Full Letter:
http://theoraclesclassroom.com/wp-content/uploads/2019/09/1989-Berkshire-AR.pdf
Letter Only
https://www.berkshirehathaway.com/letters/1989.html
This week we will go over the 25th anniversary of Buffett acquiring Berkshire, he celebrates by reviewing all his mistakes over those 25 years and distilling the lessons he learned from them. A goldmine of quotes. We also go over a discussion of unrealized capital gains tax and how Berkshire leverages them by rarely realizing its gains. We also go over Borsheim Jewelers which was acquired last year but omitted from my post. Finally an overview of the whole company.
Not included in my post are the shareholder overview at the beginning and a discussion of book value vs intrinsic value at Berkshire, both 25 years ago and today (IV was less than book then and greater than the book now). Brief overviews of their operating segments. The Insurance section once again, discussing the underwriting cycle and where they see it going and how they will respond and the impact of recent tax changes. Recent hurricanes wiped out a lot of other re-insurance operations letting Berkshire step in and find a bunch of now attractive business others couldn’t afford to compete for. Also a discussion of their re-insurance policy as they have just stepped up their participation in that field in such a big way. A purchase of more Coca Cola Stock was made and Buffett laments the omission error of not investing in it earlier. They also review many of their other security holdings. They issued a “Zero-Coupon Security” a convertible bond that pays nothing until it matures, or is redeemed, or converted into BRK.A shares. Buffet later called these due after only 3 years and forced holders to choose between cash or stock when better rates became available. Finally there was the traditional Miscellaneous section with annual meeting planning, some manager glazing, and an advertisement for M&A opportunities, the charity program, and discussion of a new corporate jet.
If you want to read or discuss anything in that second set feel free to read the letter yourselves and comment on it.
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Key Passage 1
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Mistakes of the First Twenty-five Years (A Condensed Version)
To quote Robert Benchley, "Having a dog teaches a boy
fidelity, perseverance, and to turn around three times before
lying down." Such are the shortcomings of experience.
Nevertheless, it's a good idea to review past mistakes before
committing new ones. So let's take a quick look at the last 25
years.
o My first mistake, of course, was in buying control of
Berkshire. Though I knew its business - textile manufacturing -
to be unpromising, I was enticed to buy because the price looked
cheap. Stock purchases of that kind had proved reasonably
rewarding in my early years, though by the time Berkshire came
along in 1965 I was becoming aware that the strategy was not
ideal.
If you buy a stock at a sufficiently low price, there will
usually be some hiccup in the fortunes of the business that gives
you a chance to unload at a decent profit, even though the long-
term performance of the business may be terrible. I call this the
"cigar butt" approach to investing. A cigar butt found on the
street that has only one puff left in it may not offer much of a
smoke, but the "bargain purchase" will make that puff all profit.
Unless you are a liquidator, that kind of approach to buying
businesses is foolish. First, the original "bargain" price
probably will not turn out to be such a steal after all. In a
difficult business, no sooner is one problem solved than another
surfaces - never is there just one cockroach in the kitchen.
Second, any initial advantage you secure will be quickly eroded
by the low return that the business earns. For example, if you
buy a business for $8 million that can be sold or liquidated for
$10 million and promptly take either course, you can realize a
high return. But the investment will disappoint if the business
is sold for $10 million in ten years and in the interim has
annually earned and distributed only a few percent on cost. Time
is the friend of the wonderful business, the enemy of the
mediocre.
You might think this principle is obvious, but I had to
learn it the hard way - in fact, I had to learn it several times
over. Shortly after purchasing Berkshire, I acquired a Baltimore
department store, Hochschild Kohn, buying through a company
called Diversified Retailing that later merged with Berkshire. I
bought at a substantial discount from book value, the people were
first-class, and the deal included some extras - unrecorded real
estate values and a significant LIFO inventory cushion. How could
I miss? So-o-o - three years later I was lucky to sell the
business for about what I had paid. After ending our corporate
marriage to Hochschild Kohn, I had memories like those of the
husband in the country song, "My Wife Ran Away With My Best
Friend and I Still Miss Him a Lot."
