BHLC: 1994 Notes and Reviews of Berkshire Hathaway Shareholder Letter

Notes on Berkshire Hathaway Shareholder Letter fromĀ 1994

Brief Summary of the Year:

Buffett is all about the simple, honest business principles. I thought this would be challenging to understand, but he makes it simple and rooted in common sense. I think that’s the power of these letters.

Notes For the Year:

Foreword: This is my second time reading a Berkshire Hathaway article so there will be revelation notes regarding continuations in format and other gems you get when diving into a new subject and begin to make connections. I hope these notes and quotes help you in whatever your working on.

Again he starts with dramatic yet simple numbers. 13.9% gain in 1994. Over the past 30 years, 23%. Very simple and to the point.

Charlie Munger, Berkshire’s Vice Chairman and my partner,
and I make few predictions. One we will confidently offer,
however, is that the future performance of Berkshire won’t come
close to matching the performance of the past. – Warren Buffett

So this is a bit odd. He’s telling everyone that he doesn’t think they will perform like in the past. If his job is to attract investors, this is uncommon behavior. Perhaps that’s why it works so well.

The problem is not that what has worked in the past will
cease to work in the future. To the contrary, we believe that
our formula – the purchase at sensible prices of businesses that
have good underlying economics and are run by honest and able
people – is certain to produce reasonable success. – Warren Buffett

As always, he’s a devotee to his strategy of intrinsic value being composed of sensible prices, underlying economic formula & management teams. (Change from the pervious year? No, but omitting something from the previous years list of 5.)

A fat wallet, however, is the enemy of superior investment
results. – Warren Buffett

“If something is not worth doing at all, it’s not
worth doing well.” – Charlie Munger

So in 1994 Charlie and Warren decided they would only invest in companies in which they could deploy $100 million plus. Their investment universe has shrunk dramatically.

Ted Williams, in The Story of My Life:

“My argument is, to be a good hitter, you’ve got to get a good ball to hit. It’s the first rule in the book. If I have to bite at stuff that is out
of my happy zone, I’m not a .344 hitter. I might only be a .250
hitter.” Charlie and I agree and will try to wait for
opportunities that are well within our own “happy zone.” – Warren Buffett

Again like 1993, Buffett describes that just because they are holding considerable cash, they aren’t likely to do anything with it unless it’s a sure win (or in their “happy zone.”)

We will continue to ignore political and economic forecasts,
which are an expensive distraction for many investors and
businessmen. – Warren Buffett

Forget politics and economic forecasts and mark them as unimportant.

Indeed, we have usually made our best purchases when
apprehensions about some macro event were at a peak. Fear is the
foe of the faddist, but the friend of the fundamentalist. – Warren Buffett

Faddist?

What we promise you – along with more modest gains – is that
during your ownership of Berkshire, you will fare just as Charlie
and I do. If you suffer, we will suffer; if we prosper, so will
you. And we will not break this bond by introducing compensation
arrangements that give us a greater participation in the upside
than the downside. – Warren Buffett

Their pricing structure is not predatory like Bank of America or many investment “offers.” They are in the battle with their clients and losses and wins are shared by all. Alignment of incentives.

Casey Stengel described managing a baseball team as “getting paid for home runs ather fellows hit.” That’s my formula at Berkshire, also. – Warren Buffett

Warren Buffett’s formula for investing.

Again, like last year, Buffett dives into the success of Gillette and Coke illustrating why they are so important to the success of the company.

It’s far better to own a significant portion of the Hope
diamond than 100% of a rhinestone, and the companies just
mentioned easily qualify as rare gems. Best of all, we aren’t
limited to simply a few of this breed, but instead possess a
growing collection. – Warren Buffett

Again, pressing the value of intrinsic value and why choosing great companies is the key to their success.

We continue to give you book value figures, however, because they serve as a rough, albeit significantly understated, tracking measure for Berkshire’s
intrinsic value. – Warren Buffett

Book Numbers to Buffett aren’t the most valuable indicators (maybe they are in Jim Cramer’s Mad Money) because one should focus on intrinsic value rather than book value. They provide the data as an understated, rough meaning of the value of a company.

