Thoughts on Business and Technology

Notes : Berkshire Annual Letter – 1989

Performance Highlights :

  • Net Worth $1.515 Billion ( gain in net worth – 44.4% over 25 years
  • Book value $4296 ( gain in book value from $19.6 , 23.8 % compounded annually   )

About 1989 stock market :

In a finite world, high growth rates must self-destruct. If the base from which the growth is
taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor.

Calculating true intrinsic value of Berkshire : 

In our view, Berkshire’s fundamental earning power is best measured by a “look-through” approach, in which we append our share of the operating earnings retained by our investees to our own reported operating earnings, excluding capital gains in both instances. For our intrinsic business value to grow at an average of 15% per year, our “look-through” earnings must grow at about the same pace. We’ll need plenty of help from our present investees, and also need to add a new one from time to time, in order to reach this 15% goal.

The Sainted Seven Plus One : Formed 8 business which were non-insurance operations at Berkshire in 1989, which were – Borsheim’s, The Buffalo News, Fechheimer Bros., Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See’s Candies, World Book. On an historical accounting basis, after-tax earnings of these operations were 57% on average equity capital.

Moat of a departmental store in nutshell :

In describing NFM and Borsheim’s success, Warren lists the following competitive advantages.

(1) unparalleled depth and breadth of merchandise at one location;
(2) the lowest operating costs in the business;
(3) the shrewdest of buying, made possible in part by the huge volumes purchased;
(4) gross margins, and therefore prices, far below competitors'; and
(5) friendly personalized service with family members on hand at all times.

Key to insurance profitability : 

Capacity :

– Like any other commodity industry, with no product differentiation the amount of available capacity ( i.e. ability to underwrite insurance by companies ) determine the profitability

– The capacity to underwrite insurance is determined by the net worth of the insurer, however it’s hard to regulate and usually depends on the willingness of the insurer to underwrite. therefore, the amount of industry capacity at any particular moment primarily depends on the mental state of insurance managers.

– Good profits will be realized only when there is a shortage of capacity. Shortages will occur only when insurers are frightened. That happens rarely

Premium Growth :

- A premium growth of 10% in premiums is necessary to keep stabilize the combined ratio and not bring it down.

CAT-Covers in Re-Insurance :

   This is the insurance cover primary insurers seek to protect themselves against huge catastrophes like hurricane or earthquakes, where a large number of their clients can claim damages. The primary insurers usually buy many layers of reinsurance and the reinsurers  require the primary insurers to keep 5% of each layer, this ensures the primary insurers have a financial stake in each loss settlement.To understand the nuances of how multiple catastrophes/events are covered read the 1989 letter on Berkshire’s website

CAT re-insurers in-turn “lay off” or reinsure a large percentage of their business/under-writings, Berkshire is one of the re-insurer of re-insurers. However Berkshire doesn’t “lay off” it’s business. Even though there is a risk of taking huge loss in this strategy, Berkshire’s earnings can compensate for the loss. In the end Buffet writes…

the damage would be a blow only to our pride, not to our well-being

Insurance Float to Premium Volume : Exceptional amount of float compared to premium volume. This circumstance should produce quite favorable insurance results

First mention of Ajit Jain in Buffet’s letters… 

At some point, however, there will be an opportunity for us to write large amounts of profitable business. Mike Goldberg and his management team of Rod Eldred, Dinos Iordanou, Ajit Jain, Phil Urban, and Don Wurster continue to position us well for this eventuality.

On Coca-Cola :     ” Invest in stocks to maximize net-worth, not immediate returns. ” 

Why Berkshire bought coke – ( started buying in 1988 and doubled it’s investment by end of 1989 )

Strong Brand: Extraordinary consumer attractiveness and commercial possibilities of the product

Track Record : Coke had been around for many years and had gained the mindshare of the consumers ( Buffet had his first coke in 1935-36 and he was selling coke for a 25% profit in 1936 )

– “A business in transition” (i.e. special situation ) : After drifting somewhat in the 1970’s, Coca-Cola had in 1981 become a new company with the move of Roberto Goizueta to CEO. Roberto, along with Don Keough (Buffet’s neighbor), first rethought and focused the company’s policies and then energetically carried them out. What was already the world’s most ubiquitous product gained new momentum, with sales overseas virtually exploding.

Great Management : Through a truly rare blend of marketing and financial skills, Roberto has maximized both the growth of his product and the rewards that this growth brings to shareholders. Normally, the CEO of a consumer products company, drawing on his natural inclinations or experience, will cause either marketing or finance to dominate the business at the expense of the other discipline. With Roberto, the mesh of marketing and finance is perfect and the result is a shareholder’s dream.

On Markets & Traders : 

Wall Streeter Ray DeVoe says: “Fools rush in where angels fear to trade.”

Other Securities purchased in 1989 : Gillett, US Air and Champion International Corp

 On Zero-Coupon Securities : 

Also known as Zero-Coupon Convertible Subordinated Debentures requires no current interest payments ( unlike most bonds); instead, the investor receives his yield by purchasing the security at a significant discount from maturity value. The effective interest rate is determined by the original issue price, the maturity value, and the amount of time between issuance and maturity.

The holder of these bonds pay tax on the unearned interest every year they hold the bonds, while the issuers of these bonds can claim tax credits for the interests they haven’t paid.

There are many ways in which companies can mislead investors with such instruments as Zero-Coupon bonds. More on that here…<coming soon >

Appendix – Lessons from my mistakes in the past 25 years…

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