A letter a day!

A letter a day!

Letter # 39 1985

Key learnings

1. This year gain in the book value per share was 23.2% compounded annually. Buffett states 2 reasons that this performance may not be repeated.

1. Very Little opportunities to invest in the market as available in the previous 10 years.

2. Size of the capital is ten times more than with what they started.

2. Four factors that have helped in building value in Berkshire Hathaway;

1)purchase price.

2)a business with fine underlying economics.

3)an able management concentrating on the interests of shareholders

4)a buyer willing to pay full business value.

3. Always study your mistakes/errors both in investing and in other areas of life.

“Before doing so, however, we should first look at a failure at one of our smaller businesses. Our Vice Chairman, Charlie Munger, has always emphasized the study of mistakes rather than successes,
both in business and other aspects of life. He does so in the spirit of the man who said: “All I want to know is where I’m going to die so I’ll never go there.” You’ll immediately see why we make a good team: Charlie likes to study errors and I have generated ample material for him,particularly in our textile and insurance businesses.”

4. Closure of textile business

Buffett acquired a majority stake in Berkshire Hathaway which was solely in textiles through Buffett Partnership Limited. In early 1967 cash generated by the textile operation was used to fund the entry into insurance via the purchase of National Indemnity Company. A gradual diversification into various businesses then followed. The textile business never became a good earner, not even in cyclical upturns, and hence it was decided to shut the same.

A detailed explanation of the closure of this business is given with the factors which led to the same. A must-read!

Buffett writes ” The situation is suggestive of Samuel Johnson’s horse: “A horse that can count to ten is a remarkable horse – not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.”

5. Always judge the increase in earnings with how much more capital was required to increase these earnings.

The financial characteristics of these businesses have allowed us to use a very large portion of the earnings they generate elsewhere. Corporate America, however, has had a different experience: in order to increase earnings significantly, most companies have needed to increase capital significantly also. The average American business has required about $5 of additional capital to generate an additional $1 of annual pre-tax earnings. That business, therefore, would have required over $300 million in additional capital from its owners in order to achieve an earnings performance equal to our group of three.

6. When returns on capital are ordinary, an earn-more-by-putting-up-more record is no great managerial achievement.

If the widget company consistently earned a superior return on capital throughout the period, or if capital employed only doubled during the CEO’s reign, the praise for him may be well deserved. But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be withheld. A savings account in which interest was reinvested would achieve the same year-by-year increase in earnings – and, at only 8% interest, would quadruple its annual earnings in 18 years.

7. Berkshire has always believed in granting incentive compensation to the key managers and no stock options. This incentives will be paid purely on the basis of the performance and is no where related to the stock prices.They have also believed that the factors like age , seniority should not impact the bonus.

8. The insurance product now is priced as any other commodity for which a free market exists: when capacity is tight, prices will be set remuneratively; otherwise, they will not be.

9. In the reinsurance business it is very difficult to divide the amount of premium between various layers of risk takers. A detailed explanation on the challenges in this regard has been discussed in this letter.

10. In this letter Buffett explains that many insurers had taken the “except for” route to gather large capital. For example a clause in the insurance would state “ we would provide insurance cover except for florida tornados”

“In any business, insurance or otherwise, “except for” should be excised from the lexicon. If you are going to play the game, you must count the runs scored against you in all nine innings. Any manager who consistently says “except for” and then reports on the lessons he has learned from his mistakes may be missing the only important lesson – namely, that the real mistake is not the act, but the actor.”