A letter a day!

letter a day!

Letter # 31 1977

Key learnings:

1. General
   We have often seen companies/fund managers who write record high earnings. Buffett writes on the same
   “Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.”

He considers Return on Equity to be a better measurement than earnings per share.

“Except for special cases (for example, companies with unusual debt‐equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.”

2. Textile operations

Textile operations have been underperforming since the last 2 years and the same has happened again this year. Many investors have started questioning to still continue with the textile business to which Buffett has replied

“Our reasons are several: (1) Our mills in both New Bedford and
Manchester are among the largest employers in each town, utilizing a labor force of high average age possessing relatively non‐transferable skills. Our workers and unions have exhibited unusual understanding and effort in cooperating with management to achieve a cost structure and product mix which might allow us to maintain a viable operation. (2)
management also has been energetic and straightforward in its approach to our textile
problems. In particular, Ken Chace’s efforts after the change in corporate control took place in 1965 generated capital from the textile division needed to finance the acquisition and expansion of our profitable insurance operation. (3) With hard work and some imagination regarding manufacturing and marketing configurations, it seems reasonable that at least modest profits in the textile division can be achieved in the future.”

3. Insurance operations

Insurance operations have performed well this year in comparison to textiles. Buffett writes

“It is comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved. In a sense, this is the opposite case from our textile business where even very good management probably can average only modest results. One of the lessons your management has learned ‐ and, unfortunately, sometimes re‐learned ‐ is the importance of being in businesses where tailwinds prevail rather than headwinds.”

Underwriting margins are not increasing at the same pace as that of cost increases. Hence underwriting profits are still expected to shrink.
But unlike textile, Buffett feels that in the insurance business, these headwinds are temporary.

Buffett on insurance as business:

“Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition. It is commonplace, in corporate annual reports, to stress the difference that people make. Sometimes this is true and sometimes it isn’t. But there is no question that the nature of the insurance business magnifies the effect which individual managers have on company performance.”

4. Buffett on purchasing small stakes in marketable securities

“We select our marketable equity securities in much the same way we would evaluate a
business for acquisition in its entirety. We want the business to be (1) one that we can
understand, (2) with favorable long‐term prospects, (3) operated by honest and
competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.”

“Our experience has been that pro‐rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies. Consequently, bargains in business ownership, which simply are not available directly through corporate acquisition, can be obtained indirectly through stock ownership. When prices are appropriate, we are willing to take very large positions in selected companies, not with any intention of taking control and not foreseeing sell‐out or merger, but with the expectation that excellent business results by corporations will translate over the long term into correspondingly excellent market value and dividend results for owners, minority as well as majority. Such investments initially may have a negligible impact on our operating earnings.”