Early Days of Berkshire Hathaway
Board: Berkshire Hathaway
Every few years I reach a level of frustration such that I stop everything I’m doing and launch into a sort of cleaning. This was one of those years. Invariably, within minutes of beginning the clean-up I come across something interesting that I’ve been saving (one friend calls it ‘hoarding’) that brings everything to a stop. I get totally side-tracked, mentally, and that’s the end of any cleaning urge for that year.
This year was no exception, and the work-stopper was a cache of old Berkshire annual reports going back to the year Buffett’s acquired control, 1965, along with some interesting accompanying materials (unfortunately I’m missing one year, 1968, which I vaguely recall pulling out for some reason - hopefully it didn’t get tossed…meanwhile if anyone wants to trade, let’s say, two 1971’s for a 1968….)
I’ve always thought it interesting that Buffett only goes back to 1977 with that on-line library of shareholder letters on the Berkshire website – especially since he had already been in control for a dozen years and had been putting his name to the letters since 1970. Granted, the pre-1977 letters were generally shorter, more specific to Berkshire and weren’t yet the platform for broader discourse. They weren’t so much sprinkled with those quotable Buffettisms, but in some regards those annual were more fascinating.
For any ‘aspiring Buffett’ wanting to understand the master’s actual road to success and maybe take some lessons from it – good and bad – the early annual reports were rather instructive. Rather than being entertained with lessons about float, moats, tailwinds, etc., we can see how he actually built Berkshire in those early years – rapidly, for sure, and without adding new equity to the business or diluting shares. We also get to see some of the unvarnished history as it was unfolding.
There is already a site that has a compilation of letters back to 1969 (skipping 1970), by maxcapital
http://www.scribd.com/doc/53616890/Berkshire-Letter-Compilat... however those are just the letters, and it’s much more instructive to be able to review the numbers behind the narrative. My first thought was to convert these statements I have to pdf and post them, but I don’t particularly want to ignore Berkshires ‘with permission’ cautions and bring legal problem son myself. Ideally, Berkshire would add these older reports to its site – there’s virtually no cost to them to posting those additional files, and people really would be interested.
In overview, most of the information here has been generally discussed in various Buffett biographies, but the financial story is usually woven into the context of a larger narrative. Details of exactly how things were achieved tend to get glossed over. The financial statements themselves, on the other hand, tell a fascinating early story of the ‘snowball’ and how it actually got underway at Berkshire.
Before jumping in, we might put the dollar amounts discussed in perspective. Hagstrom notes the Buffett Partnership’s average purchase price for Berkshire was about fifteen cents shy of $15. If my math is correct, this translates to around $9 million for 60% of the outstanding shares. [Already, aspiring Buffetts might notice two levels of Buffett’s control leverage – first through his controlling management of ‘opm’ through the Partnership, and a second through the Partnership then having essentially a leveraged interest in controlling the public company (at least initially) though 60% of its shares.]
Annual reports by year:
Ken Chace’s letter (also signed by chairman Malcolm Chace, unrelated) noted that Seabury Stanton was out after fifty years with Berkshire. We’ll remember that when Buffett first visited the Berkshire mills, he didn’t get VIP treatment from the Stantons but instead was shunted to Ken Chace - the chemical engineer managing the mill’s operations - who thoroughly impressed Buffett during the tour.
Revenue was flat from 1964, at $49 million, but reported net earnings were up from the $125k in ’64 (under Stanton) to $2.3 million in ’65 under the new management. The statement footnotes disclosed that the company had substantial tax loss carry-forwards, however, meaning the ‘income tax’ number calculated into those ‘net earnings’ numbers was non-cash. This meant that Berkshire actually realized $4.3 million from earnings on a cash basis – a year-to-year improvement of also over $4 million. In his letter, Chace noted that inventories were down $1.4 million (essentially raising additional cash).
As a result of that 1965 operating performance, the company’s beginning-of-year outstanding debt of $2.5 million was completely paid off during that first year, and the company ended the year with $2.9 million in marketable securities, versus none the year earlier. The company’s operating cash balances of $1 million were approximately unchanged.
Shares outstanding were slightly over one million; shareholder’s equity was $24.5 million.
This letter, again by Chace, noted that 1966 revenues were still flat at $49 million and that he had elected to idle production just before year-end in order to avoid (further) inventory build-up in a weakening market caused by a combination of both increased imports and competitors’ excessive domestic production.
