A letter a day!

A letter a day!

Letter # 38 1984

Theme : Buybacks

Key learnings:

1. When companies with outstanding businesses and comfortable financial positions find their shares selling far
   below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases/buy backs.

2. Two main benefits of share buybacks 1. major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. When companies purchase their own stock, they often find it easy to get $2 of present value for $1. 2. By making repurchases when a company’s market value is well below its
   business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value.

3. Nebaska furniture mart was introduced by Buffett in the last years letter. Investors continuously ask him how can this business do so well on which he replies

“I have been asked by a number of people just what secrets the Blumkins bring to their business. These are not very esoteric. All members of the family: (1) apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts; (2) define with extraordinary realism their area of special competence and act decisively on all matters within it; (3) ignore even the most enticing propositions failing outside of that area of special competence; and, (4) unfailingly behave in a high-grade manner with everyone they deal with. (Mrs. B boils it down to “sell cheap and tell the truth”.)”

4. The see candies business is more of a seasonal one. The company does 40% volume before the Christmas and produces 75% of the profit. In order to handle the increase in the demand, there is no compromise on the quality as done by the competitors.

” Their solutions have in no way involved compromises in either quality of service or quality of product. Most of our larger competitors could not say the same. Though faced with somewhat less extreme peaks and valleys in demand than we, they add preservatives or freeze the finished product in order to smooth the production cycle and thereby lower unit costs. We reject such techniques, opting, in effect, for production headaches rather than product modification.”

5. In the past letters we have seen that Buffett has highlighted the importance for creating a financial strength for the insurance business. In this letter he writes:

” For some years I have told you that there could be a day coming when our premier financial strength would make a real difference in the competitive position of our insurance operation. That day may have arrived. We are almost without question the strongest property/casualty insurance operation in the country, with a capital position far superior to that of well-known companies of much greater size.”

6. While tracking/studying an insurance company, it is extremely important to check the financial strength of the business that can help at the time of adversities.

“Our financial strength is a particular asset in the business of structured settlements and loss reserve assumptions that we reported on last year. The claimant in a structured settlement and the insurance company that has reinsured loss reserves need to be completely confident that payments will be forthcoming for decades to come. Very few companies in the property/casualty field can meet this test of unquestioned long-term strength. (In fact, only a handful of companies exists with which we will reinsure our own liabilities.)”

7.The over performance by the stock relative to the performance of the business obviously
could not occur every year, and that in some years the stock must under perform the business.

8. Warren Buffett on the “The intelligent investor” book:

“In what I think is by far the best book on investing ever written – “The Intelligent Investor”, by Ben Graham – the last section of the last chapter begins with, “Investment is most intelligent when it is most businesslike.” This section is called “A Final Word”, and it is appropriately titled”

9. Unconventional behavior in investing which involves making risky bets can be done only by if we think of ourselves as business owners and not fund managers. Buffett says this in the context of the investment in the Washington Public power supply system
   bonds, the company which had been defaulted in the past.

“Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)

Our equation is different. With 47% of Berkshire’s stock, Charlie and I don’t worry about being fired, and we receive our rewards as owners, not managers. Thus we behave with Berkshire’s money as we would with our own. That frequently leads us to unconventional behavior both in investments and general business management.”

10.Unrestricted earnings should be retained only when there is a reasonable
prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.