Thirty Years of Berkshire Hathaway
Board: Berkshire Hathaway
Thirty Years of Berkshire
In June, 2003, I posted a message called “The Lesson” which reviewed changes in Berkshire Hathaway for the period of 1980 to 2002. The only significance to the start date is that 1980 is my oldest Berkshire annual report. Much has happened in just eight years, and this is an update as of December 31, 2010.
First, an overview of the company at the beginning and end of the period. At the end of 1980 Berkshire Hathaway had assets of $1 billion, equity of $400 million and after tax profits of $53 million. At the end of 2010, it had assets of $372 billion, equity of $163 billion and after tax profits of $13 billion. This will be a selective discussion of that period of time. So, as Dan Rather once introduced a newscast on CBS Radio: “And now, the sequence of events, in no particular order.”
Marketable Equity Securities:
Warren Buffett was first recognized as a stock picker, so we will start with marketable equity securities. At December 31, 1980, Berkshire owned marketable equity securities that were worth a full 133% of stockholders' equity.
At December 31, 2010, equities comprised only 37% of stockholders' equity. In total, at the end of 1980, Berkshire had 193% of its equity invested in liquid, marketable investments compared to 80% at the end of 2010.
When comparing the equity marketable securities owned to the total market value of Berkshire Hathaway at December 31 for both 1980 and 2010, the difference is staggering. At December 31, 1980, the market value of Berkshire Hathaway was $420 million, and it owned $526 million of marketable equity securities, or $1.25 of equities for every dollar of market value. For that same percentage relationship to exist at the end of 2010, Berkshire Hathaway would need to own $247 billion of equities instead of the actual amount of $61 billion.
The large exposure in 1980 to the equity markets was especially timely. During the following year, Buffett placed another $30 million into equities, which along with that year's equity appreciation increased the total value of equities to $641 million at December 31, 1981. So going in 1982 and the beginning of one of the greatest bull markets of all time, Berkshire Hathaway had a total market value of $552 million, but held $641 million of marketable equity securities.
The change in the names of the equity investments over this period is dramatic. The schedule of marketable equity securities as of December 31, 1980 included 18 companies by name. Of these 18 names, Berkshire Hathaway is currently associated with only two: GEICO and The Washington Post. The four largest holdings by market value were GEICO at $105 million, General Foods at $60 million, SAFECO at $45 million and The Washington Post at $42 million. These four companies equaled 44% of the total $526 million of equities. At December 31, 2010, the largest four equity positions were Coca-Cola at $13,154 million, American Express at $6,507 million, Procter and Gamble at $4,657 million and Wells Fargo at $11,123 million. These four companies equaled 57% of the $61,513 million of equities.
So over this 30 year period Berkshire’s marketable equity portfolio has become more concentrated, has grown much larger in dollar terms, but has also found itself less important to the company’s economic performance. This brings us to one of the really significant recent changes in Berkshire: succession planning.
I don’t know when Buffett first announced that eventually his job would be divided between two people, one to manage operations and the other to manage investments. The impression was that these two positions would be co-equal. And, in 2005, the board did approve a plan to hire or identify one or more younger investment managers to succeed Buffett as chief investment office when the time came. The 2010 annual report however put an end to any idea of these positions being co-equal. Buffett writes, “When Charlie and I are no longer around, our investment manager(s) will have responsibility for the entire portfolio in a manner then set by the CEO and Board of Directors. Because good investors bring a useful perspective to the purchase of businesses, we would expect them to be consulted – but not to have a vote – on the wisdom of possible acquisitions.”
The decision to make the chief investment officer report to the chief executive officer makes perfect sense. If one wants, he may want to argue that Berkshire was built by picking stocks. But an examination of the decreasing importance of the marketable equity securities portfolio to the company shows that is clearly no longer true. For many years, Berkshire has been becoming less a home for equities, and more a home for operating companies. The decision to make the investment manager report to the CEO is appropriate for at least six significant reasons.
(1) The sheer size of the investment portfolio hinders the ability of even the most able manager to create sizable percent profits. The bigger the investment portfolio, the less ability it has to create outsized performance. So managing investments takes a step down in importance.
(2) Because of the changing nature of the company, today’s Berkshire investment manager has a greater chance of harming intrinsic value by doing something really stupid than substantially increasing intrinsic value by doing something really brilliant. The biggest future gains in intrinsic value will come from the operations side, not the investing side.
(3) Regardless of how talented and resourceful they may be, two chief managers of two different functions can not be co-equal in running the total enterprise without the almost inevitable conflicts and clashes. There has to be one last go-to guy.
(4) In the 2010 annual report, Buffett wrote: “There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ.” There is a retained earnings allocation question when deciding whether to buy a new operating subsidiary, invest more in an existing subsidiary, or to buy some shares of a publicly traded company. That will not go away. But, if Berkshire owns a company it has sole discretion over the allocation of the new capital it produces; something it lacks as a minority shareholder of a publicly traded company. The more businesses Berkshire controls the more retained earnings it allocates. The more important the allocation of retained earnings, the more valuable it is to own all instead of just a portion of a company. We are seeing, and have been seeing for decades, Berkshire shifting from an owner of equities to an owner and manager of companies.
(5) Managing the operations is harder than managing the investments, and will be even more so in the future. Berkshire would be better served to closet index the investment of the equities than to closet index the management of the operations. The person doing the most important and the hardest job should be the one to lead.
