A letter a day!

A letter a day!

Letter #32 1978

Key Learnings:

1. Inclusion of capital gains in evaluating the performance:
   Capital gains are not the results of daily operations. Hence it may indicate a high EPS for that year.

“While we believe it is improper to include capital gains or losses in evaluating the performance of a single year, they are an important component of the longer-term record. Because of such gains, Berkshire’s long‐term growth in equity per share has been greater than would be indicated by compounding the returns from operating earnings that we have reported annually.”

2.Textile Business

Buffett explains the situation in the textile business in a humorous way
“Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management is diligent in pursuing such objectives. The problem, of course, is that our competitors are just as diligently doing the same thing.”

He also adds

“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. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.
We hope we don’t get into too many more businesses with such tough economic characteristics.”

If I summarize it there are 2 key takeaways from this to be careful with the business having 1) Undifferentiated goods 2) Capital-intensive business.

3. Insurance Business

National Indemnity Company was the biggest contributor to the earnings of Berkshire in 1978. Buffett says:

“Present successes reflect credit not only upon present managers but equally upon the business talents of Jack Ringwalt, founder of National Indemnity, whose operating philosophy remains etched upon the company.

Jack Ringwalt retired from the company in 1973. He must have been a terrific manager that even after 5 years after his departure, Buffett is praising him for the success of National Indemnity.

Buffett is open to both ways of expanding the insurance business organic and inorganic.

He says “It is not easy to buy a good insurance business, but our experience has been that it is easier to buy one than to create one. However, we will continue to try both approaches, since the rewards for success in this field can be exceptional.”

4. We often buy a stock that according to us is cheaper in valuation and we expect the market to value it upwards. But many times cheap stocks become cheaper
   On this Buffett says:

“We are not concerned with whether the market quickly revalues upward securities that we believe are selling at bargain prices. In fact, we prefer just the opposite since, in most years, we expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up in stock prices to levels at which we are unwilling to continue buying.”

5. Buffett on concentrated holdings:

“Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts.”
“We simply can’t find one hundred different securities that conform to our investment requirements. However, we feel quite comfortable concentrating our holdings in the much smaller number that we do identify as attractive.”

The lesson to take away from here is not to stop diversification but to avoid over-diversification and invest only if the stock meets
all your required criteria.

6. Buffett on retained earnings of his indirect holdings:

“We are not at all unhappy when our wholly-owned businesses retain all of their earnings if they can utilize internally those funds at attractive rates. Why should we feel differently about the retention of earnings by companies in which we hold small equity interests, but where the record indicates even better prospects for the profitable employment of capital? (This proposition cuts the other way, of course, in industries with low capital requirements, or if management has a record of plowing capital into projects of low profitability; then earnings should be paid out or used to repurchase shares — often by far the most attractive option for capital utilization.)

Berkshire itself hasn’t declared dividends for a prolonged period of time but it has generated wealth for shareholders by
deploying capital in better opportunities.

7. Associated Retail became part of Berkshire in 1978. At the time of the merger Ben Rosner was managing it. About Ben, Buffet says:

“Associated’s business has not grown, and it consistently has faced adverse demographic and retailing trends. But Ben’s combination of merchandising, real estate, and cost-containment skills has produced an outstanding record of profitability, with returns on capital necessarily employed in the business often in the 20% after-tax area.”

Most of these managers are very old and yet they are actively involved in running their businesses. With Ben, Buffett tells what a great manager can do to a business even when things are difficult. Buffett once again uses the financial metric of returns on capital employed to measure management quality and ability.