A letter a day!

A letter a day!

Letter #37 1983

Theme: Principles of Berkshire Hathaway (general)

Key learnings:

1. Due to the merger with blue as stated in the 1981 letter, many new investors are now the shareholders of Berkshire Hathaway.
   In the beginning of the letter, Buffett has briefed them with the policies they follow at Berkshire, most of which is a repeated for those have read all the previous letters. (But it is a must read)

2. Acquisition of Nebraska Furniture Mart
   Buffett narrates the story of Mrs. Berklin that how she started Nebraska furniture mart. On acquiring it, he writes

” One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.”

Mrs Berklin sold her 90% of the business at the age of 90. But she still remains the chairman and ran the business. Inspiring!

3. Book value VS intrinsic value

Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

Buffett narrates a practical example to explain this in a more simple manner:

“An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously – from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.”

4.Never underestimate the power of goodwill (Both economic and accounting)

“You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.”

5)This year Charlie Munger has replaced Louie Vincenti as Chairman of Wesco.(For the very first time there is a mention of Charlie Munger in the letter)

6. Buffett has never believed in the stock split of the Berkshire Hathaway shares. He thinks this action is only beneficial to the non quality shareholders.

*” In large part, however, we feel that high quality ownership can be attracted and maintained if we consistently communicate our business and ownership philosophy – along with no other conflicting messages – and then let self selection follow its course. For example, self selection will draw a far different crowd to a musical event advertised as an opera than one advertised as a rock concert even though anyone can buy a ticket to either.

Through our policies and communications – our “advertisements” – we try to attract investors who will understand our operations, attitudes and expectations. (And, fully as important, we try to dissuade those who won’t.) We want those who think of themselves as business owners and invest in companies with the intention of staying a long time. And, we want those who keep their eyes focused on business results, not market prices.”

7. One of the ironies of the market is people always focus on penny stocks or high turnover stocks.

“One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as “marketability” and “liquidity”, sing the praises of companies with high share turnover (those who cannot fill your pocket will confidently fill your ear). But investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pickpocket of enterprise.”

“We are aware of the pie-expanding argument that says that such activities improve the rationality of the capital allocation process. We think that this argument is specious and that, on balance, hyperactive equity markets subvert rational capital allocation and act as pie shrinkers. Adam Smith felt that all non collusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy.)”