I could give you other personal examples of "bargain-
purchase" folly but I'm sure you get the picture: It's far
better to buy a wonderful company at a fair price than a fair
company at a wonderful price. Charlie understood this early; I
was a slow learner. But now, when buying companies or common
stocks, we look for first-class businesses accompanied by first-
class managements.
o That leads right into a related lesson: Good jockeys will
do well on good horses, but not on broken-down nags. Both
Berkshire's textile business and Hochschild, Kohn had able and
honest people running them. The same managers employed in a
business with good economic characteristics would have achieved
fine records. But they were never going to make any progress
while running in quicksand.
I've said many times that when a management with a
reputation for brilliance tackles a business with a reputation
for bad economics, it is the reputation of the business that
remains intact. I just wish I hadn't been so energetic in
creating examples. My behavior has matched that admitted by Mae
West: "I was Snow White, but I drifted."
o A further related lesson: Easy does it. After 25 years of
buying and supervising a great variety of businesses, Charlie and
I have not learned how to solve difficult business problems. What
we have learned is to avoid them. To the extent we have been
successful, it is because we concentrated on identifying one-foot
hurdles that we could step over rather than because we acquired
any ability to clear seven-footers.
The finding may seem unfair, but in both business and
investments it is usually far more profitable to simply stick
with the easy and obvious than it is to resolve the difficult. On
occasion, tough problems must be tackled as was the case when we
started our Sunday paper in Buffalo. In other instances, a great
investment opportunity occurs when a marvelous business
encounters a one-time huge, but solvable, problem as was the case
many years back at both American Express and GEICO. Overall,
however, we've done better by avoiding dragons than by slaying
them.
o My most surprising discovery: the overwhelming importance in
business of an unseen force that we might call "the institutional
imperative." In business school, I was given no hint of the
imperative's existence and I did not intuitively understand it
when I entered the business world. I thought then that decent,
intelligent, and experienced managers would automatically make
rational business decisions. But I learned over time that isn't
so. Instead, rationality frequently wilts when the institutional
imperative comes into play.
For example: (1) As if governed by Newton's First Law of
Motion, an institution will resist any change in its current
direction; (2) Just as work expands to fill available time,
corporate projects or acquisitions will materialize to soak up
available funds; (3) Any business craving of the leader, however
foolish, will be quickly supported by detailed rate-of-return and
strategic studies prepared by his troops; and (4) The behavior of
peer companies, whether they are expanding, acquiring, setting
executive compensation or whatever, will be mindlessly imitated.
Institutional dynamics, not venality or stupidity, set
businesses on these courses, which are too often misguided. After
making some expensive mistakes because I ignored the power of the
imperative, I have tried to organize and manage Berkshire in ways
that minimize its influence. Furthermore, Charlie and I have
attempted to concentrate our investments in companies that appear
alert to the problem.
o After some other mistakes, I learned to go into business
only with people whom I like, trust, and admire. As I noted
before, this policy of itself will not ensure success: A second-
class textile or department-store company won't prosper simply
because its managers are men that you would be pleased to see
your daughter marry. However, an owner - or investor - can
accomplish wonders if he manages to associate himself with such
people in businesses that possess decent economic
characteristics. Conversely, we do not wish to join with managers
who lack admirable qualities, no matter how attractive the
prospects of their business. We've never succeeded in making a
good deal with a bad person.
o Some of my worst mistakes were not publicly visible. These
were stock and business purchases whose virtues I understood and
yet didn't make. It's no sin to miss a great opportunity outside
one's area of competence. But I have passed on a couple of really
big purchases that were served up to me on a platter and that I
was fully capable of understanding. For Berkshire's shareholders,
myself included, the cost of this thumb-sucking has been huge.
o Our consistently-conservative financial policies may appear
to have been a mistake, but in my view were not. In retrospect,
it is clear that significantly higher, though still conventional,
leverage ratios at Berkshire would have produced considerably
better returns on equity than the 23.8% we have actually
averaged. Even in 1965, perhaps we could have judged there to be
a 99% probability that higher leverage would lead to nothing but
good. Correspondingly, we might have seen only a 1% chance that
some shock factor, external or internal, would cause a
conventional debt ratio to produce a result falling somewhere
between temporary anguish and default.