1966 net ‘after-tax’ reported income was up from last year’s $2.3 million to $2.7 million. Tax loss carry-forwards meant that the cash earned by textiles was essentially (an untaxed) $5 million. Of that, $2 million had gone to (apparently unintentionally) fund increased inventories, and $2.5 million was added to the portfolio of marketable securities, which now totaled $5.4 million.
“…the Company has been searching for suitable acquisitions within, and conceivably without, the textile field….imperative that we have available the liquid assets with which to consummate such acquisitions..” [The following had me double-check the year on the report cover: “Present uncertainties such as war, tax rates, and decreased levels of business activity all combine to emphasize the continuing need for a strong financial condition”. It’s easy these days to forget that the first ‘uncertainty’ mentioned really was near the forefront of many people’s concerns.]
Re-reading these reports in the present, it would appear that Buffett had an increasing editorial influence over the editorial. For example, this explanation of the now-growing portfolio of marketable securities, which: “..also provides us with the opportunity to participate in earnings derived outside of our textile business, even if only temporarily and indirectly”.
Lastly, the famous (or infamous) 10-cent dividend was declared, costing $100k.
Berkshire converted from its historical October year-end to a December year-end (cover reads: “…for Fifteen Months Ended..”), actually, the fiscal calendar closed on the Saturday closest to December 31.
1967 was a year of big developments:
Sales dropped to $39 million; production was curtailed, a plant in nearby Warren, RI closed. Reported net earnings from the textile business fell to $393k (however again on a cash basis, with the benefit of the loss carry-forward, ‘cash earnings’ totaled $608k). Two newly acquired Omaha-based insurance companies added another $478k in earnings. $311k of realized investment gains resulted in combined earnings of $1.4 million.
Back in those days, balance sheets (and NBV) reported marketable securities at the ‘lower of cost or market.’ At year-end, Berkshire held securities worth $7.8 million (cost: $3.8 million). Footnotes indicated that at the prior year-end “market approximated cost,” suggesting an exceptional portfolio performance during 1967, to say the least.
Perhaps the most impressive thing was that Berkshire was still holding that $7.8 million (at market) portfolio at year-end after paying $8.6 million to acquire those two insurance companies. No new equity came into the business, and no share dilution. How did Berkshire manage that? Through the combination of $2 million in new bank debt; what appears to be about $3 million draw out of that 1966 year-end portfolio (essentially the major portion of the textile business’ 1966 earnings); plus an additional $3.6 million of working capital funding that Chace was able to extract from the textile business (lower inventories, stretched supplier terms, etc).
1967 also saw something that I (and it seems many Buffett followers) had forgotten: an open-ended share buy-back offer. Berkshire (under Chace’s signature) distributed an “Exchange Offer” to shareholders in mid-’67. The deal was that Berkshire would issue (unsecured, callable) 20-year bonds paying 7.5% to any shareholder wanting the exchange, at $20 per share.
According to the offering document, shares were trading at $18.50 just prior to the offer, and had traded in a range of $27 and $16.50 the prior year. Presumably any of Berkshire’s minority ‘partners’ who were spooked by the decline of the textile business had an exit if they wanted. 32,065 shares were tendered, and $641k of debt issued.
The report indicated that the 10-member board now included a 3-member Finance Committee (Buffett, Chace, and Chace).
I can’t seem to locate that report!
Earnings were $4.7 million; $4.73 per share, including $1.49 of realized capital gains. The textile tax loss carry-forward was apparently exhausted early in the year.
One of my all-time favorite Berkshire letters (still under Chace’s signature) for the following line: “We have liquidated our entire portfolio of marketable securities…we anticipate no further purchase of marketable securities, but our search for desirable acquisitions continues.”
Earnings were $8.07 per share, including $3.87 of realized gains from the portfolio liquidation.
Berkshire purchased The Illinois Bank and Trust of Rockford (approx.$17.5 million), again without new equity or share dilution. Just over $5 million of funding was from the liquidated portfolio; Chace managed to wring yet an additional $4 million out of the textile business’ working capital; about $5 million was assumed in additional bank notes; and apparently a few million net cash was contributed from the current earnings of the insurance companies.
The report is the first with the management letter penned under Buffett’s name.
