Summary_WB_1979 Shareholder Letter

 Berkshire Hathaway 1979 Shareholder Letter: Key Themes and Insights

This briefing document synthesizes the key themes, insights, and facts from the provided excerpts of "Buffett's Principles: Value, Inflation, and Business Reality" and the "Chairman's Letter - 1979" to the shareholders of Berkshire Hathaway.

I. Measuring True Business Performance: Beyond Superficial Metrics

A central theme of the 1979 letter is Buffett's critique of commonly used financial metrics and his emphasis on understanding the underlying economic reality of a business. He consistently argues that nominal growth figures, particularly in an inflationary environment, can be misleading.

Critique of EPS and Book Value Growth: Buffett challenges the conventional focus on "earnings per share" (EPS) and simple "book value per share" increases as primary indicators of performance. He illustrates this with a stark analogy: "'Earnings per share' will rise constantly on a dormant savings account or on a U.S. Savings Bond bearing a fixed rate of return simply because ‘earnings’ (the stated interest rate) are continuously plowed back and added to the capital base. Thus, even a ‘stopped clock’ can look like a growth stock if the dividend payout ratio is low."

Emphasis on Operating Earnings Relative to Equity: Buffett asserts that "the ratio of operating earnings (before securities gains or losses) to shareholders’ equity with all securities valued at cost is the most appropriate way to measure any single year’s operating performance." This method, he explains, avoids distortions from volatile market value changes. For 1979, Berkshire's operating earnings were "18.6% of beginning net worth—good, but 'not quite as good as that of 1978.'"

The Illusion of Accounting Changes: The letter highlights how changes in accounting rules, specifically requiring insurance companies to carry equity securities at market value, significantly increased Berkshire's reported net worth for 1978–1979. However, Buffett cautions that this is "partly an illusion" as it reflects unrealized gains that are subject to market fluctuations and could reverse. He even points out an inconsistency where "the same equities" could be valued differently on Berkshire's and Blue Chip Stamps' books due to varying accounting rules.

Long-Term vs. Short-Term Measurement: While advocating for operating earnings for short-term assessment, Buffett acknowledges that for "measuring long term economic performance... it is appropriate to recognize fully any realized capital gains or losses as well as extraordinary items, and also to utilize financial statements presenting equity securities at market value." This is because, over time, "such capital gains or losses, either realized or unrealized, are fully as important to shareholders over a period of years as earnings realized in a more routine manner through operations."

II. The Pernicious Effects of Inflation

Inflation is presented as a severe threat to real wealth creation, eroding the purchasing power of even strong nominal gains.

Erosion of Real Returns: Despite a 20.5% compounded annual growth in book value since 1964, Buffett warns that high inflation "will be the ultimate determinant as to whether our internal operating performance produces successful investment results - i.e., a reasonable gain in purchasing power from funds committed - for you as shareholders." He starkly illustrates this: "A business earning 20% on capital can produce a negative real return for its owners under inflationary conditions not much more severe than presently prevail."

The "Investor's Misery Index": Buffett introduces this concept as "the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings)." When this index exceeds the business's return on equity, "the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all."

Real vs. Nominal Value: A striking comparison is made: Berkshire's book value in 1964 could buy "about one-half ounce of gold," and fifteen years later, despite significant growth, "the book value produced will buy about the same half ounce." This underscores the point that "government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil."

III. Prudent Capital Allocation and Investment Philosophy

Buffett outlines Berkshire's disciplined approach to capital allocation, emphasizing long-term value creation and avoidance of speculative endeavors.

High Return on Equity (ROE) without Gimmicks: The "primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.)"

Focus on Intrinsic Value: Berkshire's strategy involves "cash-based acquisitions of private businesses" and "negotiated deals and cautious expansion rather than risky bets." They acquired "full ownership of thirteen businesses" and "started six others."

Avoidance of "Turnarounds": Reflecting on the "mistake" of acquiring Waumbec Mills, a textile company purchased at a bargain price but in a struggling industry, Buffett concludes: "'turnarounds' seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price."

Skepticism Towards Long-Term Bonds: In an inflationary environment, Buffett expresses "severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract." He criticizes the "cultural lag" in the bond market where long-term fixed prices are accepted, unlike in other industries. Berkshire has primarily limited net fixed dollar commitments to convertible bonds, believing their conversion options provide a "far shorter average life." His updated adage: "Neither a short-term borrower nor a long-term lender be."

IV. Insurance Operations and the Power of "Float"

Insurance remains a core and well-managed segment of Berkshire, primarily due to its generation of "float"—the premiums collected before claims are paid, which can be invested.

Industry Trends: The letter notes a worsening industry underwriting ratio, rising "over three points, from roughly 97.4% to 100.7%," pushing the industry into an underwriting loss position.

Berkshire's Underwriting Discipline: In contrast, Berkshire's own underwriting ratio decreased from 98.2% to 97.1%, showcasing superior management. This is attributed to managers like Phil Liesche who are willing to "reduce volume in order to underwrite profitably." Buffett emphasizes that "such strong-mindedness is as rare as it is sound - and absolutely essential to the running of a first-class casualty insurance operation."

Forecast for 1980 and Beyond: Buffett predicts further worsening for the industry's underwriting performance, expecting an "average combined ratio for the industry in the 105 area over the next five years" due to prevailing interest rates encouraging underwriting at a loss to gain investment income.

V. Shareholder Communication and Owner Mentality

Buffett's communication style is a hallmark of Berkshire Hathaway, fostering a partnership between management and shareholders.

Shareholders as Partners: Buffett views shareholders as partners and writes to them directly, emphasizing transparency and long-term thinking. He aims to provide "the same information we would find useful if the roles were reversed."

Direct CEO Communication: He firmly believes "that owners are entitled to hear directly from the CEO as to what is going on and how he evaluates the business, currently and prospectively." This ensures candid, manager-to-owner communication, not a "public relations document."

Cultivating the Right Shareholder Base: Buffett likens attracting shareholders to a restaurant attracting customers, preferring "owners who like our service and menu and who return year after year." He seeks a stable shareholder base that "understands our operation, approves of our policies, and shares our expectations."

VI. Organizational Structure and Prospects

Berkshire's lean and decentralized structure is key to its operational efficiency and ability to attract top talent.

Centralized Financial Decisions, Decentralized Operations: Berkshire operates with "centralization of financial decisions at the top (the very top, it might be added), and rather extreme delegation of operating authority to a number of key managers at the individual company or business unit level."

Benefits of Decentralization: This approach "eliminates large layers of costs and dramatically speeds decision-making." Crucially, "it enables us to attract and retain some extraordinarily talented individuals... who find working for Berkshire to be almost identical to running their own show."

Outlook for 1980: Buffett forecasts that operating earnings as a percentage of equity will decline from the 18.6% attained in 1979, with a "fair chance that operating earnings in aggregate dollars will fall short of 1979." This is partly due to the impending divestiture of the Illinois National Bank and Trust Company, which performed exceptionally, earning "approximately 2.3% on average assets last year, a level again over three times that achieved by the average major bank." This divestment is mandated by the Bank Holding Company Act of 1969.

In summary, the 1979 letter is a foundational document in understanding Buffett's investment philosophy, emphasizing genuine economic performance over superficial accounting gains, the destructive power of inflation, disciplined capital allocation, and a unique, transparent approach to shareholder relations. It underscores the importance of an "owner's mindset" in navigating complex economic realities.