Chairman Letter's 1997
In a bull market, one must avoid the error of the preening duck that quacks
boastfully after a torrential rainstorm, thinking that its paddling skills have
caused it to rise in the world. A right-thinking duck would instead compare its
position after the downpour to that of the other ducks on the pond.
Under these circumstances, we try to exert a Ted Williams kind of discipline. In
his book The Science of Hitting, Ted explains that he carved the strike
zone into 77 cells, each the size of a baseball. Swinging only at balls in his
"best" cell, he knew, would allow him to bat .400; reaching for balls in his
"worst" spot, the low outside corner of the strike zone, would reduce him to
.230. In other words, waiting for the fat pitch would mean a trip to the Hall of
Fame; swinging indiscriminately would mean a ticket to the minors.
If they are in the strike zone at all, the business "pitches" we now
see are just catching the lower outside corner. If we swing, we will be locked
into low returns. But if we let all of today's balls go by, there can be no
assurance that the next ones we see will be more to our liking. Perhaps the
attractive prices of the past were the aberrations, not the full prices of
today. Unlike Ted, we can't be called out if we resist three pitches that are
barely in the strike zone; nevertheless, just standing there, day after day,
with my bat on my shoulder is not my idea of fun.
But now for the final exam: If you expect to be a net saver during the next five
years, should you hope for a higher or lower stock market during that period?
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. In effect, they rejoice because prices have risen for
the "hamburgers" they will soon be buying. This reaction makes no sense. Only
those who will be sellers of equities in the near future should be happy at
seeing stocks rise. Prospective purchasers should much prefer sinking prices.
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.")
Truly outsized risks will exist in these contracts if they are not properly
priced. A pernicious aspect of catastrophe insurance, however, makes it likely
that mispricing, even of a severe variety, will not be discovered for a very
long time. Consider, for example, the odds of throwing a 12 with a pair of dice
-- 1 out of 36. Now assume that the dice will be thrown once a year; that you,
the "bond-buyer," agree to pay $50 million if a 12 appears; and that for
"insuring" this risk you take in an annual "premium" of $1 million. That would
mean you had significantly underpriced the risk. Nevertheless, you could go
along for years thinking you were making money -- indeed, easy money. There is
actually a 75.4% probability that you would go for a decade without paying out a
dime. Eventually, however, you would go broke.
Looking for business that are understandable; possess excellent economics; and are run by outstanding
people.
The reasoning that Berkshire applies to the merger of public companies
should be the calculus for all buyers. Paying a takeover premium does not
make sense for any acquirer unless a) its stock is overvalued relative to the
acquiree's or b) the two enterprises will earn more combined than they would
separately. Predictably, acquirers normally hew to the second argument because
very few are willing to acknowledge that their stock is overvalued. However,
voracious buyers -- the ones that issue shares as fast as they can print them --
are tacitly conceding that point. (Often, also, they are running Wall Street's
version of a chain-letter scheme.)
In some mergers there truly are major synergies -- though oftentimes
the acquirer pays too much to obtain them -- but at other times the cost and
revenue benefits that are projected prove illusory. Of one thing, however, be
certain: If a CEO is enthused about a particularly foolish acquisition, both his
internal staff and his outside advisors will come up with whatever projections
are needed to justify his stance. Only in fairy tales are emperors told that
they are naked.
Though we don't attempt to predict the movements of the stock market, we do try,
in a very rough way, to value it. At the annual meeting last year, with the Dow
at 7,071 and long-term Treasury yields at 6.89%, Charlie and I stated that we
did not consider the market overvalued
if 1) interest rates remained
where they were or fell, and 2) American business continued to earn the
remarkable returns on equity that it had recently recorded. So far, interest
rates have fallen -- that's one requisite satisfied -- and returns on equity
still remain exceptionally high. If they stay there -- and if interest rates
hold near recent levels -- there is no reason to think of stocks as generally
overvalued. On the other hand, returns on equity are not a sure thing to remain
at, or even near, their present levels.