(6) Berkshire Hathaway shareholders are quick to acknowledge the importance of Buffett and Munger. But it can’t be both ways. Arguing their current importance is also arguing the significance of their absence. It makes perfect sense to increase our perception of an asset’s value as its future becomes more certain and predictable and to decrease our perception of an asset’s value as its future becomes less certain and predictable. So it also makes as much sense to view the value or price of an asset as capitalized uncertainty as it does to view it as capitalized certainty. The real uncertainty is not how well the marketable securities of Berkshire will perform, but how well its operating entities will perform and how well its cash flows will be allocated. The amount of capitalized uncertainty rests not in the management of securities, but in the actions of the CEO.
One of Warren Buffett’s wisest contributions to the success of Berkshire during the financial crisis of 2008-2009 was in previously refusing to participate in the craziness that caused the disaster. He was not tempted by the whole easy money, quick and outsized profits environment of the residential housing sector in the prior years. This allowed him to take advantage of the opportunities the crisis provided. His chosen method was to invest in loans and preferred stock of some major corporations such as Goldman Sachs, General Electric, Wrigley, Swiss Re and Dow. These investments were structured to pay high current interest and dividends while providing various equity kickers as well. This was typical Buffett. Berkshire received assets that had a higher degree of safety than common stock, very high rents plus potential participation on an eventual financial recovery. He also invested big, spending over $20 billion. These types of investments were only available to a company like Berkshire: one with plenty of ready cash, the ability to act quickly, the ability to analyze a security and the confidence to act.
Finance and Financial Products
The Financial Operations were first broken out separately in the 1988 annual report. Since the prior year was also provided, the 1988 statements also included 1987. This was the beginning of the since discontinued practice of presenting an unaudited balance sheet and statement of earnings for each of the Insurance Group, the Manufacturing and Retailing Businesses, the Finance-Type Businesses and the Non-Operating Activities. Eventually these statements were printed on colored paper, giving them their common name of The Gray Pages.
In 1987, the only two operations included in this segment were Mutual Savings and Loan Association, owned by Wesco, and the Scott Fetzer Financial Group. Decreasing profitability coupled with increasing regulations and regulatory pressures prompted Mutual Savings and Loan to give up its status as a regulated savings and loan association and sell its operations. On October 8, 1993, Mutual transferred its savings accounts and other liabilities along with substantially all of its real estate loans to another savings institution, effectively quitting that business. This is one of the rare examples of Berkshire selling a business that it was operating. But there was good reason. The industry was in a crisis that would cost the taxpayers $124 billion by 1999.
Currently this segment includes Clayton Homes, the furniture/transportation equipment leasing businesses and various other financial investments that are not part of the other segments. I would hate to compete with Clayton Homes. Not only is it the country’s leading manufacturer of manufactured and modular homes, it also sells, insurers, leases and finances these products. And if a place to locate a home is needed, it has subdivisions as well.
Like the other segments of Berkshire, Finance and Financial Products has grown considerably. For 1987, the Finance Group had revenues of $71 million, net earnings of $6 million and total assets of $558 million. In 2010 it had revenues of $4.3 billion, net earnings of $441 million and total assets of $25 billion.
Manufacturing, Service, Retailing, Energy and Transportation:
These businesses in 1980 had sales of $267 million, operating profits before tax of $24 million and assets of $218 million. For 2010, sales were $93 billion, operating profit before tax was $9 billion and assets, excluding goodwill, were $132 billion. The growth has been enormous and created mostly without the issuance of any additional common stock. The existing operations at the end of 1980, while providing much of the funding for subsequent acquisitions, provided only moderate contributions to the growth.
During 1980, there were ten different operations with enough significant activity to be listed under "Sources of Reported Earnings" in the Shareholders' Letter. It is instructive to look at the changes that occurred in these ten units. The largest unit, the insurance group, is the only one of the ten whose ownership was subsequently neither increased nor decreased. Of the other nine, Berkshire-Waumbec Textiles was slowly liquidated, Associated Retail Stores was sold, See's Candies, 60% owned in 1980 had its ownership subsequently increased to 100% and is currently insignificant, Buffalo Evening News, 60% owned in 1980 had its ownership subsequently increased to 100% and is currently insignificant, Blue Chip Stamps - Parent, 60% owned in 1980 had its ownership subsequently increased to 100% and is currently insignificant, Illinois National Bank was spunoff, Wesco Financial - Parent, 48% owned in 1980 had its ownership subsequently increased to 100% and is currently insignificant, Mutual Savings and Loan, 48% owned in 1980 had its ownership subsequently increased to 80% and was subsequently sold, and Precision Steel, 48% owned in 1980 had its ownership subsequently increased to 100% and is currently insignificant. Of the nine non-insurance sources of earnings for 1980, two were sold, one was liquidated, one was spunoff and five are currently insignificant in regard to assets or earnings.
Why the fading away of so many companies? In the 1985 annual report, Buffett wrote, "I won't close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable." If a company does not provide adequate returns on its capital, Buffett will not kill it, but it will not put it on indefinite life support either.
At the 2000 annual meeting, Charlie discussed this very thing: "I think it's in the nature of things for some businesses to die. It's also in the nature of things that in some cases, you shouldn't fight it. There's no logical answer in some cases except to wring the money out and go elsewhere."
Berkshire would not have been near as profitable an enterprise if Buffett had not been willing to let go of underperforming units; not necessarily killing them, but not encouraging them either. This is, unfortunately, a major departure from the way many business enterprises are operated. Once a company gets associated with doing something, it tends to continue to do that something, even if returns are unsatisfactory.
But Berkshire was all about using the funds generated by companies that may not be doing well to purchase other enterprises with much better prospects such as See's Candies, the Buffalo paper, the Nebraska Furniture Mart and Borsheim’s. With the purchases of companies with moats and the slow abandoning of enterprises without moats, such as Associated Retail Stores and the textile operations, the Berkshire of "substantial competitive advantages" was being formed. These early moats shared at least one commonality: geography. They all had geographical moats, dominating one city such as Omaha or Buffalo, or entrenching themselves in one region, such as the West for See's. This is not to say that geography was the only moat enjoyed by these companies, for it isn't. But geography may be the most easily identified and recognizable moat. It was left to subsequent acquisitions to more fully flesh out the range of ways in which businesses can enjoy substantial competitive advantages.
