What I learned from Warren Buffett’s 1977 letter
I will share what I learned from his 1977 shareholder letter, which has helped me become better at investing & understanding businesses.
Article Background
Hello Everyone!
If any successful investor is asked for good material to learn about investing, he will definitely refer you to Warren Buffett (here-forth called WB) & his annual letters to shareholders of his company, Berkshire Hathaway (here-forth called BH). I read these letters & I strongly believe it has taught me a lot about understanding & evaluating businesses.
As they say, the best stuff is always available cheap. These letters are available for absolutely free on BH’s websites & anyone can read it. But, very few actually have read these letters. I feel there are few reasons behind it,
1. They don’t know about it.
2. The letters start from 1977 till the current year & it looks quite a heavy task to read them all.
3. The letters are very long with many consisting of 15–20 pages & sometimes talk in terms a novice will find it difficult to understand.
It is said that you learn the best when you can teach it to anyone. I felt I should write short articles explaining each year’s letters in an easy to understand language. The idea is to explain stuff that helps you become better at understanding & evaluating businesses. I might skip over the yearly updates about a particular business if it’s just a normal business update & if no lesson as such is present. I apologize if I miss out on any particular lesson because of this.
Please let me know if there’s any mistake, improvement, suggestion, etc. I look forward to receiving feedback from you guys!
The actual notes
In the opening, WB talks about how to measure the performance of a company. I’ve added my own explanation to understand it better.
A Company’s earnings normally consist of 2 parts:
1. operating earnings that they earn from their normal business activities
2. realized gains from the assets they own
Assets can be a land parcel, securities (stocks, bonds), contracts (derivatives), etc. For land: realized gain means it is sold at a value higher than it was quoted in the balance sheet). For stocks & such assets: gain is realized when it is actually sold in the market
Many times, the second kind of earnings completely distorts the results & can lead to wrong conclusions about the underlying business.
When examining a company’s earnings, focus on operating earnings (operating earnings/share to be exact), the realized gains/losses part should not be considered every year but it is the long-term record of aggregate realized gains/losses should be considered for judging the management performance.
Companies often emphasize YoY growth in profits. But that is not the most accurate metric to measure company performance. Shocked? Let me explain:
1. as a shareholder, profits attributable to you are according to ownership % in the company, suppose the company issues shares to another entity (say for buying it, or allots in the money options to its employees), your ownership stake is diluted automatically. So it is the not the profits but profits/share or earnings/share (eps) that matter to you.
2. Even eps is not the fully correct metric to measure management performance. Consider a dormant savings account that hypothetically gives you 20% interest/year. At the beginning of the first year, you deposited 100 Rs., at first year’s end & second year’s end, it generated Rs. 20 & Rs. 44 profit correspondingly. Why was interest in the second year more than the interest in the first year? It was because of the profit Rs. 20 from the first year’s end, which was added to the principal to generate the second year’s profit.
Similarly, companies generate profit every year & use it to expand their business (the technical term is they add it to their equity capital). So, to measure the management performance, don’t just compare YoY growth in profits but measure how much profits are generated from the available equity capital. (return on equity or ROE). In the above example, profit has more than doubled, but ROE is still 20% in both years (which is pretty damn good though! ).
ROE is a good measure in normal cases where the company does not have large debt compared to its equity & both earnings & assets are measured at realistic values. (more on this comes in later letters).
After these thoughts on measuring company performance, he talks about various businesses, investments Berkshire Hathaway owns & lessons he learned from each of them, I will list them one by one & also elaborate on some of his statements:
- Textile business:
“Poor performance mostly due to textile industry problems. Some industries just don’t allow companies to generate adequate returns on their capital however well you try.”
2. Insurance business:
“various insurance companies were bought at $8.6 million in 1967. Their premiums have grown from 22 million to 151 million, this growth was achieved without any issue of additional shares.”
I will elaborate on the importance of the last sentence. For any business, as you increase the scale, you need to invest in additional assets that you will need (maybe machinery for a factory, etc.). To fund buying those assets, 3 ways are possible:
1. Through the cash generated from daily business operations.
2. Borrowing by issuing bonds/ taking a loan from a bank.
3. Raising equity capital (this is the least preferred option out of all 3 ways).
But you can not take too much debt as it risks the entire business (1 bad year & you may not be able to pay the interest & you will have to declare bankruptcy), hence people raise equity capital to maintain the debt/equity ratio in check. What the last sentence says is they have managed to increase their business 6.5x in 10 years (almost 20% growth each year for 10 consecutive years), and all of this growth has been achieved only by using cash accruals & nothing else. The shareholders got the extra profit without any additional investment.
“This growth was achieved despite making some mistakes. It is important for being in business with tailwinds the majority of the time. Also, insurance generates high funds for investment. There is no trademark, patent in the insurance business. Everything can be copied. It is individual managers who affect company performance.”
In the second last sentence, he has slightly touched upon the idea of float. I will talk about that concept in later articles. Also lastly, he explains the importance of individual managers in the insurance business.
3. Insurance Investments:
“ Investment at cost grown from 134.6 million to 252.8 million in 2 years. Growth in insurance reserves, a large gain in premium volumes & retained earning contribute to this. Income from investments went from 8.4 to 12.3 million pretax.”
“$74 million of unrealized gains, shouldn’t be taken too seriously. Stocks will be held for many years & their performance will be decided by the business results over that time. As it is foolish to focus too much on short-term prospects when buying a company, equally foolish to concentrate just on upcoming near-term earnings when buying small pieces of company i.e. stocks.”
“Select stocks same way we buy a business:
1. we understand the business model
2. has favorable long term prospects
3. operated by honest & competent people
4. available at attractive prices.”
We don’t care about anticipated price behavior in the short term. If the business results are good, we welcome lower prices so that we can buy more. Sometimes stocks trade at a large discount compared to buyout prices, In such cases, we buy large positions, not to do merger/acquisition but with the hope that excellent business results will eventually turn into excellent market value & dividends. Such investments may show negligible earnings as only dividends are attributed as earnings & not the entire profit share.”
Please note the philosophy of stock investing. When you are deciding to buy a stock, don’t just think about the anticipated price increase in the short term but think about the long term prospect of the underlying business (where will the business be roughly 10–20 years down the line, will it be significantly more profit-generating/share basis or not). Over the long term, it is the business performance that will decide your investment performance.
4. Banking:
“The ROA (return on assets) achieved > 3 times most large banks. This was achieved while paying max interest rates & keeping assets of low risk & adequate liquidity & most importantly except the starting equity amount no additional funds have been raised”
Banks need to maintain various capital adequacy & liquidity ratios, so most often banks raise equity to support these ratios when they are growing their loan book thus diluting the existing owner’s stake, what he says they have been able to achieve this growth without needing to dilute existing owner’s stake.
5. Blue chip stamps:
He didn’t mention anything noteworthy but just normal business updates (according to me, at least).
That’s all for notes for this letter. I hope you liked it! Follow me for the next articles & please let me know your feedback in the comments :)
Notes for the next letter will be released soon!
Link to the letter:
