth at the end of fiscal 1964 had fallen to $22 million from $55 million at the time of the 1955 merger. The full $22 million was required by the textile operation: The company had no excess cash and owed its bank $2.5 million.
For a time I got lucky: Berkshire immediately enjoyed two years of good operating conditions. Better yet, its earnings in those years were free of income tax because it possessed a large loss carry-forward that had arisen from the disastrous results in earlier years.
Then the honeymoon ended. During the 18 years following 1966, we struggled unremittingly with the textile business, all to no avail. But stubbornness – stupidity? – has its limits. In 1985, I finally threw in the towel and closed the operation
Interestingly, the "cigar butt" method of investing can indeed be highly lucrative, with one caveat: it only works when one is investing relatively small sums (it is completely useless when investing billions--unfortunately not a problem yours truly has to deal with presently). We know this because Buffett states that when practicing his cigar butt method of investing in the 1950s, "that decade by far the best of my life for both relative and absolute investment performance" [emphasis added]. So to all the small investors out there: the next time you see a soggy, nasty-looking discarded cigar butt on the ground, think of Buffett and his outsized 1950s returns.
For the record, in 2014 Berkshire's stock appreciated 27%, beating the S&P 500 by 13.3%, the Giants beat the Royals 4-3 in the World Series, the Patriots beat the Seahawks 28-24 in Super Bowl XLIX, and the five best performing stocks in the S&P 500 were the following:
(1) Southwest Airlines Co. (ticker LUV) – Up 123%
(2) Electronic Arts Inc. (ticker EA) – Up 106%
(3) Edwards Lifesciences Corp. (ticker EW) – Up 96%
(4) Allergan Inc. (ticker AGN) – Up 92%; and
(5) Avago Technologies Ltd. (kna Broadcom) (ticker AVGO) – Up 80%.