In the summer of 1979, when equities looked cheap to me, I wrote a
Forbes
article entitled "You pay a very high price in the stock market for a cheery
consensus." At that time skepticism and disappointment prevailed, and my point
was that investors should be glad of the fact, since pessimism drives down
prices to truly attractive levels. Now, however, we have a very cheery
consensus. That does not necessarily mean this is the wrong time to buy stocks:
Corporate America is now earning far more money than it was just a few years
ago, and in the presence of lower interest rates, every dollar of earnings
becomes more valuable. Today's price levels, though, have materially eroded the
"margin of safety" that Ben Graham identified as the cornerstone of intelligent
investing.
Chairman's letter 1998
The Economics of Property-Casualty Insurance
With the acquisition of General Re — and with GEICO’s business mushrooming — it becomes more important than ever that you understand how to evaluate an insurance company. The key determinants are: (1) the amount of float that the business generates;
(2) its cost; and
(3) most important of all, the long-term outlook for both of these factors.
In allocating capital, activity does not correlate with achievement.
Indeed, in the fields of investments and acquisitions, frenetic behavior is often counterproductive. Therefore, Charlie and I mainly just wait for the phone to ring.
Though the two plans are an economic wash, the cash plan we are putting in will produce a vastly different
accounting result. This Alice-in-Wonderland outcome occurs because existing accounting principles ignore the cost of stock options when earnings are being calculated, even though options are a huge and increasing expense at a great many corporations. In effect, accounting principles offer management a choice: Pay employees in one form and count the cost, or pay them in another form and ignore the cost. Small wonder then that the use of options has mushroomed. This lop-sided choice has a big downside for owners, however: Though options, if properly structured, can be an appropriate, and even ideal, way to compensate and motivate top managers, they are more often wildly capricious in their distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders.
Chairman Letter's 1999
If profits do indeed grow along with GDP, at about a 5% rate, the valuation placed on American business is
unlikely to climb by much more than that. Add in something for dividends, and you emerge with returns from equities that are dramatically less than most investors have either experienced in the past or expect in the future. If investor expectations become more realistic — and they almost certainly will — the market adjustment is apt to be severe, particularly in sectors in which speculation has been concentrated.
Chairman Letter's 2000
A second factor that helped us in 2000 was that the market for junk bonds dried up as the year progressed.
In the two preceding years, junk bond purchasers had relaxed their standards, buying the obligations of everweaker issuers at inappropriate prices. The effects of this laxity were felt last year in a ballooning of defaults. In this environment, “financial” buyers of businesses ¾ those who wish to buy using only a sliver of equity ¾ became unable to borrow all they thought they needed. What they could still borrow, moreover, came at a high price. Consequently, LBO operators became less aggressive in their bidding when businesses came up for sale last year. Because we analyze purchases on an all-equity basis, our evaluations did not change, which means we became considerably more competitive.
We find it meaningful when an owner cares about whom he sells to. We like to do business with someone
who loves his company, not just the money that a sale will bring him (though we certainly understand why he likes that as well). When this emotional attachment exists, it signals that important qualities will likely be found within the business: honest accounting, pride of product, respect for customers, and a loyal group of associates having a strong sense of direction. The reverse is apt to be true, also. When an owner auctions off his business, exhibiting a total lack of interest in what follows, you will frequently find that it has been dressed up for sale, particularly when the seller is a “financial owner.” And if owners behave with little regard for their business and its people, their conduct will often contaminate attitudes and practices throughout the company.
Under GAAP accounting, this “retroactive” insurance neither benefits nor penalizes our current earnings. Instead, we set up an asset called “deferred charges applicable to assumed reinsurance,” in an amount reflecting the difference between the premium we receive and the (higher) losses we expect to pay (for which reserves are immediately established). We then amortize this asset by making annual charges to earnings that create equivalent underwriting losses. You will find the amount of the loss that we incur from these transactions in both our quarterly and annual management discussion. By their nature, these losses will continue for many years, often stretching into decades. As an offset, though, we have the use of float ¾ lots of it.