These early operating entities had another commonality: they weren't growing very quickly. For Buffett, this is not a problem. At the 1994 annual meeting, he said, "We're willing to buy companies that aren't going to grow at all - assuming we get enough for our money when we do it. But you can certainly have a situation where there's absolutely no growth in a business and it's a much better investment than some company that's going to grow at very substantial rates - particularly if they're going to need capital in order to grow. There's a huge difference between the business that grows and requires lots of capital to do so and the business that grows and doesn't require capital." He will use the cash flow from these companies in the same way in which he used the cash flow from the textiles businesses and Blue Chip Stamps: investing it in other operations. This whole mode of business operation is not often practiced, and not even widely understood.
For many companies, it is almost predetermined how their ready capital will be deployed. They do a particular thing, they are going to continue to do that particular thing, and they are going to attempt to get bigger at doing that particular thing until even the slowest thinker recognizes the need to make a change. So, the value of a company can be limited by the preconceived notions vested in its future capital expenditures. Not so at Berkshire. At the 2001 annual meeting, Buffett said, "It's relatively easy to figure out the present value of most of our businesses. But the question becomes what do we do with the money as it comes in? That will have a huge impact on the value 10 years from now. “What that "huge impact" will be is a central question of valuation. And since Buffett understands the importance of this impact, he makes it central to business practice.
Although most of this document is from my 2003 message, I would like to specifically quote something from that earlier post. Discussing 2002 I wrote, “Most of these sources of reported earnings were acquired in the last eight years. If acquisitions in the next eight years are of sufficient size and profitability to make a similar change in the listed sources, I have a hard time thinking what they could be. If that happens, Berkshire's non-insurance operations will have grown to an enormous size. But it may.” I may have had a hard time imagining what purchases could be made that would diminish Buffett’s previous acquisition activity; but fortunately for us all, he was not so hindered. I don’t mind being short-sighted as long as Buffett is not.
From 1980 to 1994, non-insurance acquisitions came at an average of about one every two years. It was not until 1995 before Buffett seemed to get serious about expanding Berkshire through acquisitions. By year, these are the reported, substantial acquisitions of non-insurance companies, based on the year the purchase closed:
1980 to 1984 - 1
1985 to 1989 - 3
1900 to 1994 - 3
1995 to 1999 - 7
2000 to 2004 - 17
2005 - 2009 - 7
2010 - 2011 - 2
An examination of the individual purchases during these periods is telling. Of the four acquisitions between 1980 and 1989, two, Nebraska Furniture Mart and Borsheim's are in Omaha, and are operations with which Buffett would have personal familiarity. And all three of the purchases during the period of 1990 to 1994 were shoe companies. Even the purchases in 1995 must have been comfortable for Buffett, being jewelry and furniture store chains. The balance of GEICO was acquired in 1996, but this was a company with which Buffett had a long relationship; not exactly groundbreaking.
Buffett's perceived circle of competence, a least with acquisitions of entire companies, seemed to contain little real adventure. Outside of reinsurance, he was comfortable selling newspapers, shoes, candy, furniture, jewelry, vacuum cleaners, encyclopedias and individual car insurance policies. Many of these companies had geographical moats, and all of them sold products directly to individual consumers, not to businesses.
If you look at this pattern of making comfortable purchases as a spinning wheel, and want to know the name of the cog that was placed in the wheel's spokes to stop the spinning, it would be FlightSafety International, purchased in 1996. It is a - gasp - INTERNATIONAL company, just look at its name. It sells highly technological products; and it sells to businesses, not individuals. This is not an Omaha furniture store.
This does not mark the end of the old Warren Buffett; he would still buy the occasional jewelry or furniture store chain. And he eventually even goes back to adding products that are similar to the textile roots of Berkshire. But the trend that continues today is of acquiring companies that sell to producers rather than end customers. I can’t recall the last time I did personal business with a freight railroad or manufacturer of metal cutting tools.
So, from here on, the acquisitions at Berkshire are increasingly eclectic, and impossible to anticipate. This is mostly by necessity; there are just so many furniture and jewelry operations worth owning. And the growing amount of investable funds requires looking at larger and larger targets of opportunity.
After the purchase of FlightSafety International came increasing larger and more varied acquisitions such as Executive Jet in 1998 and MidAmerican Energy Holdings in 1999. Buffett saw something in the value of building material companies in 2000, initiating purchases of Justin Industries, Benjamin Moore, Shaw industries and Johns Manville, following up with MiTek in 2001. It is difficult to find industry patterns in the burst of acquisition activity from 2000 to 2004. These 17 purchases ranged from pipelines to farming equipment systems to home kitchenware parties to clothing to manufactured housing and more.
Eventually the acquisitions decreased in number, only 9 after 2004, but increased in price. Many of Berkshire’s largest acquisitions such as PacifiCorp, The Marmon Group, Iscar Metalworking, Burlington Northern Santa Fe and Lubrizol are also some of its most recent ones. Now, and for some time, the emphasis is not on industry type. Though fewer in number, acquisitions are larger in price; though quality still trumps all.