Earnings were $4.38 per share, all from operations. The prior year (1969) EPS were $8.07, including $4.41 from operations and the remainder from capital gains, etc. Of the $4.6 million net, $2.6 million was from banking and $2.o million from insurance.
The textile business reduced working capital further and sold some other assets, raising something over $1.5 million, which essentially funded a partial pay-down of the bank-purchase debt by that amount.
As an aside, the insurance subs had portfolios of $64 million - $52 million of bonds and $12 million in stocks (with minimal unrealized gain), up from a combined $43 million the year before.
Textiles ”continued to struggle throughout 1971” with net earnings of $200k. Working capital related to the business was cut by $2.5 million, and in addition, deprecation exceeded (minimal) capital expenditures by $300k, meaning the textile business contributed $3 million to cash flow, however essentially was generated through a partial wind-down.
The insurance businesses had an “extraordinarily good year”, including the two year old reinsurance start-up under George Young. Insurance net earnings from operations were $5 million after tax plus an additional $0.7 million in net investment gains.
In 1971 Buffett Berkshire purchased some insurance businesses, principally the Home and Automobile Insurance Company, for $8.5 million. $3 million of the purchase was essentially funded by cash contributed by the textile business (including $2.5 million from reduction in working capital - reduced inventories and extended payables) and the remainder from insurance earnings.
The company refinanced long-term debt, adding $5.25 million.
We are reminded that Berkshire had agreed to divest the bank prior to 1981 in compliance with the Federal Bank Holding Company Act.
The board of directors by this time is down to four: Buffett, Chace, Chace, and Scott.
Buffett reminded shareholders that no equity had been added to the company since he took control in May 1965 (and no share dilution) and that on the contrary, the number of shares had been reduced through reacquisition. Book value was now $69.72 per share. EPS were $12.38, $1.03 of which was from investment gains.
Pretax income from the insurance companies was $10.7 million; the bank’s pretax was $2.7 million; textiles contributed $1.7 million, and pretax realized gains were $1.4 million. The overall effective tax rate was 23.2%.
The insurance companies had taken in “large amounts of investible funds…most of these funds were placed in tax-exempt bonds and our investment income, which has increased from $2,025,201 in 1969 to $6,755,242 in 1972, is subject to a low effective tax rate. Our bond portfolio possesses unusually good call protection, and we will benefit for many years to come…”
From the footnotes: The Company is subject to price control regulations under the Economic Stabilization Program.
After year-end but prior to report publication, Berkshire announced that it had borrowed $20 million at 8% from institutional lenders. $9 million went toward repayment of existing debt, and the remainder was designated for insurance business growth.
The board of directors now consisted of Buffett, Chace, Chace, and McKenzie
On the investment side of our insurance operation, we made substantial additional commitments in common stocks in 1973. We had significant unrealized depreciation – over $12 million- in our common stock holdings…. Nevertheless, we believe that our common stock portfolio at cost represents good value in terms of intrinsic business worth…In spite of the large unrealized loss..we expect satisfactory results…over the long term”
Running down the businesses, pretax earnings were: Insurance operations $10.2 million; textiles $2.8 million; bank $2.8 million; BRK’s share of Blue Chip $1.1 million; other (interest on debt, corporate costs) -$2 million; and the tax hit was $3.5 million.
And the report includes an early rendition of that now-familiar line: “Prospects for 1974 indicate some further decline in rate of return on our enlarged equity base”
Buffett reported that Berkshire issued 195,000 shares to acquire Diversified Retailing. Diversified owned 109,551 shares of Berkshire, meaning the net increase in Berkshire shares would be 85,449. Buffett noted that Diversified’s other most important asset is 16% of Blue Chip Stamps. Berkshire already owned 22.5% of Blue Chip, which would bring its post-merger position to 38.5%. (Next year’s letter reports that this proposed merger subsequently fell through).
One minor side note: Berkshire now started getting a ‘qualified opinion’ from Peat Marwick. Opinion letters are usually boiler-plate, and when we see an explanatory paragraph inserted in the letter the caution flags should go up; the auditor has a problem with the sign-off.
In this case, the issue was benign. Berkshire was including “equity in net earnings of Blue Chip Stamps” in its P&L, however Blue Chip’s fiscal year ended at eom February each year, so unaudited numbers closest to Berkshire’s fiscal year-end were used. Complicating the matter a bit, Blue Chip used different auditors. Peat Marwick just had to start including a note explaining that Blue Chip was beyond the scope of their audit and the Blue Chip numbers we were seeing were ‘as-is’ and without any warranties. Buffett reminded us that he was on the boards of both companies, if that was a consolation (he didn't say that of course, at least not quite).