We define intrinsic value as the discounted value of the
cash that can be taken out of a business during its remaining
life. – Warren Buffett

I’m pretty sure this is a direct repetition from last years definition of intrinsic value.

Now let’s get less academic and look at Scott Fetzer, an
example from Berkshire’s own experience. This account will not
only illustrate how the relationship of book value and intrinsic
value can change but also will provide an accounting lesson that
I know you have been breathlessly awaiting. Naturally, I’ve
chosen here to talk about an acquisition that has turned out to
be a huge winner.

Berkshire purchased Scott Fetzer at the beginning of 1986.
At the time, the company was a collection of 22 businesses, and
today we have exactly the same line-up – no additions and no
disposals. Scott Fetzer’s main operations are World Book, Kirby,
and Campbell Hausfeld, but many other units are important
contributors to earnings as well.

We paid $315.2 million for Scott Fetzer, which at the time
had $172.6 million of book value. The $142.6 million premium we
handed over indicated our belief that the company’s intrinsic
value was close to double its book value.

In the table below we trace the book value of Scott Fetzer,
as well as its earnings and dividends, since our purchase. – Warren Buffett

How intrinsic value and book value shift over time.

Throughout our years of ownership, Scott Fetzer has operated as a
conservatively-financed and liquid enterprise. – Warren Buffett

Conservatively-financed liquid enterprise – This is something to aspire to as a young entrepreneur.

You might expect that Scott Fetzer’s success could only be
explained by a cyclical peak in earnings, a monopolistic
position, or leverage. But no such circumstances apply. Rather,
the company’s success comes from the managerial expertise of CEO
Ralph Schey, of whom I’ll tell you more later. – Warren Buffett

Again with the hailing of great management teams. Great management teams play a pivotal role in Warren Buffett’s love for your business.

The reasons for Ralph [Schey]’s success are not complicated. Ben
Graham taught me 45 years ago that in investing it is not
necessary to do extraordinary things to get extraordinary
results. – Warren Buffett

Buffett is purposeful in giving credit to others. His mentor from 45 years ago especially as he is mentioned in 1993’s letter too.

Charlie and I, at 71 and 64 respectively, now keep George Foreman’s
picture on our desks. You can make that our book scorn for a
mandatory retirement age will grow stronger every year. – Warren Buffett

“You can make book.” ? What does that mean -> Warren Buffett on how retirement age is for suckers. His love for investing shines through in every word of this letter.

Understanding intrinsic value is as important for managers
as it is for investors. When managers are making capital
allocation decisions – including decisions to repurchase shares –
it’s vital that they act in ways that increase per-share,
intrinsic value and avoid moves that decrease it. This principle
may seem obvious but we constantly see it violated. And, when
misallocations occur, shareholders are hurt. – Warren Buffett

Going back to our college-education example, imagine that a 25-year-old
first-year MBA student is considering merging his future economic
interests with those of a 25-year-old day laborer. The MBA
student, a non-earner, would find that a “share-for-share” merger
of his equity interest in himself with that of the day laborer
would enhance his near-term earnings (in a big way!). But what
could be sillier for the student than a deal of this kind? – Warren Buffett

Warren Buffett thinks you should get a job, not an MBA.

Almost by definition, a really good business generates
far more money (at least after its early years) than it can use
internally. – Warren Buffett

Warren Buffets advice for picking good companies, find one’s that have far more money than it can use internally. Sounds obvious right?

The acquisition problem is often compounded by a biological
bias: Many CEO’s attain their positions in part because they
possess an abundance of animal spirits and ego. If an executive
is heavily endowed with these qualities – which, it should be
acknowledged, sometimes have their advantages – they won’t
disappear when he reaches the top. When such a CEO is encouraged
by his advisors to make deals, he responds much as would a
teenage boy who is encouraged by his father to have a normal sex
life. It’s not a push he needs. – Warren Buffett

About CEO’s – How they got to their position creates a challenge when they are advised to start building investment opportunities. They rose to the top of an organization, that doesn’t mean they are good at (or even competent) at capital allocation. Warren and Charlie are the top investors in the world and they only buy a company a year.

