the richest man in atherstone

SOURCE: Berkshire Hathaway Shareholder Letter 1977

Business Advice
Buffett begins this letter by giving a general overview of Berkshire Hathaway's annual results highlighting that the insurance companies have had outstanding performance whereas the textile companies came in well below forecast.

Shareholders have raised their concerns about keeping the textile companies when bigger profits could be made in other industries. Buffett explains that Berkshire intends to continue supporting them as they employ a large number of people with non-transferrable skills and both employees and management have worked hard together to keep the business as a viable operation. Buffett believes that it is realistic to expect modest returns from this division.

In contrast, the insurance division of Berkshire has performed exceedingly well despite a number of small mistakes. Buffett highlights the importance of being in businesses that can absorb some of the damage when mistakes are made.

"One of the lessons your management has learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds."

Buffett continues by stating that there is very little product differentiation within the insurance sector, therefore the fantastic results obtained must be credited to the management of those companies.

Investment Advice
Something that I found particularly interesting was that Buffett uses the same criteria to select the shares he invests in as he would use if he were to buy the entire company. He recommends that a business should:

1. Be easy to understand.
2. Have favourable long-term prospects.
3. Be operated by honest and compentent people.
4. Be available at a very attractive price.

Having found a favourable business to invest in, the purchase price should represent good value for money. Stock market fluctuations should be used to the investors advantage and shares should only be bought at a discount. Buffett actually welcomes low share prices in his portfolio because it gives him the chance to purchase more stock at discount.

"If [a company's] business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price."

Buffett understands that an outstanding company bought at a discount due to market fluctuations will eventually realise the value it deserves.

He also notes that by buying stock through the markets, discounts can be attained that would not be possible if the company was bought as a whole. If a business and its management are performing well, it would cost more to purchase the company rather than a large holding of stock, while there would be no advantage in taking control.

"To purchase, directly, properties such as Capital Cities owns would cost in the area of twice our cost of purchase via the stock market, and direct ownership would offer no important advantages to us."

Buffett warns readers to be careful of the figures when companies report "record earnings". His grievance is that this phrase is often used when earnings per share (EPS) hits a new high. He explains that it is usual for a company to increase their equity base each year, so higher EPS should be expected.

"Even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding."

Buffett continues by explaining that a better performance indicator is Return on Equity (ROE). Not only is ROE more accurate, it also takes into account the company's debt levels.