Berkshire’s effective tax rate was 21.4% (the Federal rate was 48% at the time), principally due to the impacts of tax-exempt interest income, and dividend exclusions relating to affiliates and dividend credits for unaffiliated companies.
Net earnings were $7 million. The pretax contributions by group were: Insurance operations $0.9 million; textiles $2.7 million; BRK’s Blue Chip portion $1.2 million. This was reduced by realized investment losses of $1.9 million; and interest and other costs of $2.3 million. Taxes were ‘negative’ (favorable), a credit of $2.5 million.
As of the report date, Chace had cut textile production to one-third of capacity.
Re-insurance underwriting losses were 12%; National Indemnity’s underwriting losses were 4%. The ‘combined ratio’ (insurance loss and expense ratio) for 1974 was 110.
At year-end the stock portfolio was $17 million less than ‘carrying value’ (ie, cost), however Buffett noted that as of report date that ‘depreciation’ (the unrealized loss) had been reduced by half.
Berkshire’s Blue Chip position was at 25.5%.
“The major variable – and by far the most difficult to predict with any feeling of confidence – is the insurance underwriting result”
The combined ratio for the insurance businesses for 1975 was 115.
The $4.7 million net earnings breakdown consisted of a pretax loss from insurance operations ($2.3 million pretax) and realized investment losses of $2.3 million; textile earnings of $1.7 million; bank earnings of 43.5 million, BRK’s share of Blue Chip $2.2 million. Interest and other costs were $2.3 million, and taxes were a negative (a credit) of $4.8 million.
Textiles showed some rebound: ”The fourth quarter produced excellent profit for our textile division…”. Berkshire acquired Waumbec Mills in New Hampshire : “…we continue to look for ways to increase our scale of operation while avoiding major capital investment in new fixed assets…” The purchase price was $1.7 million, approximately $500k in cash and the remainder an 8% promissory note. The Waumbec purchase included $2.6 million in unused net operating (tax) loss carryovers (which probably didn't end up having the value initially anticipated).
National Fire and Marine acquired Kerkling Reinsurance for $2 million.
K&W was also acquired, for $2.25 million, $1 million of which was a 9% promissory note.
The insurance “combined ratio” improved dramatically to 99.
Net earnings rebounded to $22.8 million, with insurance operations pretax of $11 million and investment gains of $10 million. The textile contribution of $1.1 million, the bank’s $3.8 million, and the Blue Chip share was $3.6 million, were approximately offset by interest, taxes and other costs.
The Waumbec purchase was a disappointment in 1976: ”marketing efforts and mill capabilities were not properly matched in our new Waumbec operations…’ however despite this ”we continue to look for ways to build our textile operation and presently have one moderate-size acquisition under consideration”.
Berkshire’s Blue Chip stake was now 33%. ”We also hope to merge at some point with Diversified Retailing….corporate simplification and enhanced ownership position in Blue Chip Stamps would be benefits..”
Earlier in the year Berkshire issued a letter to shareholders holding 99 or fewer shares, offering to purchase all of their outstanding shares at $65 per share providing they tender ALL of their shares (not my emphasis). Around the time of the offer, shares were trading as low as $38, rising up to low $60’s - likely with news of that offer. Apparently 6,647 shares were tendered. That year’s fourth quarter high was $95.
The board was still just comprised of Buffett, Chace, Chace, and McKenzie
The year-by-year history from the annual reports is probably a little more interesting for some Berkshire shareholders, especially now in retrospect, than some of the more polished summarizations we get in the broad-consumption biographies, and maybe even more than some of Buffett’s current-day capsulations of that era.
Not all the actions or commentary taking place at the time fit into the broader Berkshire framework that eventually developed. We’ll also note that these reports were all from before Munger actually joined Berkshire and the board – and maybe that pre-Charlie era was intentionally omitted from Berkshire’s on-line archives.
What we do see from the early reports, however, is a fascinating history of the actual formation of the snowball and maybe an appreciation for the powerful combination of nut-and-bolts operational, strategic, investment, and even market timing skills it actually required. And it’s hard not to have a renewed respect for that handful of early managers running Berkshire’s business segments.