Berkshire Hathaway Inc. - Chairman's Letter 1989: Briefing Document
Source: Excerpts from "Chairman's Letter - 1989" by Warren E. Buffett
Main Themes:
This letter provides a comprehensive overview of Berkshire Hathaway's performance in 1989, along with broader insights into investment philosophy, business management, and economic observations. The key themes are:
Focus on Intrinsic Value vs. Book Value: Buffett emphasizes that true value lies in the discounted future cash flows of businesses, which can differ significantly from book value, especially when carrying values don't reflect current market realities.
The Impact of Market Corrections: Berkshire's past performance benefited from both the intrinsic growth of its holdings and the market's recognition of their true value, leading to a "double-dip." Future gains will likely be a "single-dip" based on underlying business performance.
The Inevitability of Growth Rate Limits: Buffett uses Carl Sagan's analogy of bacteria to illustrate that high growth rates cannot be sustained indefinitely, especially as the base grows. Berkshire faces this challenge with its increasing net worth.
The Nuances of Deferred Taxes: Buffett provides a detailed explanation of Berkshire's deferred tax liability, highlighting that it's neither a simple liability nor a meaningless fiction but rather an "interest-free loan from the U.S. Treasury." He also explains the mathematical advantage of long-term investing due to tax deferral.
Emphasis on Owner-Oriented Management and Splendid Businesses: Buffett reiterates the importance of partnering with talented and aligned managers in businesses with strong economic characteristics ("The Sainted Seven Plus One"). He highlights individual successes within these businesses (Borsheim's, See's Candies, Nebraska Furniture Mart, Buffalo News, Fechheimer, World Book/Kirby).
Challenges in the Insurance Industry: Buffett provides a pessimistic outlook on the property-casualty insurance industry, predicting continued increases in the combined ratio due to insufficient premium growth relative to incurred losses. He contrasts this with Berkshire's disciplined underwriting and opportunistic deployment of capacity during periods of shortage, like after the 1989 catastrophes.
Long-Term Investment Strategy: Buffett details Berkshire's approach to marketable securities, focusing on long-term common stock holdings in businesses they understand and admire. He explains the increased Coca-Cola investment and acknowledges that current valuations of major holdings are high.
Caution Regarding Arbitrage and Fixed-Income: Berkshire was selective in arbitrage due to unattractive deals. They reduced holdings in medium- and long-term fixed income, reinvesting in convertible preferred stocks of companies with strong management, despite uncertainty about their industries' economics.
Strategic Use of Zero-Coupon Securities: Buffett justifies Berkshire's issuance of zero-coupon convertible debentures due to the tax benefits. However, he strongly criticizes the widespread use of zero-coupon and PIK bonds by weaker credits, labeling them as instruments of "deceptive" finance that can mask underlying financial weakness through concepts like "EBDIT."
Review of Past Mistakes: Buffett candidly discusses key mistakes over the past 25 years, including the "cigar butt" approach to investing, buying into poor businesses despite good management, the failure to recognize the "institutional imperative," and missed opportunities.
Criteria for New Acquisitions: Buffett outlines the specific criteria Berkshire looks for in potential acquisitions: large, consistently profitable, high-return, low-debt, well-managed, simple businesses with a disclosed offering price.
Appreciation for Key Individuals and Partnerships: Buffett consistently praises the managers of Berkshire's subsidiaries and its major investees, emphasizing their talent, integrity, and alignment with shareholder interests. He also highlights the valuable contributions of individuals like Harry Bottle and Berkshire's stock specialist, Jim Maguire.
Most Important Ideas and Facts:
Intrinsic Value is King: "What counts, however, is intrinsic value - the figure indicating what all of our constituent businesses are rationally worth. With perfect foresight, this number can be calculated by taking all future cash flows of a business - in and out - and discounting them at prevailing interest rates."
The "Double-Dip" is Over: "Our performance to date has benefited from a double- dip: (1) the exceptional gains in intrinsic value that our portfolio companies have achieved; (2) the additional bonus we realized as the market appropriately 'corrected' the prices of these companies, raising their valuations in relation to those of the average business...our 'catch-up' rewards have been realized, which means we'll have to settle for a single-dip in the future."
Growth Faces Limits: "In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor."
Deferred Taxes as an Interest-Free Loan: "In economic terms, the liability resembles an interest-free loan from the U.S. Treasury that comes due only at our election..."
Long-Term Investing's Tax Advantage: Comparing two scenarios, Buffett demonstrates: "The sole reason for this staggering difference in results would be the timing of tax payments."
Investing in Excellent Management: Describing the managers of "The Sainted Seven Plus One," Buffett states: "Most of these managers have no need to work for a living; they show up at the ballpark because they like to hit home runs. And that's exactly what they do."
Disciplined Insurance Underwriting: "We have no interest in writing insurance that carries a mathematical expectation of loss; we experience enough disappointments doing transactions we believe to carry an expectation of profit."
Opportunistic Catastrophe Reinsurance: "Our willingness to put such a huge sum on the line for a loss that could occur tomorrow sets us apart from any reinsurer in the world."
Coca-Cola Investment Rationale: Buffett's explanation highlights the power of a strong brand, effective management (Roberto Goizueta and Don Keough), and his own delayed recognition of the opportunity. "Only in the summer of 1988 did my brain finally establish contact with my eyes."
Criticism of Zero-Coupon Junk Bonds and EBDIT: "Promoters needed to find a way to justify even pricier acquisitions...So, stepping through the Looking Glass, promoters and their investment bankers proclaimed that EBDIT should now be measured against cash interest only..." and "Our advice: Whenever an investment banker starts talking about EBDIT...zip up your wallet."
The "Cigar Butt" Mistake: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner."
The "Institutional Imperative": Buffett notes its powerful influence on corporate decision-making, often leading to irrational behavior.
Importance of Trustworthy Partners: "After some other mistakes, I learned to go into business only with people whom I like, trust, and admire."
Criteria for Acquisitions: The six specific criteria provide a clear understanding of Berkshire's acquisition strategy.
Quotes for Emphasis:
On intrinsic value: "What counts, however, is intrinsic value - the figure indicating what all of our constituent businesses are rationally worth."
On growth limitations: "In a finite world, high growth rates must self-destruct."
On management: "Good jockeys will do well on good horses, but not on broken-down nags."
On avoiding difficult problems: "What we have learned is to avoid them."
On the "institutional imperative": "Instead, rationality frequently wilts when the institutional imperative comes into play."
On partnering with good people: "We've never succeeded in making a good deal with a bad person."
On missed opportunities: "For Berkshire's shareholders, myself included, the cost of this thumb-sucking has been huge."
On zero-coupon bond folly: "With zeros, one party to a contract can experience 'income' without his opposite experiencing the pain of expenditure."
This briefing document summarizes the key insights and information presented in Warren Buffett's 1989 Chairman's Letter, offering valuable perspectives on investing, business management, and financial markets.
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