Berkshire Hathaway Inc. Chairman's Letter 1978

Berkshire Hathaway Inc. - Chairman's Letter - 1978: Briefing Document

Source: Excerpts from "Chairman's Letter - 1978" by Warren E. Buffett

Subject: Review of Key Themes, Ideas, and Facts from the 1978 Chairman's Letter

Introduction:

This briefing document summarizes the main themes, important ideas, and key facts presented in Warren Buffett's 1978 letter to Berkshire Hathaway shareholders. The letter provides valuable insights into the company's financial reporting complexities following the merger with Diversified Retailing, highlights the performance and outlook of its various business segments, and articulates Buffett's investment philosophy.

Main Themes and Important Ideas:

1. Accounting Complexities Due to Diversified Merger:

• The merger with Diversified Retailing significantly complicated Berkshire's financial reporting due to the full consolidation of Blue Chip Stamps (in which Berkshire's ownership increased to approximately 58%).

• This consolidation resulted in the aggregation of diverse businesses (textiles, insurance, candy, newspapers, trading stamps) with vastly different economic characteristics, making the consolidated figures less informative.

• Buffett emphasizes that this consolidated presentation is not how Berkshire management views the business internally and is of limited value for management activities.

• Quote: "Such a grouping of Balance Sheet and Earnings items - some wholly owned, some partly owned - tends to obscure economic reality more than illuminate it. In fact, it represents a form of presentation that we never prepare for internal use during the year and which is of no value to us in any management activities."

• A second accounting complication arose from the retrospective restatement of 1977 and earlier figures as if the merger had occurred earlier, making comparative commentary confusing.

• Quote: "Accounting convention requires that when two entities such as Diversified and Berkshire are merged, all financial data subsequently must be presented as if the companies had been merged at the time they were formed rather than just recently. So the enclosed financial statements, in effect, pretend that in 1977 (and earlier years) the Diversified-Berkshire merger already had taken place, even though the actual merger date was December 30, 1978."

• To provide a clearer picture, the report includes significant segmented financial information and commentary on the various business units, mirroring the internal management perspective.

2. 1978 Performance and Near-Term Outlook:

• Buffett states that "1978 was a good year," with operating earnings (excluding capital gains) at 19.4% of beginning shareholders' investment, close to the 1972 record.

• He acknowledges the importance of capital gains to long-term growth, noting that Berkshire's per-share net worth had virtually doubled in the last three years due to a combination of good operating earnings and substantial capital gains.

• However, Buffett cautions that neither the 25% overall equity gain nor the 19.4% operating earnings return on equity is sustainable.

• He expresses a cautious near-term outlook, predicting that the insurance cycle has turned downward in 1979 and that operating earnings measured by return on equity are likely to fall. However, dollar earnings might increase due to a larger shareholder equity base.

• In contrast, he is optimistic about the long-term prospects for major equity investments held by the insurance companies.

3. Focus on Long-Term Value Investing:

• Buffett reiterates his belief that successfully forecasting short-term stock price movements is impossible.

• Quote: "We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do."

• His investment strategy focuses on identifying undervalued businesses with strong long-term prospects and honest, competent management.

• Quote: "We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively."

• He highlights the significant unrealized and realized gains in the insurance subsidiaries' equity portfolio between 1975 and 1978, a period when the Dow Jones Industrial Average declined.

• Buffett contrasts Berkshire's approach of buying small fractions of outstanding businesses at bargain prices in the stock market with the enthusiasm and often high prices paid for entire businesses in corporate acquisitions.

• He prefers market conditions that allow for consistent attractive purchasing of securities over short-term price run-ups that would halt buying opportunities.

• Berkshire's investment policy is to concentrate holdings in companies they are highly confident in, rather than making small, lukewarm investments.

4. Segment Performance and Commentary:

• Textiles (Berkshire-Waumbec): Acknowledges improved earnings but still a low return on capital due to the industry's tough economic characteristics (undifferentiated goods, capital intensive, excess capacity). Despite this, Berkshire intends to continue supporting the textile business due to its importance to the community, management's efforts, labor cooperation, and modest cash returns.

• Quote: "The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage."

• Insurance Underwriting: National Indemnity's segment run by Phil Liesche was the top contributor with an "extraordinary" underwriting profit. Home and Automobile also had its best year. Worker's Compensation showed mixed results, with Cypress Insurance performing outstandingly and efforts underway to improve the California business. Reinsurance provided large sums for investment but underwriting results needed improvement. Homestate operation was disappointing, while Kansas Fire and Casualty had a remarkable start. Overall, the insurance operation had an excellent year, but a downturn in the industry's combined ratio is expected in 1979.

• Insurance Investments: Expresses considerable optimism regarding equity investments in companies like SAFECO, GEICO, American Broadcasting, etc. Highlights the strategy of buying high-quality businesses at attractive prices. Praises SAFECO as the "best run large property and casualty insurance company" and notes the benefit of retained earnings in well-managed companies, even if not reflected in reported operating earnings.

• Quote: "SAFECO probably is the best run large property and casualty insurance company in the United States. Their underwriting abilities are simply superb, their loss reserving is conservative, and their investment policies make great sense."

• Banking (Illinois National Bank and Trust Company): Continues to establish new records with high earnings and lower asset risk under Gene Abegg's management. However, Berkshire is required to divest the bank by December 31, 1980, likely through a spin-off to shareholders. Praises Abegg's ability to control costs.

• Retailing (Associated Retail Stores): Despite facing adverse trends, the business has maintained outstanding profitability under Ben Rosner's leadership due to his merchandising, real estate, and cost-containment skills. Highlights the value of managers who think like owners.

5. Importance of Management:

• Buffett consistently emphasizes the critical role of honest and competent management in the success of Berkshire's businesses and its investments.

• He praises the managers of various subsidiaries, highlighting their skills, dedication, and owner-like mentality.

• He values long-term relationships with managers who enjoy their work and are focused on building value.

• Quote: "It is a real pleasure to work with managers who enjoy coming to work each morning and, once there, instinctively and unerringly think like owners. We are associated with some of the very best."

Key Facts and Figures:

• Berkshire's ownership of Blue Chip Stamps increased to approximately 58% after the merger with Diversified Retailing.

• Operating earnings in 1978 were 19.4% of beginning shareholders' investment.

• Berkshire's per share net worth virtually doubled in the last three years (1976-1978).

• The insurance subsidiaries' common equity portfolio increased from a market value of $39.3 million at the end of 1975 to $216.5 million at the end of 1978.

• Pre-tax gains from common equities over the three-year period were approximately $24.7 million (realized) plus $87.4 million (unrealized).

• Illinois National Bank's earnings in 1978 were approximately 2.1% of average assets, about three times the level of major banks.

• Berkshire held significant equity positions in companies like American Broadcasting, GEICO, Interpublic Group, Kaiser Aluminum, Knight-Ridder, SAFECO, and The Washington Post Company.

Conclusion:

The 1978 Chairman's Letter provides a detailed look into Berkshire Hathaway's post-merger financial landscape and reinforces Warren Buffett's core principles of long-term value investing, focus on business fundamentals, and the importance of exceptional management. The letter highlights a strong performance in 1978 but also sets realistic expectations for the near future, particularly within the insurance industry. Buffett's emphasis on understanding businesses, buying at attractive prices, and partnering with talented managers remains a central theme. The complexities introduced by the merger underscore the importance of transparent and segmented reporting to provide shareholders with a true understanding of Berkshire's diverse operations.