At Berkshire, our managers will continue to earn
extraordinary returns from what appear to be ordinary businesses.
As a first step, these managers will look for ways to deploy
their earnings advantageously in their businesses. What’s left,
they will send to Charlie and me. We then will try to use those
funds in ways that build per-share intrinsic value. Our goal
will be to acquire either part or all of businesses that we
believe we understand, that have good, sustainable underlying
economics, and that are run by managers whom we like, admire and
trust. – Warren Buffett

How they structure the business inside Berkshire Hathaway and another plug at intrinsic value.

In setting compensation, we like to hold out the promise of
large carrots, but make sure their delivery is tied directly to
results in the area that a manager controls. – Warren Buffett

Warren Buffett about setting compensation and providing big money opportunities to management teams, as long as the money is tied directly to results that the manager has direct control over. Again, it seems so obvious, but when things get large, it’s easy to lose track.

The product of this money’s-not-free approach is definitely
visible at Scott Fetzer. If Ralph can employ incremental funds
at good returns, it pays him to do so: His bonus increases when
earnings on additional capital exceed a meaningful hurdle charge.
But our bonus calculation is symmetrical: If incremental
investment yields sub-standard returns, the shortfall is costly
to Ralph as well as to Berkshire. The consequence of this two-
way arrangement is that it pays Ralph – and pays him well – to
send to Omaha any cash he can’t advantageously use in his
business. – Warren Buffett

MONEY’S-NOT-FREE APPROACH – This goes in direct contradiction to the way some government sectors waste money to show that they need more money. Here at the best capital allocation organization in the world, they do the opposite, you have money you don’t know how to spend? Just sent it up the ladder and we’ll keep the cash until a great deal comes around.

In our book, alignment means being a partner in both directions, not just on the upside. Many “alignment” plans flunk this basic test, being artful forms
of “heads I win, tails you lose.” – Warren Buffett

Alignment of incentives is so important. He’s back on the same point.

I can’t resist mentioning that our compensation arrangement
with Ralph Schey was worked out in about five minutes,
immediately upon our purchase of Scott Fetzer and without the
“help” of lawyers or compensation consultants. – Warren Buffett

Another theme of Warren Buffett deals. The deal is worked out easily, no lawyers, no compensation consultants. This was similar with the 100 year old woman from last years letters. A hand-shake and a good business managers word are all you need to be sure of a solid deal. Simplicity at the highest courts of business.

It made sense to him and to me in 1986, and it makes sense now. – Warren Buffett

Long term approach to great deal setting.

In all instances, we pursue rationality. – Warren Buffett

Again, great simple deals. How to prosper over the long run is to seek rational, mutually beneficial relationships.

We have carefully designed both the company and our jobs so that we do things we enjoy with people we like. Equally important, we are forced to do very few
boring or unpleasant tasks. – Warren Buffett

On how to build organizations that maximize what they are the best at. Follow your passion message from Warren Buffett.

Indeed, if we were not paid at all, Charlie and I would be
delighted with the cushy jobs we hold. At bottom, we subscribe
to Ronald Reagan’s creed: “It’s probably true that hard work
never killed anyone, but I figure why take the chance.” – Warren Buffett

Warren Buffett on the value of hard work. LoL

Our intent is to supply you with the financial information that we would wish you to give us if our positions were reversed. – Warren Buffett

Again he’s repeating himself here. The Golden Rule seems to be a constant at Berkshire Hathaway.

LOOK THROUGH EARNINGS – Source: http://www.investopedia.com/terms/l/look-through-earnings.asp

Look-through earnings include the profits that a company pays to its shareholders in the form of dividends and the retained earnings that the company uses to expand its operations. This concept was popularized by Warren Buffet to analyze the overall earnings-generating capabilities of the firm. The idea is that all of these profits have value to investors – the dividends provide an immediate benefit, while the retained earnings should increase the stock’s value in the future.

As we’ve explained in past reports, what counts in our
insurance business is, first, the amount of “float” we develop and,
second, its cost to us. Float is money we hold but don’t own. In
an insurance operation, float arises because most policies require
that premiums be prepaid and, more importantly, because it usually
takes time for an insurer to hear about and resolve loss claims. – Warren Buffett

How Warren Buffett describes float money which is money they hold but don’t own yet. This is like when you pay an insurance company, they keep some of that cash on hand to prepare for the inevitable claims that are sure to come and need to be paid out. They would call it float money as it’s money they have but can’t spend.

