the richest man in atherstone

SOURCE: Berkshire Hathaway Shareholder Letter 1979

Business Advice
Buffett begins with a few words about changes to accounting procedure. Equities owned by insurance companies are now required to be listed on the balance sheet at market value whereas previously they were recorded as either the purchase price or the aggregate market value (whichever was lower). This has resulted in the net worth of the insurance division increasing substantially. It also means that should an insurance company and a non-insurance company purchase the same equity, they would be recorded differently on each balance sheet. Again, Buffett's inegrity and his ability to explain difficult concepts in layman's terms is highlighted. A less scrupulous chairman might use this change in procedure to make it appear as though the company has done better than it has.

Buffett explains that the previous year has bought good results, however the increased amount of capital that was available at the start of the year has not been utilised as efficiently as in previous years. This is further explained in the 'Investment Advice' section below.

Berkshire Hathaway has bought 13 new companies for cash and have started 6 others, however the outlook for equities looks less desirable than in previous years due to the current economic climate. Increases to inflation rates and taxes could wipe out any real profits.

"When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all."

Buffett is forthright enough to say that he has no solution to this problem.

Associated Retail Stores has produced fantastic results in an unpredictable sector. Berkshire Hathaway's textile businesses however, have performed poorly in comparison to capital employed despite being profitable. As in previous letters, Buffett explains that the problem is not so much the specific businesses but the industry that they're in. This is because the capital employed in property, machinery etc is high and the relative profits are low.

Berkshire Hathaway's Insurance businesses have been a mixed bag this year. Competition from other companies in the insurance sector has increased as they are prepared to sacrifice profitable underwriting for volume of premiums. Despite the tough market, some of Berkshire Hathaway's businesses have performed extraordinarily well, most notably National Indemnity and Workers Compensation. These businesses have continued to only underwrite at a profit without worrying about the volume of premiums. The managers have been singled out for praise by Buffett for their strong-mindedness. I have noticed that when he is handing out praise, Buffett is eager to name the managers, however if results are poor he only mentions the company name.

Analysts at the time have predicted the insurance industry will do poorly for a year or so before getting back on track. Buffett disagrees with this, citing that he doesn't think that insurance companies will stop issuing policies at an underwriting loss and forecasts around a five year dip. As Berkshire Hathaway's companies will not be underwriting at a loss, he predicts this time will be difficult for them and warns that performance will not be as lucrative as previous years. Buffett demonstrates that he is single-minded and will go against conventional wisdom if he believes it to be incorrect. He also shows a high level of honesty towards his shareholders again.

The Illinois National Bank has beaten its own records and outperformed its competitors again, however due to legislation (the Bank Holding Company Act 1969), Berkshire Hathaway are being forced to sell most or all of the business. Buffett hopes to find a buyer next year but highlights that price is not the only factor. He wants to ensure the staff will be treated well after providing Berkshire Hathaway with a fantastic service over the years. Buffett does not expect to be able to employ the proceeds from the sale in as profitable a business.

"You simply can’t buy high quality businesses at the sort of price/earnings multiple likely to prevail on our bank sale."

Berkshire Hathaway are listed for trading on the NASDAQ, meaning that its earnings are now quoted in the Wall Street Journal and the Dow Jones ticker solving previous issues of information dissemination.

Buffett displays a great amount of respect for Berkshire Hathaway shareholders and takes the time to discuss the format of the companies annual reporting principles. As most shareholders are long-term investors and have a significant proportion of their wealth in Berkshire Hathaway stock, Buffett does not tend to restate things he has said in previous annual reports and aims to keep them informed of all the important issues in the companies operations.

"Many of these owners are willing to spend a significant amount of time with the annual report, and we attempt to provide them with the same information we would find useful if the roles were reversed."

Due to the long-term view, explanations are kept to a minimum in quarterly reports and saved for the annual reports, which are written by Buffett himself.

He goes on to explain that Berkshire Hathaway is not all things to all people and he intends for it to stay that way so that shareholders and potential shareholders know exactly where they stand. Buffett is happy with his current shareholders as they have the same views as the management and he does not want to lose them, in favour of new ones, as a consequence of becoming more universal.

"We much prefer owners who like our service and menu and who return year after year. It would be hard to find a better group to sit in the Berkshire Hathaway shareholder “seats” than those already occupying them."

Buffet expects next year to provide increased operating earnings but decreased return on equity. He states three reasons that could reduce operating earnings:

"the outcome depends partly upon the date of disposition of the bank, partly upon the degree of slippage in insurance underwriting profitability, and partly upon the severity of earnings problems in the savings and loan industry."

Berkshire Hathaway's financial decisions are made at the very top by Buffett's own very small team with operations delegated to a small number of key managers in each company. Buffett explains that this structure both reduces costs and speeds up the decision-making process as well as attracting and retaining some very talented individuals. Buffett believes that this is one of the reasons that Berkshire Hathaway continues to produce outstanding results year after year.

Investment Advice
Buffett describes what Berkshire Hathaway considers to be the best way to measure a companies performance over a year:

"We continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders’ equity with all securities valued at cost is the most appropriate way to measure any single year’s operating performance."

He goes on to explain that if securities were recorded at their current market value, it would create wild fluctuations from one year to the next due to the nature of the market. This would not show the true picture of how a company itself is performing.

Earnings per Share for Berkshire Hathaway has increased by 20%, however Buffett does not think this represents a sound figure on which to focus as capital has been somewhat under-utilised over the previous 12 months despite the fact that more had been available than in previous years. He goes on to provide further explanation of this:

“'Earnings per share' will rise constantly on a dormant savings account or on a U.S. Savings Bond bearing a fixed rate of return simply because 'earnings' (the stated interest rate) are continuously plowed back and added to the capital base."

"The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share."

In contrast, when measuring performance over the long term, Buffett believes that equities should be represented at market value and all realised capital gains and losses should be recorded as well as any extraordinary items. In the short term however, they are not good performance indicators.

"...it is just that their impact is often extremely capricious in the short run, a characteristic that makes them inappropriate as an indicator of single year managerial performance."

Investments by Berkshire Hathaway's insurance companies has produced good performance over the last year. Buffett forecasts that over the next year, equity markets will be less profitable but he doesn't intend to adjust any of the stock portfolios to match the market for one specific year, preferring to hold with a view to the long term.

Insurance companies are required to invest a percentage of their money in fixed income bonds, however Buffett explains that due to high inflation, long-term bonds are a risky as the value of the dollar is constantly being eroded. He goes on to explain that it is ironic that some insurance companies are only offering 6 month car policies as it is difficult to forecast the future in the current economic climate yet they are still investing in 30 and 40 year bonds!

"We have severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day."

One of the reasons for Berkshire Hathaway's outperforming competitors is that they have favoured convertible bonds (the bonds can be converted to shares) over normal bonds. Additionally, they have favoured equities over bonds.

Despite this, Buffett admits that mistakes have been made with the purchase of shorter term bonds (15 years). These were purchased knowing that bonds would probably underperform other investments and erred on the side of caution (15yr bonds instead of 40yr bonds).

"You do not adequately protect yourself by being half awake while others are sleeping."

Buffett concludes his discussion of bonds by saying that, on the positive side, new government legislation or higher interest rates could still protect bond buyers.