However, it is still all about moats. From the 2000 annual meeting: "If you're evaluating a business year-to-year, the number one question you want to ask yourself is whether the competitive advantage has been made stronger and more durable. And that's more important than the P&L for a given year." Moats trump P&L. So, when Buffett goes shopping, he is always looking for sustainable competitive advantages. A common moat of many of the more recent acquisitions is market dominance. The companies Buffett has purchased recently are usually either a leader, or the leader in their industry. For instance, Larson-Juhl is the U. S. leader in custom-made picture frames, Fruit of the Loom produces about a third of male underwear in the U. S., MiTek is the world's leading producer of connector plates for roofing trusses, XTRA is a leading lessor of truck trailers, Justin Industries is the leading maker of Western boots, Acme is the leading producer of bricks in its geographical areas, Shaw Industries is the world's largest carpet manufacturer, Johns Manville is the nation's leading producer of commercial and industrial insulation, FlightSafety International is the world's leader in pilot training, Iscar Metalworking is an industry leader in the metal cutting tools business, Russell is a global leader in the sporting goods industry, Business Wire is the leading global distributor of corporate news, multimedia and regulatory filings, Forest River is a leading manufacturer of leisure vehicles in the U.S., TTI, Inc. is a world’s leading distributor of electronic components, Clayton Homes produced 47% of the manufactured homes built in the U.S. in 2010 and Burlington Northern is one of only two national railroads operating in the western half of the country. NetJets is not only is the worldwide leader, but it actually created the industry. And looking in the insurance segment, the products of Applied Underwriters are unique – they are not only the leader in their field, they are the only one in their field.
Market dominance itself may not be the important moat. It may actually be evidence of other advantages that in turn create the domination. But once achieved, market dominance becomes one more nasty moat to harry the competition. It is the width and depth of these moats, and the ferocity of its resident vermin, that will determine much of the future success of Berkshire. Also from the 2000 annual meeting, "So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn't necessarily mean the profit will be more this year than it was last year because it won't be sometimes. However, if the moat is widened every year, the business will do very well."
But, Buffett is not willing to build the moat. It must come preconstructed, and it must not be messy. Another common characteristic of some purchases is a good, preacquisition cleaning. Justin Industries and Shaw Industries had both gone through a period of restructuring before Berkshire's purchase. They had consolidated and disposed of some operations. Benjamin Moore restructured by closing half of its plants, cutting its workforce by 25% and reducing its product line by 30%. Johns Manville and Fruit of the Loom came scrubbed clean out of bankruptcy. As part of a reorganization, Russell had cut 2,300 jobs and moved 1,200 positions to Honduras and Mexico. So, the best way to predict an acquisition of Berkshire is to identify a company that has been recently restructured in bankruptcy, leads the world in its industry, has management in place - and is a chain of furniture stores.
So, we come to my inevitable discussion of moats. Although Buffett inspired, any complaint you have with these points should be directly only at me.
(1) Moats come in many shapes and sizes; and they are not always obvious. A moat may be the result of high market share, low costs, exceptional customer service, legal protections such as patents, superior products or any of a number of other advantages. In some unusual cases, a company’s management may even constitute a moat.
(2) Profits, even extraordinary profits, can exist without moats. And moats, even extraordinary moats, can exist without profits. While one can be evidence of the other, neither necessitates the other’s existence.
(3) A company that has moat-like characteristics but fails to use them is no more advantaged than one that has no moat-like characteristics at all. In the same way in which a story is not an idea, but ideas about an idea; a moat is not a thing, but ideas about a thing. For instance, a patent is not a moat; just a big pile of papers and a filing. The moat is, in addition to the patent, the profitable exploitation of the opportunities it produces. So, just because something looks like a moat, or should be a moat, does not mean that it is being exploited in a sustainable or advantageous way.
(4) When an enterprise with a properly functioning and sustainable moat is presented with a conflict between generating higher current profits or strengthening the defenses of its moat, the decision should always be made in the favor of the moat.
(5) By definition, moats are sustainable, but they are not inviolate. Moats are impermanent. (New Coke anyone?) Even the deepest and widest moats can silt. Every year, ask yourself, “is the company attempting to deepen and widen the moat and fill it with even more vermin? Or, does the company value short term financial gain over the maintenance and expansion of the moat?” Think of the moat as being surrounded by an equally wide levee, as high as the moat is deep. It is in the nature of nature to wash the levee into the moat. In the same way, it is in the nature of competition and poor decision making to ruin economic moats.
(6) If it could be said that moats have a desire, it would be to demoat: the process identified as demoatation.
(7) Once the ditch has silted and the vermin have fled, the barbarians will be frying eggs in the kitchen and the moat will be lost forever.
I used this story about the Buffalo News in the previous version of this article, but now it has a different lesson. The News was purchased by Blue Chip Stamps in 1977 for $34 million. It proceeded to lose money, about $12 million through the end of 1982. In 1977, the News started a Sunday edition, and as a result suffered interlocutory injunctions from its Sunday competitor. Before these injunctions were reversed in 1979, they created circulation and promotion problems for the News.
Then in 1980, the News took a short strike. Losses, lawsuits and labor unrest put Munger in a pensive mood. In the 1981 annual report for Blue Chip Stamps, he wrote, "If we hadn't purchased the News in 1977 but had simply earned returns on the unspent purchase price comparable with the average earnings power of the rest of our shareholders' equity, we would now have about $70 million in value of other assets, earning over $10 million per year, in place of the Buffalo Evening News and its current red ink. No matter what happens in the future in Buffalo we are about 100% sure to have an economic place lower than we would have occupied if we had not made our purchase."
