This year’s letter started with a reiteration of something that was mentioned in the previous year’s letter. Even though undistributed and unrecorded earnings of non-controlled holdings will not be reflected in the accounts, they will eventually be translated into tangible value over the long run.
A note on general acquisition behaviour. Buffett would rather buy 10% of X company at Y per share than 100% of X at 2Y per share. Most corporate managers however, prefer just the reverse. This results in a larger empire, but poorer citizens.
There are however some dazzling exceptions and most of them fall into two major categories.
The first category involves purchase of business that are well adapted to an inflationary environment. These businesses are able to raise their price without fear of significant fear of loss of market share or unit volume. They are also able to accomodate large increases in their volume with only minor addition of investment capital.
The second category involves the mangerial superstar – people who are able to recognise businesses that are “the rare prince disguised as a toad”.
Buffett finds values most easily through the open-market purchase of fractional positions in companies with excellent business franchises and competent, honest managements.
In most cases, undistributed earnings from such companies will produce full value for Berkshire and its shareholders. If they don’t, it could be due to three reasons: (1) the management (2) the future economics of the business; or (3) the price that was paid.
There follows a lengthy discussion on “Equity Value-Added”. To justify an investment in equity, there should be additional earnings above passive investments returns. This is derived from the employment of managerial and entrepreneurial skills in conjunction with that equity capital.
Also, since an equity capital position requires additional risks, we should be getting a higher return for the risk.
When a business is able to achieve this, a dollar of each is usually valued at more than a hundred cents. Conversely, if investment returns of passive instruments are higher than the returns from a business, such a business will be valued at less than a dollar for each dollar.
The bottomline? Interest rates (an inflation rates) would and will affect the valuation of any business.
An ironic situation is that a “bad” business will usually need to retain most of it’s capital to continue operating. Consider if you have a 5% bond and current rates were about 10%. Will you take the coupons from the bond and pay hundred cents on the dollar for more 5% bonds when the same dollar will buy you a 10% bond? Yet, that is what “bad” business are doing by retaining capital. Shareholders would be better served receiving the earnings as dividends and re-investing them elsewhere.
On the other hand, a “good” business with a high return on equity should retain all it’s capital so that shareholders can earn premium returns on enhanced capital.