A letter a day!

A letter a day!

Letter #51 1997

Key learnings:

1. Unconvential commitments

Buffett has written in this letter that when he unable to find an investment opportunity , they choose to invest in quality short term investments. He had invested in the following unconvential investments:

1. The derivative contracts for 14.0 million barrels of oil.
2. Silver.
3. A long-term zero-coupon obligations of the U.S. Treasury.

“In purchasing zeros, rather than staying with cash-equivalents, we risk looking very foolish: A macro-based commitment such as this never has anything close to a 100% probability of being successful. However, you pay Charlie and me to use our best judgment – not to avoid embarrassment – and we will occasionally make an unconventional move when we believe the odds favor it. Try to think kindly of us when we blow one. Along with President Clinton, we will be feeling your pain: The Munger family has more than 90% of its net worth in Berkshire and the Buffetts more than 99%.”

2. Prospective purchasers should much prefer sinking prices.Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come,
   they are elated when stock prices rise and depressed when they fall.

“So smile when you read a headline that says “Investors lose as market falls.” Edit it in your mind to “Disinvestors lose as market falls – but investors gain.” Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: “Every putt makes someone happy.”)”

3. Float and cost of float in an insurance business

The float is money insurer’s have but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money.
Typically, this pleasant activity carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.

“Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.

The expiration of several large contracts will cause our float to decline during the first quarter of 1998, but we expect it to grow substantially over the long term. We also believe that our cost of float will continue to be highly favorable.”

4. Buffett on buying businesses on cash instead of issuing shares

“Our problem has been that we own a truly marvelous collection of businesses, which means that trading away a portion of them for something new almost never makes sense. When we issue shares in a merger, we reduce your ownership in all of our businesses – partly-owned companies such as Coca-Cola, Gillette and American Express, and all of our terrific operating companies as well. An example from sports will illustrate the difficulty we face: For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event – except when the team must trade a .380 hitter to make the deal.”