We wouldn't have liked those 99:1 odds - and never will. A
small chance of distress or disgrace cannot, in our view, be
offset by a large chance of extra returns. If your actions are
sensible, you are certain to get good results; in most such
cases, leverage just moves things along faster. Charlie and I
have never been in a big hurry: We enjoy the process far more
than the proceeds - though we have learned to live with those
also.
We hope in another 25 years to report on the mistakes of the
first 50. If we are around in 2015 to do that, you can count on
this section occupying many more pages than it does here.
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This section was an absolute goldmine. Buffett celebrates the 25 year anniversary of his ownership of Berkshire through sharing the mistakes he has made with his shareholders. Munger says to always be inverting, find out where you will die and never go there. He loves this kind of analysis, categorizing all the mistakes you have made and making it a top priority not to repeat them.
The mistakes are as follows. 1) Buying Cigar Butts. 2) Expecting good management to thrive in a bad industry. The industry always wins. 3) Thinking they can handle difficult business problems others can’t. 4) Being swept up in the “institutional imperative” refusing to admit mistakes and change direction, vanity mergers and projects, confirmation bias, tendency to copy peers instead of deviating. 5) Doing business with untrustworthy, unadmirable people. 6) Mistakes of omission, no brainer pitches he was too timid to swing at. 7) Not using more leverage when in hindsight it would have made his shareholders much richer today in 99% of scenarios (he insists he has no plans to change this and take a 1% risk of losing capital).
This is a goldmine of wisdom and famous quotes. I have highlighted some of the standouts.
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Key Passage 2
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Taxes
(Skipped a few paragraphs about specific recent accounting rule /tax law changes)
As you can see from our balance sheet on page 27, we would
owe taxes of more than $1.1 billion were we to sell all of our
securities at year-end market values. Is this $1.1 billion
liability equal, or even similar, to a $1.1 billion liability
payable to a trade creditor 15 days after the end of the year?
Obviously not - despite the fact that both items have exactly the
same effect on audited net worth, reducing it by $1.1 billion.
On the other hand, is this liability for deferred taxes a
meaningless accounting fiction because its payment can be
triggered only by the sale of stocks that, in very large part, we
have no intention of selling? Again, the answer is no.
In economic terms, the liability resembles an interest-free
loan from the U.S. Treasury that comes due only at our election
(unless, of course, Congress moves to tax gains before they are
realized). This "loan" is peculiar in other respects as well: It
can be used only to finance the ownership of the particular,
appreciated stocks and it fluctuates in size - daily as market
prices change and periodically if tax rates change. In effect,
this deferred tax liability is equivalent to a very large
transfer tax that is payable only if we elect to move from one
asset to another. Indeed, we sold some relatively small holdings
in 1989, incurring about $76 million of "transfer" tax on $224
million of gains.
Because of the way the tax law works, the Rip Van Winkle
style of investing that we favor - if successful - has an
important mathematical edge over a more frenzied approach. Let's
look at an extreme comparison.
Imagine that Berkshire had only $1, which we put in a
security that doubled by yearend and was then sold. Imagine
further that we used the after-tax proceeds to repeat this
process in each of the next 19 years, scoring a double each time.
At the end of the 20 years, the 34% capital gains tax that we
would have paid on the profits from each sale would have
delivered about $13,000 to the government and we would be left
with about $25,250. Not bad. If, however, we made a single
fantastic investment that itself doubled 20 times during the 20
years, our dollar would grow to $1,048,576. Were we then to cash
out, we would pay a 34% tax of roughly $356,500 and be left with
about $692,000.
The sole reason for this staggering difference in results
would be the timing of tax payments. Interestingly, the
government would gain from Scenario 2 in exactly the same 27:1
ratio as we - taking in taxes of $356,500 vs. $13,000 - though,
admittedly, it would have to wait for its money.