Charlie need not be so despondent. For in 1982, the Courier Express, the News' competitor, failed. This left the News as the only area-wide daily newspaper in Buffalo. Enjoying its newfound monopoly status, the Buffalo News experienced pretax earnings of $19 million in 1983, and $27 million in 1984. In the 1982 annual report for Blue Chip Stamps, Munger writes, "Finally, our shareholders should recognize that if our 1977 purchase of the News has now worked out acceptably from their viewpoint, which contrary to our prediction last year may now be true even after taking into account time delays, the conclusion does not follow that we made a sound managerial decision buying the News when we did for the price we paid." In other words, "even though I was wrong last year when I said that ‘we are about 100% sure' that the purchase of the News was a mistake, its purchase was still a bad managerial decision." Or, “even though it was not a mistake, and therefore a mistake to say it was a mistake, it was still a mistake."
The moat of the Buffalo News has come full circle. When originally purchased, it had a potential moat: that of a monopoly newspaper. Through much expense and risk, it gained this moat only to have technological advances significantly erase its value. World Book, another early purchase of Berkshire, also demoated. Moats, as value and hard-earned as they may be, are still impermanent.
Of course, the best moat is a monopoly. I have no inside knowledge, but I can identify some transactions in which Berkshire’s strong financial condition may have allowed it to be one of the few or even the only option considered. For instance, the large catastrophic reinsurance that has been offered by Berkshire for many years can only be written by an insurer with large capital reserves.
Berkshire has also been writing retroactive insurance for years, and at the end of 2010 had reserves for this line of business of $18.7 billion. The often misunderstood Equitas transaction in 2006 is illustrative. For a fee of $7.1 billion, Berkshire agreed to pay up to $13.9 billion of the future claims and expenses transferred. The types of claims Berkshire assumes in these retroactive contracts are usually long-tail and will be paid out over many years. No reasonable person would pay of fee of $7.1 billion without a well-founded expectation that the corresponding claims would be paid in full when due. And a well-founded expectation could only be held when the claims were scheduled to be paid by a very well capitalized company with a secure future. So, just how many companies competed with Berkshire for the Equitas transaction?
Other examples where Berkshire’s balance sheet was a competitive advantage are more recent. During 2008 and 2009 Buffett purchased over $20 billion of the preferred stocks and bonds of a variety of companies including Goldman Sachs, General Electric, Wrigley, Swiss Re and Dow. How many other financial institutions had the ability to make these kinds of investments during that troubled period of time?
Buffett has also sold various types of derivative contracts. These contracts are similar to insurance contracts in that they are promises-to-pay. These contracts are in the billions of dollars and some are not scheduled to settle until 2026. A purchaser of billions of dollars of promises-to-pay that stretch out as far as 2026 is going to demand a large, sound balance sheet in the promisor, something not many can provide. These derivative contracts also are an example of a difference between Buffett and most of the rest of the financial community. Warren Buffett is content knowing that these derivative contracts should profit handsomely over their long expected term. However, the considerable short-term volatility these contracts create in the reported earnings of Berkshire drives much of the financial press and many of its own shareholders to distraction. This is a charter example of how Buffett values economic returns over accounting predictability.
Finally, in 2010 Berkshire entered into a life reinsurance agreement that will produce annual premiums of $2 billion for decades. In pure dollar amounts, this may eventually exceed any of the previous examples. And because of its size and length, it surely was not available to anyone without a strong financial position and solid future.
So with Warren Buffett, moats are in. But what is out? He says that he does not understand technology. And if you watch him, he has consistently shunned investments that require repeated applications of technological innovation to either grow or continue operations. But Buffett’s comments on technology have been habitually misunderstood. When he says that he does not understand technology he is not saying that he can’t understand why airplanes can fly but football stadiums can’t. Instead, he is saying that he can’t determine what a high technology product or service will look like ten years from now. And how do you properly analyze an investment if you can’t see its future? However, that does not mean that technological progress has no value. For Buffett, the profitable exploitation of a technological advance is not so much in the production of a new product or service, but in its application to make existing processes, products and services faster, cheaper and better. He wants to use technology, not create it.
To my eyes anyway, there is an unfolding trend in Buffett’s more recent non-insurance acquisitions. It is like he is saying, “Dear industrial and commercial enterprises: Try to build structures, manufacture products or provide services without using the products and services of MidAmerican, Johns Manville, Benjamin Moore, Shaw, MiTek, McLane, Acme, Scott Fetzer, Burlington Northern, XTRA, Marmon, CTB, Lubrizol, TTI or Iscar – more to follow.” It does not matter who will be producing the Next Big Thing, Berkshire will be selling something to them. If industry was an organic creature, Berkshire would be several bones in the spine; allowing the animal to stand erect.
Being the backbone instead of the head, arms and legs, the risk of technological change is not so much born by Berkshire as by its suppliers and customers. Companies A and B may manufacture the new Widgets X and Y, but Berkshire does not care which is more successful. It will sell to both. And if Company C comes along and blows both A and B out of the water with its Widget Z, so be it. Berkshire sells stuff to Company C also. Plus, Berkshire may use Widget Z to make its own products with a lower cost and a higher quality to boot. It is the difference between being the track and owner of the horse. The track always wins; the owner – not so often. Sure, compared to the potential profit of the owner, the track’s profits are constrained. But the owners, jockeys and horses come and go, but the track remains.
However, his attraction to moats and aversion to technology are only two of Buffett’s tools to achieve outsized returns. What he is really worried about are things that can go wrong. The presence of moats and the absence of significant technology components offer protection against competition and change. But, there are other things that can go wrong. Economic processes have differing exposures to things like raw material supply disruption, governmental regulation, commoditization of pricing, labor disputes, energy or raw material cost increases, environmental remediation, changes in consumer preferences based on style, ability of customers to acquire financing and the uneven, deleterious effects on consumer spending during economic hardship. And this list is far from exhaustive. Some things, such as having an otherwise trusted manager doing something illegal, are subject to very little, if any, avenues of self-protection. So, Buffett makes a mental list of the things that can go wrong in the business and his enthusiasm for the enterprise is inversely related to the length of its list.