Here Berkshire has a major advantage: Ajit Jain, our super-cat manager, whose
underwriting skills are the finest. His value to us is simply enormous. – Warren Buffett

Again pointing out excellence in managing partners – a common theme of the letters.

He mentioned the size of Berkshire Hathaway allows it to take $400 million risk of a Caifornia earthquake insurance (Super-cat policies – Super Catastrophe Policies.)

Too often, insurers (as well as other businesses) follow sub-
optimum strategies in order to “smooth” their reported earnings.
By accepting the prospect of volatility, we expect to earn higher
long-term returns than we would by pursuing predictability. – Warren Buffett

When doing long term insurance Warren Buffett expects volatility and long-term returns to be better to seek out than pursuing predictability. On this podcast, Mike Dever talks about volatility and how creating predictability is important. This also makes me think of what Nicholas Nassim Taleb says about betting against things that are resistant to volatility.

For example, were we to have super-cat losses from a large Southern California earthquake, they might well be accompanied by a major drop in the value of our holdings in See’s, Wells Fargo and Freddie Mac. – Warren Buffett

Notice that Buffett is exposed to Freddie Mac. It will be fun to see.

We try to price, rather than time, purchases. In our view, it
is folly to forego buying shares in an outstanding business whose
long-term future is predictable, because of short-term worries
about an economy or a stock market that we know to be
unpredictable. Why scrap an informed decision because of an
uninformed guess? – Warren Buffett

– He is often self deprecating.

Rather, this was a case of sloppy analysis, a lapse that may have been caused by the fact that we were buying a senior security or by hubris. Whatever the reason,the mistake was large. – Warren Buffett

I wonder what exactly constitutes a sloppy analysis of a company in Warren Buffett’s mind.

During this period, with the longer-term problems largely invisible but slowly metastasizing, the costs that were non-sustainable became further embedded. – Warren Buffett

Invisible long term problems (in this case cost issues) lead to non-sustainable business practice.

-He goes into the airline industry, deregulation and how it effected them over the long run with the USAir investment.

In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction. – Warren Buffett

Warren Buffett on commodities and competitive sustainability.

Bankruptcy court for airlines has become a health spa. – Herb Kelleher

On the fluctuations of the airline industry.

A prime rule of investing: You don’t have to make it
back the way that you lost it. – Warren Buffett

Prime Rule of Investing

We made only one minor acquisition during 1994 – a small
retail shoe chain – but our interest in finding good candidates
remains as keen as ever. The criteria we employ for purchases or
mergers is detailed in the appendix on page 21. – Warren Buffett

In all of 1994 Warren and Charlie made one acquisition despite 422 million in undistributed earnings of major investments.

Last year we displayed some of Berkshire’s products at the
meeting, and as a result sold about 800 pounds of candy, 507 pairs
of shoes, and over $12,000 of World Books and related publications.
All these goods will be available again this year. – Warren Buffett

They sell lots of their own products at their annual meetings.

When you’re there be sure to say hello to Mrs. B, who, at 101, will be hard at work in our Mrs. B’s Warehouse. – Warren Buffett

Here’s a great example of the hard work ethic/theme in these letters.

About 1,400 shareholders attended the event
last year. Opening the game that night, I had my stuff and threw a
strike that the scoreboard reported at eight miles per hour. What
many fans missed was that I shook off the catcher’s call for my
fast ball and instead delivered my change-up. This year it will be
all smoke. – Warren Buffett

Question I would Love Answered:

What is Warren Buffett’s research cycle when exploring new companies?

I bet he goes to meet with management teams and spends a good amount of time with each company that fits a specified criteria. Buffett is proud of the corporate jet which I’m sure enables a quicker, more enjoyable travel process than anyone doing commercial airlines in the US today.

Anyways, what are your thoughts? Do you know any information on this?

Continue reading “BHLC: 1994 Notes and Reviews of Berkshire Hathaway Shareholder Letter”