Warren Buffet Chairman's letter summary 1977-1981

Chairman's letter 1977

Insurance business -

Monetary Inflation raises cost of repairing humans and property

" Social Inflation " - a broadening definition by society and juries of what is covered by insurance policies.

Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition. It is commonplace, in corporate annual reports, to stress the difference that people make. Sometimes this is true and sometimes it isn’t. But there is no question that the nature of the insurance business magnifies the effect which individual managers have on company performance. We are very fortunate to have the group of managers that are associated with us.

Chairman's letter 1978

The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.

(1) businesses we can understand,

(2) with favorable long-term prospects,

(3) operated by honest and competent people, and

(4) priced very attractively.

Chairman's letter 1979

In some businesses - a network TV station, for example - it is virtually impossible to avoid earning extraordinary returns on tangible capital employed in the business. And assets in such businesses sell at equally extraordinary prices, one thousand cents or more on the dollar, a valuation reflecting the splendid, almost unavoidable, economic results obtainable. Despite a fancy price tag, the “easy” business may be the better route to go.

the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.

Present interest rates encourage the obtaining of business at underwriting loss levels formerly regarded as totally unacceptable. Managers decry the folly of underwriting at a loss to obtain investment income, but we believe that many will. Thus we expect that competition will create a new threshold of tolerance for underwriting losses.

Nevertheless, we believe that insurance can be a very good business. It tends to magnify, to an unusual degree, human managerial talent - or the lack of it

Chairman's letter 1980

Rather, we borrowed because we think that, over a period far shorter than the life of the loan, we will have many opportunities to put the money to good use.  The most attractive opportunities may present themselves at a time when credit is extremely expensive - or even unavailable.  At such a time we want to have plenty of financial firepower.

Our acquisition preferences run toward businesses that generate cash, not those that consume it.

However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.

Chairman's letter 1981

In fairness, we should acknowledge that some acquisition records have been dazzling. Two major categories stand out.

The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and 

(2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.

The second category involves the managerial superstars - men who can recognize that rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise. 

We expect that undistributed earnings from such companies will produce full value (subject to tax when realized) for Berkshire and its shareholders. If they don’t, we have made mistakes as to either: (1) the management we have elected to join; (2) the future economics of the business; or (3) the price we have paid.

Category (2) miscalculations are the most common. 

Like virginity, a stable price level seems capable of maintenance, but not of restoration.

Inflationary experience and expectations will be major (but not the only) factors affecting the height of the crossbar (of passive income) in future years.  If the causes of long-term inflation can be tempered, passive returns are likely to fall and the intrinsic position of American equity capital should significantly improve.  

What makes sense for the bondholder makes sense for the shareholder.  Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital.  Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas. (The Scriptures concur.  In the parable of the talents, the two high-earning servants are rewarded with 100% retention of earnings and encouraged to expand their operations.  However, the non-earning third servant is not only chastised - “wicked and slothful” - but also is required to redirect all of his capital to the top performer.  Matthew 25: 14-30)

But inflation takes us through the looking glass into the upside-down world of Alice in Wonderland.  When prices continuously rise, the “bad” business must retain every nickel that it can.  Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy.  If it wishes to continue operating in the future as it has in the past - and most entities, including businesses, do - it simply has no choice.

For inflation acts as a gigantic corporate tapeworm.  That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.  Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year.  The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.

Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or “real” dividends.  The tapeworm of inflation simply cleans the plate. (The low-return company’s inability to pay dividends, understandably, is often disguised.  Corporate America increasingly is turning to dividend reinvestment plans, sometimes even embodying a discount arrangement that all but forces shareholders to reinvest.  Other companies sell newly issued shares to Peter in order to pay dividends to Paul.  Beware of “dividends” that can be paid out only if someone promises to replace the capital distributed.)