This is in very general terms, but there may be sweet spots in the evolutionary development of many products and services. If a product or service is generated simply by brute application of capital employment with little application of knowledge, a commodity is created. If a product or service is produced by significant applications of knowledge, technological obsolescence is threatened. The sweet spot is located where the sufficiently restrained application of knowledge results in a product or service that is much too boring to attract the ambitious, yet difficult enough to discourage the simply capital endowed. That may be the spot with the fewest things that can go wrong.
Buffett is not just concerned with things that can go wrong because their occurrence may make the investment a mistake. What he wants are assets that rapidly grow their intrinsic value, and the absence of things that can go wrong reduces the hindrances to this result. Sometimes the stuff you avoid is as important as the stuff you get. Investors are better served by purchasing a great investment at a reasonable price than a mediocre investment at a cheap price; and the quantity and significance of things that can go wrong is an essential differentiator between the two.
For Buffett, an asset with many things that can go wrong should simply be avoided; obtaining a larger margin of safety in the purchase price does not make the purchase under consideration any more acceptable. A margin of safety in the purchase price can help protect an investment against ordinary things that can go wrong and mitigate errors in security analysis, but it has little to offer if many things go very badly wrong. If an investment is a total loss, a slightly larger margin of safety in the purchase price is of little emotional consolation or economic importance. Over the long term, the financial return provided by an asset is based on its underlying return on capital. Slowly the original purchase price becomes of diminishing importance: eventually becoming only a historical curiosity. Sure, if a little less was paid for one asset some other asset could be purchased with the savings. But of more importance is the difference in the compounding effect on intrinsic value between high return on capital assets and low return on capital assets. Better one great asset than two poor ones. If something is not worth buying at all, it is not worth buying cheaper.
A few numbers provided in the 2010 annual report give the best summary of the growth of the insurance business since 1980. At the end of 1980, Berkshire had investments per share of $754. At the end of 2010, each share of Berkshire common stock represented $94,730 of investments. Total float at the end of 1980 was $237 million, while total float at the end of 2010 was $65,832 million. Yes, some of this growth came from acquisitions, even acquisitions funded with Berkshire stock. But even the two largest of these acquisitions, General Re and GEICO, provided only about $18 billion of additional float at the time of their purchase. Of the $65 billion increase in float, most has been organic growth. The biggest single contributor of organic growth was the Berkshire Hathaway Reinsurance Group which grew float from very little in 1980 to $30,370 million at the end of 2010. And it did so while recording substantial underwriting profits as well. Insurance has been a stellar performer for Berkshire Hathaway, but there is a reason for that.
Warren Buffett has always insisted that investors focus on their own circle of competence. Honoring ones circle of competence helps to avoid doing especially stupid things. However, it may actually provide a competitive advantage over other investors. Buffett seems to be especially attracted to investments in banks and insurance companies. They both have a similar problem. Banks don’t know how good their assets are and insurance companies don’t know how bad their liabilities are. The value of the assets of banks and the correct amount of the liabilities of insurers are unusually vulnerable to errors of estimation. Determining how grounded in reality these reported estimates actually are requires an especially exacting and discerning eye. This provides a competitive advantage to someone with the skill sets of Buffett. Add to that the opportunity to generate substantial amounts of investable capital, and insurance becomes the perfect industry for someone like Warren Buffett.
In 1980, the insurance premium income of Berkshire Hathaway was $185 million. In 1984, it was only $140 million. The business was moribund. This came from Buffett at the 1996 annual meeting, but it explains why Berkshire is willing to suffer falling volume in insurance: "We have promised people at all of our insurance operations that we will never have layoffs because of a drop in volume. We do not want the people who run our insurance operations to feel like they have to write $X in order to keep everybody there. We can afford some overhead costing us a little money through lack of using our operation at full capacity - because it isn't that much relative to the size of our insurance operation. What we can't afford is people feeling some internal compulsion to keep writing business in order to keep their jobs. So we have a strong policy on that."
In 1985, premium income started to grow, and topped out at $825 million in 1987 before falling to a low of $395 million in 1989 when a major quota share treaty expired. All of this period was plagued by underwriting losses, which started appearing in 1982 and persisted until 1992. To illustrate just how bad it was, the combined ratio was a painful 121 in 1983, and a devastating 134 in 1984. When the first underwriting profits in a decade were finally enjoyed in 1993, insurance premiums had grown back to $650 million.
Reading the insurance discussion in the annual reports for this period is a very sour experience, each year's commentary more dismal than the previous. Buffett continually pounded the table, insisting that a 10% increase in written premiums was necessary to just keep the combined ratio unchanged. And he annually posted a table showing that such percentage increase was not reached in the previous year. At times, the reader could rightly wonder why Berkshire even remained in the insurance business. In 1987, Buffett wrote, "The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. In such a commodity-like business, only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels."
Warren Buffett was clearly looking for a moat for the insurance operations of Berkshire Hathaway. According to him, some moats just simply are not possible in this business. There are hundreds of competitors, so forget monopoly pricing. There is an ease of entry by new competitors; so even if you knock off some of your competitors, new ones spring up to replace them. The product cannot be differentiated in any meaningful way. Your offered insurance policy is no different and no more desirable than the policies of one of your many competitors; so forget brand names. He identifies only two possible moats: being the low cost producer and finding a niche.
