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Share Repurchases

When a company with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, repurchases of the shares by the company provide sure benefits to shareholders.

One benefit involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. Corporate acquisition seldom do as well.

Another less obvious benefit is that when management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, shareholders and potential shareholders usually increase their estimates of future returns from the business. This upward revision, produces market prices more in line with intrinsic business value.

Buffalo Evening News

A point that I managed to pick out was that the economics of a dominant newspaper are excellent, among the very best in the business world. Once dominant, the newspaper itself and not the marketplace determines just how good or how bad the paper will be. And either way, it will prosper. Do you have a dominant newspaper?

Errors in Loss Reserving (Insurance)

The determination of costs is a main problem in the insurance industry. Most of an insurer’s costs result from losses on claims, and many of the losses that should be charged against the current year’s revenue are exceptionally difficult to estimate.

In some cases, dishonest companies that would be out of business if they realistically appraised their loss costs have, in some cases, simply preferred to take an extraordinarily optimistic view about these yet-to-be-paid sums. Others have engaged in various transactions to hide true current loss costs.

In other businesses, insolvent companies will run out of cash. Insurance is different: you can be broke but flush. Since cash comes in at the start of an insurance policy and losses are paid much later, insolvent insurers don’t run out of cash until long after they have run out of net worth.

Washington Public Power Supply System (Bonds)

In the past year, there was a purchase of large quantities of Projects 1, 2, and 3 of Washington Public Power Supply System (“WPPSS”).

When Warren buys marketable stocks, he would apply the same criteria that he would use for the purchase of the entire business. This business-valuation approach applies even to bond purchases such as WPPSS.

The interest earned by the bond is treated as operating profits earned by the ‘business’. Such a valuation method means that he will never buy a bond giving a 1% yield! As Benjamin Graham quoted in his book “The Intelligent Investor”, Investment is most intelligent when it is most businesslike.

Dividend Policy

Even though allocation of capital is crucial to business and investment management, dividend policy is seldom explained. It’s often simply stated as a percentage of net earnings.

Inflation causes some or all of the reported earnings to become “restricted” – i.e. if the business is to retain its economic position, cannot be distributed as dividends.

For the rest of the unrestricted earnings, they can either be distributed or retained.

There should only be ONE reason for retention: Unrestricted earnings should be retained only when there is a reasonable prospect that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This means that returns are higher than market rate returns.

Many companies that show good returns both on equity and on overall incremental capital have employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, help to camouflage repeated failures in capital allocation elsewhere.

In Berkshire’s case, no dividend is given out for the simple reason that Warren can generate higher than market returns on those capital!

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A change in accounting has it that insurance companies have to quote their equity securities at their market value. Before this, these were quoted at the lower of aggregate cost or market value.

This means that an investment owned by Berkshire directly could be valued very differently if it was now owned by one of it’s insurance subsidiaries (even though the business owned is exactly the same!). Therefore, when reading the accounts, it is important to understand the accounting conventions used and interpret the numbers accordingly.

Warren feels that when measuring the operating performance (earnings), we should compare it with all securities measured at cost and not market value. This is because the market value might vary greatly in different years and this will distort the comparison.

A large decline in securities values might make medicore earnings look good. Conversely, successful equity investments might make operating performance look bad even if it’s not the case.

Warren again mentions that the earnings rate on equity employed should be used to measure performance rather than just the earnings per share as the latter will always rise on an expanding equity base even if the business performance stays the same.

As a example, assume a dormant savings account with $1000 that earns 10% interest every year. In the first year, the earnings (interest) will be $100. In the second year, the earnings will be $110. In the third year, the earnings will be $121. That’s a 10% increase in earnings every year, even for doing nothing. On the other hand, if you look at the earnings rate (compare interest to account balance), you will notice that the earnings (interest) are consistent at 10%. Nothing much has changed.

Also, when looking at any investment performance, we should always compare it to the inflation rate and tax rate. Warren calls this the investor’s misery index. The ultimate aim in any investment is to increase the purchasing power of the capital over time. This is achieved as long as the investment returns (minus tax) is higher than the inflation rate.

One interesting observation is that the book value of Berkshire at the end of 1969 would have bought one half ounce of gold. 15 years later, the book value (that has compounded at 20.5% annually) would have bought about the same amount of gold. A similar comparison can be made with Middle Eastern oil.

The government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.

The continuous (under)performance of the textiles unit leads Warren to conclude that capital would be much better employed in a good business purchased at a fair price, than in a poor business purchased at a bargain price. Always remember this!

There’s a short discussion on bonds as an extraordinary amount of money has been lost by the insurance industry in the bond area within the year.

In periods of high inflation and uncertain interest rates, many insurance companies have decided that a one-year auto policy is inappropriate. Six-month policies have been brought in as replacements.

It is ironic that they have then turned around, taken the proceeds from the sale of that six-month policy to purchase a bond for thirty or forty years.

The buyer of long term money has been able to obtain a firm price now for each year of its use while the buyer of just about any other product or service will never be able to do the same. In most other areas of commerce, parties to long-term contracts now either index prices in some manner, or insist on the right to review the situation every year or so.

Warren would never buy any straight thirty or forty year bonds as he has severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day.

However, convertible bonds provide an attractive alternative as the conversion option gives the bonds an earnings retention factor. They also have a shorter life than that implied by their maturity dates.

A note about quarterly reporting. There’s no narrative with Berkshire’s quarterly reports. The owners and managers both have very long time-horizons in regard to this business, and it is difficult to say anything new or meaningful each quarter about events of long-term significance.

On the other hand, you can (and should) expect to hear directly from the CEO on what’s happening in the annual reports.

A final note about trading activities in shares. It is puzzling why some managements seek high trading volume in their shares. In effect, such managements are saying that they want a good many of the existing shareholders continually to desert them in favor of new ones – because you can’t add new owners without losing former owners.

Warren much prefers owners who like their company and stay on as shareholders. This can be seen in low share turnovers among the owners, reflecting a constituency that understands their operation, approves of their policies, and shares their expectations.

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