Berkshire Hathaway Inc. Chairman's Letter 1979

Berkshire Hathaway Inc. - Chairman's Letter 1979: Briefing Document

Source: Excerpts from "Chairman's Letter - 1979" by Warren E. Buffett, Berkshire Hathaway Inc.

Overview: This briefing document summarizes the key themes, important ideas, and facts presented in Warren Buffett's 1979 Chairman's Letter to Berkshire Hathaway shareholders. The letter provides insights into the company's 1979 performance, accounting changes, long-term investment philosophy, challenges posed by inflation, and the management approach at Berkshire.

Key Themes and Important Ideas:

1. Impact of Accounting Changes:

• The accounting profession's decision to require insurance companies to carry equity securities at market value significantly increased Berkshire's reported net worth for 1978 and 1979 due to large unrealized gains.

• Buffett highlights the inconsistency this creates with their 60%-owned subsidiary, Blue Chip Stamps, which still carries equity investments at the lower of cost or market. He notes, "Should the same equities be purchased at an identical price by an insurance subsidiary of Berkshire Hathaway and by Blue Chip Stamps, present accounting principles often would require that they end up carried on our consolidated balance sheet at two different values. (That should keep you on your toes.)"

• Despite the change, Buffett maintains that operating performance should be measured against shareholders' equity with securities valued at cost to avoid distortions caused by market fluctuations. "We continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders� equity with all securities valued at cost is the most appropriate way to measure any single year�s operating performance."

2. Focus on Long-Term Economic Performance:

• Buffett emphasizes that while annual operating performance is best measured against cost-basis equity, long-term performance should fully recognize both realized and unrealized capital gains and utilize market-value financial statements. "Such capital gains or losses, either realized or unrealized, are fully as important to shareholders over a period of years as earnings realized in a more routine manner through operations..."

• He points to the significant compounded annual growth in book value per share (20.5% since 1964) as a testament to long-term success, driven by capital appreciation in insurance equity investments.

3. Critique of Earnings Per Share (EPS) as a Primary Metric:

• Buffett strongly criticizes the overemphasis on EPS, arguing it can be misleading. "The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share."

• He illustrates how EPS can increase even with mediocre performance if capital is simply retained, likening it to a "stopped clock" that can look like a growth stock with a low dividend payout.

4. The Threat of Inflation:

• Buffett identifies inflation as a major challenge that can erode real investment returns even for businesses achieving high nominal returns on equity. "For the inflation rate, coupled with individual tax rates, will be the ultimate determinant as to whether our internal operating performance produces successful investment results - i.e., a reasonable gain in purchasing power from funds committed - for you as shareholders."

• He introduces the concept of an "investor's misery index" (inflation rate plus the percentage of capital paid by the owner in taxes) and warns that when this exceeds the return on equity, investors' purchasing power shrinks. "When this index exceeds the rate of return earned on equity by the business, the investor�s purchasing power (real capital) shrinks even though he consumes nothing at all."

• He acknowledges that Berkshire has no corporate solution to high inflation and its ability to generate higher returns on equity is not helped by it.

5. Investment Philosophy and Performance:

• Buffett expresses satisfaction with the performance of their insurance equity investments, attributing it to the outstanding performance of the underlying companies and their managements. "In 1979 they continued to perform well, largely because the underlying companies in which we have invested, in practically all cases, turned in outstanding performances."

• He notes the substantial and growing retained earnings within these investee companies, which are not reflected in Berkshire's financial statements, and expresses faith in their effective utilization.

• Looking ahead to 1980, he anticipates underperformance in their equity portfolio for the first time in recent years but emphasizes their commitment to their chosen companies and lack of interest in short-term market timing.

6. Concerns Regarding Long-Term Fixed-Income Investments (Bonds):

• Buffett expresses strong concerns about long-term fixed-interest bonds in an inflationary environment, highlighting the "extraordinary amount of money" lost by the insurance industry in this area.