"At Berkshire," continues Buffett in the same 1987 annual report, "we work to escape the industry's commodity economics in two ways. First, we differentiate our product by our financial strength, which exceeds that of all others in the industry." OK, he identifies three moats: being the low cost producer, finding a niche, and having market leading financial strength. "Our second method of differentiating ourselves is the total indifference to volume that we maintain. In 1989, we will be perfectly willing to write five times as much business as we write in 1988 - or only one-fifth as much." OK, so he identifies four moats: being the low cost producer, finding a niche, having market leading financial strength and maintaining pricing discipline even at the expense of volume - or "The Refusal To Shoot One's Own Foot" moat.
Throw in one more moat, providing superior customer service, and we have identified the moats on which the various Berkshire Hathaway insurance companies attempt to make their fortune. GEICO is predicated on customer service and being the low cost producer, and the rest of the insurance businesses employ niches, financial strength and pricing discipline at the expense of volume. And how to put this superior financial strength to work? Again, from the 1987 annual report, "Our insurance business has also made some important non-financial gains during the last few years. Mike Goldberg, its manager, has assembled a group of talented professionals to write larger risks and unusual coverages. His operation is now well equipped to handle the lines of business that will occasionally offer us major opportunities." This paragraph was a foretelling. In the 1988 annual report, the now familiar name of Ajit Jain first appears. And the 1989 annual report contains the first discussion of Cat covers. The now immensely profitable Berkshire Hathaway Reinsurance Group was being constructed new. Before Ajit, the Berkshire reinsurance business was not what Buffett would have called a wonderful company. Goodwill is only recorded with an acquisition, not with the hiring of an individual. I will leave it to Buffett to determine the amount of free goodwill Berkshire received with the hiring of Ajit Jain.
Things got better. In 1992 Buffett wrote, "Charlie and I continue to like the insurance business, which we expect to be our main source of earnings for decades to come. The industry is huge; in certain sectors we can compete world-wide; and Berkshire possesses an important competitive advantage. We will look for ways to expand our participation in the business, either indirectly as we have done through GEICO or directly as we did by acquiring Central States Indemnity." Those 1992 comments reflect a more sanguine Warren Buffett. And by 1994, when Berkshire produced a $130 million underwriting gain, the man was almost giddy. And events subsequently proved that his confidence in the future profitability and size of the Berkshire insurance business was not misplaced. In every year from 1993 until 2001, the Super Cat business of Berkshire produced a substantial underwriting gain.
In 1996, Berkshire paid $2.3 billion to buy the other 49% of GEICO it did not already own. Occasionally Buffett has added to the insurance group called the Berkshire Hathaway Primary Group, which are more specialized companies that principally write liability coverage for commercial accounts. This is no small group, with 2010 revenues of $1.7 billion and consistent underwriting profits. But, in 1998 came the return of horrible underwriting results with the purchase of General Re.
Selling insurance is like buying a common stock, only in reverse. When buying a stock, you know the amount of your cash outflow; but not your cash inflow. When selling insurance, you know the amount of your cash inflow, but not your cash outflow. But, the emotional skills of selecting a company to buy will transfer to selecting a risk to assume. You still need to stay within your circle of competence, you need to be disciplined, you need to be grounded in reality, you need to determine value, and you need to price with a margin of safety. In both cases, you need to compute the present value of a future stream of cash flows. It is all the same thing.
In both investing in common stocks and selling reinsurance, excess returns will flow to those who are the most skillful at exploiting market inefficiencies. As Buffett said at the 2000 annual meeting, "Reinsurance is not the world's most efficient business - and it never will be - because it's not strictly actuarial. All excess returns will not be competed away. There will be people who earn very sub-normal returns in the business. And there will be people who get killed in the business. That means there will be quite a deviation from the mean in terms of the results of individual insurers." So, reinsurance, and General Re, is an excellent business for an old stock picker like Buffett. Just as in buying marketable securities, it provides opportunities to profit from mispriced transactions.
The early years of ownership of General Re provided one of those personal growth opportunities we have all have learned to fear and hate. In contrast to almost all other acquisitions at Berkshire, it was large enough to be material, it was done entirely with Berkshire common stock, and it was immediately a problem. Certainly, no acquisition during this period under study had raised as many legitimate questions as General Re. While other factors played their part, especially market prices for equity securities, after its acquisition General Re was a primary drag on growth at Berkshire. In 1999, the first full year after the purchase of General Re, Berkshire’s book value per share grew by .5%. In 2000, 6.5%; in 2001 a negative 6.2%; and in 2002, 10%. For a company that had historically grown book value per share at a rate in excess of 20% a year, this is a significant reduction. The 2010 annual report provided the percent annual change in book value per-share for every five year period since 1965. Three of the four smallest gaining periods were 1999-2003, 2000-2004 and 2001-2005, with 1999-2003 being the smallest of all.
Berkshire was sufficiently reserved for unpaid insurance losses at the end of 1997, the year before the purchase of General Re. However, by the end of 2000, Berkshire was significantly under-reserved and it took until the end of 2004 for Berkshire to get its reserves back to a sufficient amount. Starting in 2004 and continuing to the current period, Berkshire’s reserve for unpaid insurance losses have been consistently over-accrued. The large reserve deficiency at the end of 2000 came from the General Re acquisition and the insurance activities in the years of 1999 and 2000. Our best estimates today indicate that Berkshire’s insurance reserves at December 31, 2000 of $28.6 billion were $9.1 billion short.
If you think that $9.1 billion is bad, look at AIG. At the same time, December 31, 2000, AIG’s insurance reserves of $27 billion were, based on current estimates, understated by $23.4 billion. That is, they should actually have been reported as $50.4 billion. So, while both Berkshire and AIG reported similar insurance reserves at the end of 2000, AIG was short $23.4 billion while Berkshire was short by $9.1 billion.
