The percentage of operating earnings as a percentage of beginning equity capital dropped to only 9.8%. One reason was that for partially-owned (<20%), nonoperated businesses, accounting rules dictate that only the dividends received can be reported as earnings.
Even the earnings of 35% owned GEICO were not included. For accounting purposes, the company was treated as a less-than-20% holding as the voting rights had been assigned.
Thus, only the dividends received from GEICO in 1982 of $3.5 million after tax were included in the “accounting” earnings. An additional $23 million that represented Berkshire’s share of GEICO’s undistributed operating earnings for 1982 were totally excluded.
There’s accounting madness at work here. If GEICO had earned less money in 1982 but had paid an additional $1 million in dividends, reported earnings would have been larger despite the poorer business results. Conversely, if GEICO had earned an additional $100 million – and retained it all – reported earnings would have remained unchanged.
Warren prefers using a concept of “economic” earnings. This includes all undistributed earnings, regardless of ownership percentage. The point to bear in mind is that accounting numbers are the beginning, and not the end of business valuation.
To further highlight this point, Berkshire’s share of undistributed earnings from four of their major non-controlled holdings came to well over $40 million in 1982. This number, which is totally unreflected in the earnings report, is much higher than the total reported earnings of $14 million in dividends received from these companies.
The gigantic auction arena of the stock market continues to offer value investors opportunities to purchase fractional portions of businesses at bargain prices. This is possible as long as the market is moderately priced.
For the investor, an over-priced purchase of an excellent company can undo the effects of even a subsequent decade of favorable business developments. Value investors want the market to be cheap, not expensive!
Insurance Industry Conditions
The insurance industry continued to bleed. It is a good example of an industry with substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc).
If prices or costs can be controlled, the ‘bleeding’ can be stopped. This can be carried out legally through government intervention, illegally through collusion, or “extra-legally” through OPEC-style foreign cartelization.
Unfortunately, for the great majority of industries selling “commodity” products, a depressing equation of business economics prevails: persistent over-capacity without controlled prices (or costs). This results in poor profitability.
Over-capacity may eventually self-correct, either as capacity drops or demand expands. When they finally occur, there usually follows an enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment.
What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years.
The insurance industry operates under substantial overcapacity as it can be instantly created by capital and an underwriter’s willingness to sign his name.
Since there can be no surge in demand for insurance policies comparable to one in copper or aluminum, the only way for it to return to profitably is to reduce the supply.
Unfortunately, major sources of insurance capacity are unlikely to turn their backs on very large chunks of business, thereby sacrificing market share and industry significance. Major capacity withdrawals will require a shock factor such as a natural or financial “megadisaster”.
Issuance of Equity
In a merger, the first choice of the buying company is to use cash or debt to fund the purchase. In cases where these are insufficient, the issuance of new equity might be used.
When this happens, you will have to take notice. Why?
Companies often sell in the stock market below their intrinsic business value. But when a company wishes to sell out completely in a negotiated transaction, it usually can receive full business value in whatever kind of currency the value is to be delivered.
If cash or debt is to be used in payment, the seller’s calculation of value received is quite straightforward. If stock of the buyer is to be the currency, the seller’s calculation is still relatively easy: just figure the market value in cash of what is to be received in stock.
If the buyer’s stock is selling in the market at full intrinsic value, using it as currency for the purchase doesn’t pose any problems.
But suppose it is selling at only half intrinsic value. In that case, the buyer will be using a substantially undervalued currency to fund the purchase of a company at full intrinsic business value.
The issuance of shares to make an acquisition amounts to a partial sale of the business. Using it to fund an acquisition means that you sell it at whatever value the market happens to be granting it at that time.
And if the market price is under-valuing the business, you will have to scrutinize the deal carefully no matter what ‘reasons’ the managers might give you.
However, there are three ways to avoid destruction of value for old owners when shares are issued for acquisitions.
One is to have a true business-value-for-business-value merger, with each receiving just as much as it gives in terms of intrinsic business value.
The second route presents itself when the acquirer’s stock sells at or above its intrinsic business value. In that situation, the use of stock may actually enhance the wealth of the acquiring company’s owners.
The third solution is for the acquirer to go ahead with the acquisition, but then subsequently repurchase a quantity of shares equal to the number issued in the merger. This essentially converts it to a “cash for stock” purchase.
Another variable in mergers that is given too much attention is the effects of dilution on earnings. There have been plenty of non-dilutive mergers that were instantly value destroying for the acquirer. And some mergers that have diluted current and near-term earnings per share have in fact been value-enhancing.
What really counts is whether a merger is dilutive or anti-dilutive in terms of intrinsic business value.
Finally, there is also a “double whammy” effect on the owners of the acquiring company when value-diluting stock issuances occur. A management that has a record of wealth-destruction through unintelligent share issuances will have a lower stock price for the company as the market accords a lower price/value ratio to them.