• He criticizes the cultural lag in the bond market where long-term fixed-price contracts persist while they have largely disappeared in other areas of commerce. "The very long-term bond contract has been the last major fixed price contract of extended duration still regularly initiated in an inflation-ridden world."

• He admits to past mistakes in purchasing even intermediate-term bonds and emphasizes their current preference for convertible bonds, which offer a shorter effective duration due to the conversion option. "It was a mistake to buy fifteen-year bonds, and yet we did; we made an even more serious mistake in not selling them (at losses, if necessary) when our present views began to crystallize."

• He concludes with a modified Polonius quote: "Neither a short-term borrower nor a long-term lender be."

7. Banking Operations and Divestiture:

• Buffett reports on the exceptional performance of the Illinois National Bank and Trust Company under Gene Abegg's management. "The bank broke all previous records and earned approximately 2.3% on average assets last year, a level again over three times that achieved by the average major bank, and more than double that of banks regarded as outstanding."

• He explains the necessity of divesting the bank by December 31, 1980, due to the Bank Holding Company Act of 1969.

• Due to restrictions imposed by the Federal Reserve Board regarding the involvement of Berkshire officers and directors in a spun-off bank, a sale of 80% to 100% of the bank's stock is being considered. Buffett stresses the importance of finding a suitable purchaser who will treat the bank and its management well, and acknowledges that replacing the bank's earning power will be difficult.

8. Financial Reporting and Shareholder Communication Philosophy:

• Buffett notes the commencement of NASDAQ trading for Berkshire Hathaway stock, which has improved the dissemination of their earnings reports.

• He describes Berkshire's shareholders as a relatively stable and long-term oriented group, influencing their reporting style, which builds upon previous years' information and provides detailed insights. "At the end of each year about 98% of the shares outstanding are held by people who also were shareholders at the beginning of the year."

• He emphasizes the importance of direct communication from the CEO to shareholders, offering a candid "manager-to-owner" perspective rather than a public relations document. "Your Chairman has a firm belief that owners are entitled to hear directly from the CEO as to what is going on and how he evaluates the business, currently and prospectively."

• He draws an analogy to a restaurant attracting its desired clientele, highlighting the importance of consistency in corporate policy and communication to cultivate a stable and understanding shareholder base.

9. Performance of Business Units:

• Insurance Underwriting: While the overall industry underwriting ratio worsened, Berkshire's improved. Phil Liesche's management at a segment of National Indemnity Company achieved exceptionally profitable underwriting. Concerns are raised about the reinsurance business due to increased competition and potential for disastrous long-tail losses. The Homestate operation had mixed results, with data processing issues impacting Cornhusker Casualty. Worker's Compensation performance was surprisingly strong. Buffett forecasts a continued worsening of the industry underwriting performance in 1980.

• Textiles and Retailing: The textile business continues to generate cash but at a low return on capital. Buffett reflects on the mistake of purchasing Waumbec Mills despite it being a statistical bargain, concluding that "turnarounds' seldom turn" and resources are better allocated to good businesses at fair prices. Associated Retail Stores continues to deliver strong earnings with low capital intensity. See's Candies also performed well. The Buffalo Evening News reported an operating loss.

10. Future Prospects:

• Buffett forecasts a decline in return on equity for 1980, even if operating earnings in dollars improve. This is attributed to a larger equity base and potential challenges in insurance underwriting and the savings and loan industry.

• He remains optimistic about their insurance equity investments and the long-term growth in their underlying earning power.

• Berkshire's management philosophy of centralized financial decisions and decentralized operating authority is reiterated as a key factor in attracting and retaining talented managers.

Conclusion:

The 1979 Chairman's Letter provides a comprehensive overview of Berkshire Hathaway's performance and outlook, marked by significant accounting changes, strong equity investment performance, and growing concerns about the impact of inflation. Buffett's candid and insightful commentary on accounting, investment strategy, the limitations of EPS, the dangers of long-term bonds in an inflationary environment, and the importance of a long-term, owner-oriented perspective offers valuable lessons for investors and business leaders. The letter also highlights the strength of Berkshire's decentralized management model and the exceptional contributions of its key operating managers.