Neither Berkshire nor AIG, of course, knew the extent of their problems at that time. But, evidentially AIG felt that it needed to show higher insurance reserves – it must have had some inkling. So, AIG consummated two contracts with Berkshire, both for $250 million - one in late 2000 and the other in early 2001. After employing fraudulent accounting for both contracts, AIG managed to boost its reserves by a total of $250 million at the end of 2000 and $500 million at the end of 2001. So, what we have is a criminal conspiracy to manipulate the financial statements of AIG to boost its reserves by $250 million at the end of 2000, when today we estimate that those reserves were actually understated by $23.4 billion. And for AIG, 2001 was even worse. Their fraudulent accounting boosted reserves for that year by $500 million when the real shortage is currently estimated as $27.4 billion. Why so cautious? If you are going to conduct fraud, conduct meaningful fraud; the prison time is no longer. If not for the harm caused by these two transactions, the puny, fraudulent attempt to obscure what was eventually recognized as a real problem of a much greater magnitude could only be classified as a high comedy.
Buffett fixed General Re the same way he had earlier fixed National Indemnity, reducing its premium income from $366 million in 1986 to $54 million in 1999. As Buffett reviewed in the 2004 annual report: “That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.” In 1997, the year before the Berkshire purchase, General Re had earned premiums of $6.6 billion. For the year of 2010, 13 years later, General Re reported earned premiums of $5.7 billion, a reduction in dollar value activity. During that same 13 year period, General Re went from a small underwriting loss to a substantial underwriting profit.
But, even the validity of those small pre-acquisition underwriting losses are questionable. Subsequent experience strongly suggests that the accrual for unpaid losses for General Re at the time of the acquisition was significantly inadequate. During the first two years of its ownership by Berkshire, 1999 and 2000, General Re recorded a $1.2 billion underwriting loss in each year. But it was probably much worse than that. The unpaid loss liability is not broken out separately for General Re, but it appears that its unpaid loss liability accrual for 1998 and prior years was actually being reduced during 1999 and 2000. Bringing these 1998 and prior year reserves back into income reduced the reported losses for 1999 and 2000. And even this was not right; the reserve reductions for 1998 and prior years were themselves eventually reversed.
During about the first five years of Berkshire’s ownership, nobody knew how bad General Re’s financial results really were. Reserves had to be made whole and the entire underwriting culture had to change. But it was done. Today General Re has less premium dollar income than even in 1997, but its reserves appear sound and it reports underwriting gains.
If I was King of Accounting I would require any company with a property and casualty insurance business to provide an additional footnote to their annual financial statements. It would present summary financial statements for each of the last ten years. For each of those ten years two financial statements would be prepared. One would show the year as originally stated, and the other would report the year based upon the best current estimates of policy losses for that year. One of two things would happen. Either nothing would happen because nobody cares about the footnotes, or the threats directed towards me would force me into a version of the witness protection program – the accountants’ protection program. I doubt if the cats would care; but my wife would miss me.
Investors tend to focus on the hand that management is playing, but all the wild cards are in the remainder of the deck. More important than the cards that management holds now are the ones they will be dealt next. And, more important than what will be dealt next is how well the new hand is played. The game is called “spending the shareholders’ cash;” and how that cash is spent will determine the real value of the company.
So, here is how Berkshire Hathaway spends the shareholders’ cash:
1) At an attractive price, it buys a wonderful company. A wonderful company has a moat, pricing power, high returns on invested capital, management in place, moderate exposure to technological obsolescence, the ability to increase volume with little increases in capital and a short list of things that can go wrong.
2) It requires that its managers not only be honest, talented and fanatics about the business, but always protective of the company’s reputation.
3) It instructs its managers to continue to widen their moats, even though profits may suffer.
4) Even though its prospects may sour or soar, it will not dispose of any company unless its employees, customers and communities would benefit from different ownership.
5) It makes sensible reinvestments, but eschews growth for growth's sake.
6) It employees a decentralized management.
7) It does not master-plan or force, but allows the process to unfold on its own; acting only when and if an appropriate opportunity is available.
Berkshire Hathaway is what happens when pre-existing ideas about how and why a business should grow and operate are ignored, instead just taking what is happily given by a less enlightened market. Buffett’s disregard of the crowd’s demands to do this or to do that - forcing some kind of action or solution - is born not from discipline but from philosophy. Could someone have successfully disciplined their emotions so consistently? Is not discipline that keeps him from quickly and easily reinvesting his ready cash, but the confidence of an unflinchingly held philosophy. Others may understand the how of what he does, but lack the how of how he does it.
This question of how the cash flow will be spent is paramount. Currently, Berkshire’s free cash flow is such that it could easily finance a $10 billion acquisition every year. Fortunately it has increased its available ways to spend this cash. During the period under consideration Berkshire has acquired a significant number of large operating companies. These companies will not only have a continuing need for capital to finance their existing operations, but can also be very active in making their own add-on acquisitions. The use of capital by existing Berkshire subsidiaries could be especially profitable in foreign countries. Since Berkshire makes so many things that fulfill the basic needs of growing economies and populations, it has many opportunities to just take what it is doing now and transfer the same activity overseas. As a percentage of its business, I expect Berkshire’s foreign activity to grow.
Finally, one way to think of Berkshire Hathaway is as a special purpose vehicle created by two especially talented and wise men to advance their vision of an intelligent business enterprise. Asking others to successfully shepherd this unique bundle of business operations is asking a lot; a special person will be required. So, the uncertainty over Buffett’s successor will continue. In addition, Berkshire is a conglomerate and becoming more so every year. Because of Berkshire’s status as a conglomerate and the amount of capitalized uncertainty due to Buffett’s age, I believe that the market will generally price it at a discount to its intrinsic value.