A letter a day!
Letter #44 1990
Key learnings:
- The investors must always keep their guard up and use accounting numbers as the beginning, not an end, in their attempts to calculate true “economic earnings” accruing to them.
“Berkshire’s own reported earnings are misleading in a different, but important, way: We have huge investments in companies (“investees”) whose earnings far exceed their dividends and in which we record our share of earnings only to the extent of the dividends we receive. The extreme case is Capital Cities/ABC, Inc. Our 17% share of the company’s earnings amounted to more than $83 million last year. Yet only about $530,000 ($600,000 of dividends it paid us less some $70,000 of tax) is counted in Berkshire’s GAAP earnings. The residual $82 million-plus stayed with Cap Cities as retained earnings, which work for our benefit but go unrecorded on our books.”
“Our perspective on such “forgotten-but-not-gone” earnings is simple: The way they are accounted for is of no importance, but their ownership and subsequent utilization is all-important. We care not whether the auditors hear a tree fall in the forest; we do care who owns the tree and what’s next done with it.”
- The non-insurance operations produced an after-tax return of about 51% in the year 1990. Buffett highlights 2 important factors behind this performance.
1)The leverage did not produce it: Almost all the major facilities are owned, not leased, and such small debt as these operations have is basically offset by the cash they hold.
- The return was not earned from industries, such as cigarettes or network television stations, possessing spectacular economics for all participating in them. Instead, it came from a group of businesses operating in such prosaic fields as furniture retailing, candy, vacuum cleaners, and even steel warehousing. The extraordinary returns flow from outstanding operating managers, not fortuitous industry economics.
- Borsheim’s is one of the fine jewelry retailers in which Berkshire has invested. If it operated only in Omaha which had a population of 6,00,00 at that time, it would fail to grow the sales by 18%. They were able to grow more through an online business which sold the jewelry across the country. One major factor which accelerated their sales was lesser operating costs in comparison to the competitor.
“We attract business nationwide because we have several advantages that competitors can’t match. The most important item in the equation is our operating costs, which run about 18% of sales compared to 40% or so at the typical competitor. (Included in the 18% are occupancy and buying costs, which some public companies include in “cost of goods sold.”) Just as Wal-Mart, with its 15% operating costs, sells at prices that high-cost competitors can’t touch and thereby constantly increases its market share, so does Borsheim’s. What works with diapers works with diamonds.”
- Buffett has already talked about corporate synergies in his letters. He shares a practical example of the same:
“I experienced a counterrevolution. Regular readers of this report know that I have long scorned the boasts of corporate executives about synergy, deriding such claims as the last refuge of scoundrels defending foolish acquisitions. But now I know better: In Berkshire’s first synergistic explosion, NFM put a See’s candy cart in the store late last year and sold more candy than that moved by some of the full-fledged stores See’s operates in California. This success contradicts all tenets of retailing. With the Blumkins, though, the impossible is routine.”
- Buffett has emphasized three points regarding the insurance business:
(1) While we expect our super-cat business to produce satisfactory results over, say, a decade, we’re sure it will produce absolutely terrible results in at least an occasional year;
(2) Our expectations can be based on little more than subjective judgments - for this kind of insurance, historical loss data are of very limited value to us as we decide what rates to charge today; and
(3) Though we expect to write significant quantities of super-cat business, we will do so only at prices we believe to be commensurate with risk. If competitors become optimistic, our volume will fall. This insurance has, in fact, tended in recent years to be woefully underpriced; most sellers have left the field on stretchers.
- Measuring the insurance performance:
1)Combined ratio is the best ratio to measure the performance of the insurance business. Additionally one can use the comparison of underwriting loss to float(i.e premium) developed.
“This loss/float ratio, like any statistic used in evaluating insurance results, is meaningless over short time periods: Quarterly underwriting figures and even annual ones are too heavily based on estimates to be much good. But when the ratio takes in a period of years, it gives a rough indication of the cost of funds generated by insurance operations. A low cost of funds signifies a good business; a high cost translates into a poor business.”
- Figuring a cost of funds for an insurance business allows anyone analyzing it to determine whether the operation has a positive or negative value for shareholders. If this cost (including the tax penalty) is higher than that applying to alternative sources of funds, the value is negative. If the cost is lower, the value is positive - and if the cost is significantly lower, the insurance business qualifies as a very valuable asset.
“In the insurance business, there is no statute of limitations on stupidity. The intrinsic value of our insurance business will always be far more difficult to calculate than the value of, say, our candy or newspaper companies. By any measure, however, the business is worth far more than its carrying value. Furthermore, despite the problems this operation periodically hands us, it is the one - among all the fine businesses we own - that has the greatest potential.”
- Buffett on his succession
" Were I to die tomorrow, you could be sure of three things: (1) None of my stock would have to be sold; (2) Both a controlling shareholder and a manager with philosophies similar to mine would follow me; and (3) Berkshire’s earnings would increase by $1 million annually since Charlie would immediately sell our corporate jet, The Indefensible (ignoring my wish that it be buried with me)."
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