I recently started to read Buffett’s Chairman’s letters of Berkshire.
The first letter (1977) includes a few simple but very important highlights besides reporting business segments’ operational performance and highlighting the roles of key personnel. First, about desired securities and second about economic value added vs accounting profits.
We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.
Such investments initially may have negligible impact on our operating earnings. For example, we invested $10.9 million in Capital Cities* Communications during 1977. Earnings attributable to the shares we purchased totaled about $1.3 million last year. But only the cash dividend, which currently provides $40,000 annually, is reflected in our operating earnings figure.
The second letter (1978) is mostly about the operational results. Again, Buffett highlights differences between accounting measures and economic value added: retained earnings within a business that manages to generate high returns are perfectly fine. Further, he stresses that the market price movements of investments within a short period, like one year, should not be taken too seriously, but over a longer period these should greatly influence returns (if done right).
In the third letter (1979), Buffett explicitly educates his shareholders about the necessity to evaluate returns on equity. Merely looking at growing earnings per share or rising EPS is not enough – this could easily be achieved by putting more money (equity) to work at a savings account at the same interest rate. Further, he describes the typical Berkshire shareholder and educates about accounting changes requiring insurance companies to account for equity securities at market prices (distortion of underlying operational performance) and inflation as a headwind to real returns.
Earnings per share, of course, increased somewhat (about 20%) but we regard this as an improper figure upon which to focus. We had substantially more capital to work with in 1979 than in 1978, and our performance in utilizing that capital fell short of the earlier year, even though per-share earnings rose. “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. Thus, even a “stopped clock” can look like a growth stock if the dividend payout ratio is low.
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 our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.
I do not know yet if reading each letter is the best use of (my) time, since they seem to inlcude only small doses of timeless content (like prinicples and wisdom) and more content relating to time specific developments, i.e. how fared the insurance business and the industry in the particular year (which can alos provide value). Maybe it is better to read a good book summarizing the timeless lessons from the letter. Thus, I read the 2020 letter next. One thing strikes ma asap: Four decades later, Buffett still educates his shareholders/readers about how to read Berkshires results (accounting vs true economic value creation). I love that! This is a great way of how to use this letter.
The part about conglomerates and their bad reputation is a great lesson about usual M&A deals and their value destruction. One of CEOs featured in The outsiders (a great book) did exactly the right thing: using his overvalued conglomerate shares as a acquisition currency for other companies. When the overvaluation stopped he stopped, fired his business development team and never bought another company again! This is the important lesson: It’s not that conglomerates are bad per se, but they can be a great shareholder value creation machines if (and only if) the CEO thinks and acts as an investor!
Buffett fell in love with GEICO 70 years ago. I currently fall in love with Progressive which is also one of the big auto insurers but different (Buffett knows that Progressive is a great business as well). The more letters and reports I read about Progressive (disclaimer: I own PGR US) the more I like it, which strikes me as a potential danger and I want to look for more discomforting facts challenging my investment thesis (so far I did not find it). Still, I believe it is unlikly that PGR will deliver returns anything close to GEICO from today, simply because it already delivered great returns and grew to a big business (late to the party).
His view at the middle of the US, apart from the ever present coasts is a refreshing reminder that the most fertile hunting grounds might not be found where everybody is looking. His way of doing deals without audit via a quick handshake was probably fine, but might be way more dangerous today.
If some investors still do not get what the difference between chasing short term earnings and act as a long-term investor /CEO, read the part about BHE’s investment project started in 2006 (projected end: 2030): modernising the grid. Somehow related, I always love to read about the decade-long shareholders, who were so wise/lucky to invest a (considerable) part of their family savings early and ‘partnered’ with Berkshire until today. The basis for this is trust in the management’s ability and integrity to act and treat them as a true partner. The recent 2020 letter was a great read!