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush ¾ and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota — nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.
Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component ¾ usually a plus, sometimes a minus ¾ in the value equation.
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities ¾ that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future ¾ will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
When Charlie and I read reports,
we have no interest in pictures of personnel, plants or products. References to EBITDA make us
shudder ¾ does management
think the tooth fairy pays for capital expenditures? We’re very suspicious of
accounting methodology that is vague or unclear, since too often that means
management wishes to hide something. And we
don’t want to read messages that a public relations department or consultant
has turned
out. Instead, we expect a company’s CEO to explain in his or her own words what’s
happening.
Chairman's letter 2001
Principles of Insurance Underwriting
When property/casualty companies are judged by their cost of float, very few stack up as satisfactory businesses. And interestingly – unlike the situation prevailing in many other industries – neither size nor brand
name determines an insurer’s profitability. Indeed, many of the biggest and best-known companies regularly
deliver mediocre results. What counts in this business is underwriting discipline. The winners are those that
unfailingly stick to three key principles:
1. They accept only those risks that they are able to properly evaluate (staying within their circle of
competence) and that, after they have evaluated all relevant factors including remote loss
scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and
are sanguine about losing business to competitors that are offering foolish prices or policy
conditions.
2. They limit the business they accept in a manner that guarantees they will suffer no aggregation of
losses from a single event or from related events that will threaten their solvency. They
ceaselessly search for possible correlation among seemingly-unrelated risks.
3. They avoid business involving moral risk: No matter what the rate, trying to write good contracts
with bad people doesn’t work. While most policyholders and clients are honorable and ethical,
doing business with the few exceptions is usually expensive, sometimes extraordinarily so.
His
extraordinary discipline,
of course, does not eliminate losses; it does, however, prevent foolish losses.
And that.s the key: Just as is the
case in investing, insurers produce outstanding long-term results primarily by
avoiding dumb decisions, rather than by making brilliant
ones.
In insurance reporting, “loss development” is a widely used term – and one that is seriously misleading. First, a definition: Loss reserves at an insurer are not funds tucked away for a rainy day, but rather a liability account. If properly calculated, the liability states the amount that an insurer will have to pay for all losses (including associated costs) that have
occurred prior to the reporting date but have
not yet been paid. When
calculating the reserve, the insurer will have been notified of many of the losses it is destined to pay, but others will not yet have been reported to it. These losses are called IBNR, for
incurred but not reported. Indeed, in some cases (involving, say, product liability or embezzlement) the insured itself will not yet be aware that a loss has occurred.
It’s clearly difficult for an insurer to put a figure on the ultimate cost of all such reported and unreported events. But the ability to do so with reasonable accuracy is vital. Otherwise the insurer’s managers won’t know what its actual loss costs are and how these compare to the premiums being charged.
When it becomes evident that reserves at past reporting dates understated the liability that truly existed at
the time, companies speak of “loss development.” In the year discovered, these shortfalls penalize reported
earnings because the “catch-up” costs from prior years must be added to current-year costs when results are
calculated.
“Loss development” suggests to investors that some natural, uncontrollable event has occurred in the
current year, and “reserve strengthening” implies that adequate amounts have been further buttressed. The truth, however, is that management made an error in estimation that in turn produced an error in the earnings previously reported. The losses didn’t “develop” – they were there all along. What developed was management’s
understanding of the losses (or, in the instances of chicanery, management’s willingness to finally fess up).
A more forthright label for the phenomenon at issue would be “loss costs we failed to recognize when they
occurred” (or maybe just “oops”). Underreserving, it should be noted, is a common – and serious – problem
throughout the property/casualty insurance industry.