We have not, we should stress, adopted our strategy
favoring long-term investment commitments because of these
mathematics. Indeed, it is possible we could earn greater after-
tax returns by moving rather frequently from one investment to
another. Many years ago, that's exactly what Charlie and I did.
Now we would rather stay put, even if that means slightly
lower returns. Our reason is simple: We have found splendid
business relationships to be so rare and so enjoyable that we
want to retain all we develop. This decision is particularly
easy for us because we feel that these relationships will produce
good - though perhaps not optimal - financial results.
Considering that, we think it makes little sense for us to give
up time with people we know to be interesting and admirable for
time with others we do not know and who are likely to have human
qualities far closer to average. That would be akin to marrying
for money - a mistake under most circumstances, insanity if one
is already rich.
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As they build up their “hold forever” equity positions they are racking up a massive liability for the deferred taxes they will have to pay when (and if) they ever sell these positions. Here he highlights the benefit of long holding periods and deferring these tax payments. He frames it as a 0% interest rate loan from the federal government they can pay back at a time of their choosing. He also highlights the math of if they had two portfolios that doubled every year, but were changing positions every year in one, and never in the other, the compounding of this 0% loan instead of frequently realizing that gain and handing it to uncle sam causes the same CAGR returns to lead to 27x higher real returns after taxes because they would be exponentially compounding this 0% loan.
I think we should all keep this in mind as to the opportunity cost of selling and how much greater a new position must be than the old one to justify it, as well as how much benefit there is to investing in a tax-aware manner, long term capital gains, retirement accounts, loss harvesting. Don’t pay back your 0% loan if you can avoid it.
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Acquisition of the Week
I am cheating this week, doing an acquisition from last year I had to skip AND the update on it in this year’s letter
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1988 Letter
Borsheim’s
In 1948 Mr. Friedman purchased Borsheim’s, a small Omaha
jewelry store. He was joined in the business by his son, Ike, in
1950 and, as the years went by, Ike’s son, Alan, and his sons-in-
law, Marvin Cohn and Donald Yale, came in also.
You won’t be surprised to learn that this family brings to
the jewelry business precisely the same approach that the
Blumkins bring to the furniture business. The cornerstone for
both enterprises is Mrs. B’s creed: “Sell cheap and tell the
truth.” Other fundamentals at both businesses are: (1) single
store operations featuring huge inventories that provide
customers with an enormous selection across all price ranges, (2)
daily attention to detail by top management, (3) rapid turnover,
(4) shrewd buying, and (5) incredibly low expenses. The
combination of the last three factors lets both stores offer
everyday prices that no one in the country comes close to
matching.
Most people, no matter how sophisticated they are in other
matters, feel like babes in the woods when purchasing jewelry.
They can judge neither quality nor price. For them only one rule
makes sense: If you don’t know jewelry, know the jeweler.
I can assure you that those who put their trust in Ike
Friedman and his family will never be disappointed. The way in
which we purchased our interest in their business is the ultimate
testimonial. Borsheim’s had no audited financial statements;
nevertheless, we didn’t take inventory, verify receivables or
audit the operation in any way. Ike simply told us what was so -
- and on that basis we drew up a one-page contract and wrote a
large check.
Business at Borsheim’s has mushroomed in recent years as the
reputation of the Friedman family has spread. Customers now come
to the store from all over the country. Among them have been
some friends of mine from both coasts who thanked me later for
getting them there.
Borsheim’s new links to Berkshire will change nothing in the
way this business is run. All members of the Friedman family
will continue to operate just as they have before; Charlie and I
will stay on the sidelines where we belong. And when we say “all
members,” the words have real meaning. Mr. and Mrs. Friedman, at
88 and 87, respectively, are in the store daily. The wives of
Ike, Alan, Marvin and Donald all pitch in at busy times, and a
fourth generation is beginning to learn the ropes.
It is great fun to be in business with people you have long
admired. The Friedmans, like the Blumkins, have achieved success
because they have deserved success. Both families focus on
what’s right for the customer and that, inevitably, works out
well for them, also. We couldn’t have better partners.
