Berkshire Hathaway Letters

Each year, Warren Buffett writes an open letter to Berkshire Hathaway shareholders which many value investors can’t wait to jump on reading. In this post, we have summarised the key learnings from the letter written in 1984, to save you the time from reading the whole letter (although still strongly recommended).

Berkshire Hathaway – 1984 Letter Learnings

Buffett: When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.

The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding for two important reasons – one that is obvious, and one that is subtle and not always understood. The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended.

The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are entirely rational. Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer. (To make the point extreme, how much would you pay to be a minority shareholder of a company controlled by Robert Wesco?)

The key word is “demonstrated”. A manager who consistently turns his back on repurchases, when these clearly are in the interests of owners, reveals more than he knows of his motivations. No matter how often or how eloquently he mouths some public relations-inspired phrase such as “maximizing shareholder wealth” (this season’s favorite), the market correctly discounts assets lodged with him. His heart is not listening to his mouth – and, after a while, neither will the market.

We have prospered in a very major way – as have other shareholders – by the large share repurchases of GEICO, Washington Post, and General Foods, our three largest holdings… We feel very comfortable owning interests in businesses such as these that offer excellent economics combined with shareholder-conscious managements.

MoneyWiseSmart (MWS): How do the management of your companies talk about, and act on, the topic of share repurchases? Do you feel comfortable with their shareholder consciousness?

Buffett: It’s been over ten years since it has been as difficult as now to find equity investments that meet both our qualitative standards and our quantitative standards of value versus price. We try to avoid compromise of these standards, although we find doing nothing the most difficult task of all. (One English statesman attributed his country’s greatness in the nineteenth century to a policy of “masterly inactivity”. This is a strategy that is far easier for historians to commend than for participants to follow.)

MoneyWiseSmart (MWS): Let’s be honest to ourselves. How good are you, or have you been, in sitting still and doing nothing?

Buffett: I have reported to you in the past few years that the performance of GEICO’s stock has considerably exceeded that company’s business performance, brilliant as the latter has been. In those years, the carrying value of our GEICO investment on our balance sheet grew at a rate greater than the growth in GEICO’s intrinsic business value. I warned you that over performance by the stock relative to the performance of the business obviously could not occur every year, and that in some years the stock must under perform the business. In 1984 that occurred and the carrying value of our interest in GEICO changed hardly at all, while the intrinsic business value of that interest increased substantially. Since 27% of Berkshire’s net worth at the beginning of 1984 was represented by GEICO, its static market value had a significant impact upon our rate of gain for the year. We are not at all unhappy with such a result: we would far rather have the business value of GEICO increase by X during the year, while market value decreases, than have the intrinsic value increase by only 1/2 X with market value soaring. In GEICO’s case, as in all of our investments, we look to business performance, not market performance. If we are correct in expectations regarding the business, the market eventually will follow along.

MoneyWiseSmart (MWS): Would you prefer the market value or the intrinsic value of your businesses to go up, if you have to choose one?

Buffett: Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)

Our equation is different. With 47% of Berkshire’s stock, Charlie and I don’t worry about being fired, and we receive our rewards as owners, not managers. Thus we behave with Berkshire’s money as we would with our own. That frequently leads us to unconventional behavior both in investments and general business management.

MoneyWiseSmart (MWS): Do the managers of your businesses act like lemming managers, or owners willing to adopt unconventional behavior?

Buffett: Dividend policy is often reported to shareholders, but seldom explained. A company will say something like, “Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI”. And that’s it – no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.

… In our opinion, management should choose whichever course makes greater sense for the owners of the business. This principle is not universally accepted.

For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders – to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.

Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)

… Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital.

MoneyWiseSmart (MWS): What are the dividend and earnings retention policies of your businesses? Do the managers explain (or even think about) them?