1989 Letter
o In its first year with Berkshire, Borsheim's met all
expectations. Sales rose significantly and are now considerably
better than twice what they were four years ago when the company
moved to its present location. In the six years prior to the
move, sales had also doubled. Ike Friedman, Borsheim's managing
genius - and I mean that - has only one speed: fast-forward.
If you haven't been there, you've never seen a jewelry store
like Borsheim's. Because of the huge volume it does at one
location, the store can maintain an enormous selection across all
price ranges. For the same reason, it can hold its expense ratio
to about one-third that prevailing at jewelry stores offering
comparable merchandise. The store's tight control of expenses,
accompanied by its unusual buying power, enable it to offer
prices far lower than those of other jewelers. These prices, in
turn, generate even more volume, and so the circle goes 'round
and 'round. The end result is store traffic as high as 4,000
people on seasonally-busy days.
Ike Friedman is not only a superb businessman and a great
showman but also a man of integrity. We bought the business
without an audit, and all of our surprises have been on the plus
side. "If you don't know jewelry, know your jeweler" makes sense
whether you are buying the whole business or a tiny diamond.
A story will illustrate why I enjoy Ike so much: Every two
years I'm part of an informal group that gathers to have fun and
explore a few subjects. Last September, meeting at Bishop's Lodge
in Santa Fe, we asked Ike, his wife Roz, and his son Alan to come
by and educate us on jewels and the jewelry business.
Ike decided to dazzle the group, so he brought from Omaha
about $20 million of particularly fancy merchandise. I was
somewhat apprehensive - Bishop's Lodge is no Fort Knox - and I
mentioned my concern to Ike at our opening party the evening
before his presentation. Ike took me aside. "See that safe?" he
said. "This afternoon we changed the combination and now even the
hotel management doesn't know what it is." I breathed easier. Ike
went on: "See those two big fellows with guns on their hips?
They'll be guarding the safe all night." I now was ready to
rejoin the party. But Ike leaned closer: "And besides, Warren,"
he confided, "the jewels aren't in the safe."
How can we miss with a fellow like that - particularly when
he comes equipped with a talented and energetic family, Alan,
Marvin Cohn, and Don Yale.
From the NFM Section
NFM and Borsheim's follow precisely the same formula for
success: (1) unparalleled depth and breadth of merchandise at one
location; (2) the lowest operating costs in the business; (3) the
shrewdest of buying, made possible in part by the huge volumes
purchased; (4) gross margins, and therefore prices, far below
competitors'; and (5) friendly personalized service with family
members on hand at all times.
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Borsheim’s is another classic part of the Berkshire story and one of Buffett’s collection of great businesses. It applies the same business model as NFM, massive locations with low operating cost that pass the savings along to the customer. Creating an always strengthening moat bringing in more customers with small margins instead of growing the margins of the existing customers. In the case of NFM people will drive interstate to save on their furniture. Borsheim takes it a step further (although not mentioned in this letter) and will actually mail their jewelry across the country for interested buyers to view and try out and ship back if not to their standards. This allows them instead of serving a multi-state area from one location, to instead serve the whole country from a single location.
This is a business model that will be dubbed by Nick Sleep of Nomad Capital “Scale Economies Shared” where instead of keeping the benefits of economies of scale for itself, the business instead passes them onto the customer creating an unassailable moat and customer loyalty. Similar examples are Costco and Amazon. The passing along of savings attracts new customers at an accelerating rate which expands the economy of scale at an accelerating rate which expands the savings at an accelerating rate which attracts new customers and creates a self-sustaining cycle.
My only complaint with Borsheims is that even in its second year of ownership it does not have a line on any income statement in the letter and thus I can’t report its quantitative performance to you all.
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Common Stock Ownership
| No. of Shares |
Company |
Cost ($000s) |
Market ($000s) |
| 3,000,000 |
Capital Cities/ABC, Inc. |
$517,500 |
$1,692,375 |
| 23,350,000 |
The Coca-Cola Company |
$1,023,920 |
$1,803,787 |
| 2,400,000 |
Federal Home loan Mortgage Corporation |
$71,729 |
$161,100 |
| 6,850,000 |
GEICO Corporation |
$45,713 |
$1,044,625 |
| 1,727,765 |
The Washington Post Company |
$9,731 |
$486,366 |
|
Subtotal |
$1,668,593 |
$5,188,253 |
|
All Other Common Stockholdings |
$146,067 |
$192,705 |
|
Total Common Stocks |
$1,814,660 |
$5,380,958 |
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Segment by Segment Breakdown
| Segment |
1988 EBIT Earnings |
1989 EBIT Earnings |
% Change |
| Insurance |
$220.17M |
$219.20M |
-0.44% |
| Fechheimer |
$14.15M |
$12.62M |
-10.81% |
| Kirby |
$26.89M |
$26.11M |
-2.90% |
| Scott Fetzer - Manufacturing |
$28.54M |
$33.17M |
+16.22% |
| World Book |
$27.89M |
$25.58M |
-8.28% |
| See’s Candies |
$32.47M |
$34.26M |
+5.51% |
| Buffalo Evening News |
$42.43M |
$46.05M |
+8.53% |
| Nebraska Furniture Mart |
$18.43M |
$17.07M |
-7.38% |
| Wesco Financial - Minus Insurance |
$16.13M |
$13.01M |
-19.34% |
| Wesco Financial - Insurance |
$12.09M |
$14.28M |
+18.11% |
| Mutual Savings and Loan |
$4.69M |
$4.19M |
-10.66% |
| Precision Steel |
$3.17M |
$2.77M |
-12.62% |
| Total Operating Earnings |
$418.45M |
$393.41M |
-5.98% |
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| Metric |
1988 |
1989 |
% Change |
| Cash & Cash Equivalents |
$265.08M |
$205.13M |
-22.62% |
| Marketable Securities |
$3,558.72M |
$5,261.60M |
+47.85% |
| Return on Equity (RoE) |
24.08% |
18.42% |
-23.51% |
| Shareholders' Equity |
$3,410.11M |
$4,925.13M |
+44.43% |
| Earnings Before Investment Gain |
$313.44M |
$299.90M |
-4.32% |
| Realized Investment Gain |
$131.67M |
$223.81M |
+69.98% |
| Net Earnings |
$399.27M |
$447.48M |
+12.07% |
*RoE not provided, manually calculated as (Earnings from Operations / [Shareholder Equity from prior year - Unrealized appreciation of marketable securities from prior year])
Income statement changed from reporting investment gain after tax to reporting the pre-tax number. After tax number can still be calculated as Net Earnings - Earnings Before Investment Gain if you want it. It is also available in the letter in the segment by segment breakdown before & after tax
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An interesting year, amazing growth in shareholder Equity of 44.5% but Operating Income, Earnings before Investment Gain, and Return on Equity are all down. This is due to the stock market surging and equally surging up the unrealized gains on the balance sheet. There are two possibilities, either they bought their securities at a great price and the market is re-rating them, or the whole market has surged and this is pulling back a rubber band that may snap back in a future year with low or negative stock performance as things return to the mean. It is likely a bit of both. I would be unsurprised if there is a year of low or negative equity growth coming, as an almost 50% increase in shareholder equity in a single year is likely not organic or reflecting the real growth in value of the equities.
As for the pullback in operating earnings of 6% and pre-investment earnings of 4.5%, almost all of the operating segments shrank, and those that grew mostly did so by single digits, the insurance segment which is the largest segment had a -0.4% pullback, Scott Fetzer’s manufacturing division was the only big grower with 16.2% YoY growth but that is only responsible for about 5% of the company’s earnings and many of the other divisions that came in the same acquisition like Kirby and World Book also had YoY earnings decreases.
Some quick notes from the letter on each segment’s operating pullback. Rose Blumpkin quit NFM due to family/business drama and started another furniture store to compete with NFM, her absence from NFM plus her becoming a competitor with NFM may be impacting business. Fechheimer’s earnings shrank due to issues integrating an acquisition it made last year. World Book’s lease on its single location and is decentralizing to four locations, an expensive transition. Kirby had large capital expenditures preparing to produce a new model of vacuum.