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High Growth Rate

If the base from which the growth is measured is small, it may still last a long time. But once it becomes big, it will eventually stop.

This phenomenal is aptly described by Carl Sagan, refering to the destiny of bacteria that reproduce by dividing into two every 15 minutes. Says Sagan:

That means four doublings an hour, and 96 doublings a day. Although a bacterium weighs only about a trillionth of a gram, its descendants, after a day of wild asexual abandon, will collectively weigh as much as a mountain…in two days, more than the sun – and before very long, everything in the universe will be made of bacteria.

Not to worry, says Sagan: Some obstacle always impedes this kind of exponential growth. “The bugs run out of food, or they poison each other, or they are shy about reproducing in public.

From Berkshire’s base of $4.9 billion in net worth, it will be much more difficult to average 15% annual growth in book value than they did to average 23.8% from the $22 million they began with.


A new accounting rule likely to be adopted will require companies to reserve against all gains at the current tax rate, whatever it may be.

In economic terms, the liability, equivalent to a transfer tax, resembles an interest-free loan from the U.S. Treasury that comes due only when the asset is sold.

Because of the way the tax law works, the Rip Van Winkle style of investing that Buffett favours, is much favourable than a short holding period of securities.

Suppose there is an investment that is bought at $1 and doubles in value. Each year, it is sold and the proceeds used to purchase another security which then doubles in value after another year.

At the end of 20 years, the 34% capital gains tax that is paid on the profits from each sale would have delivered about $13,000 to the government and $25,250 to the investor.

However, if there is a fantastic investment that itself doubled 20 times during the 20 years, its final value would grow to $1,048,576. If it were then sold, there would be a 34% tax of roughly $356,500 and the investor would be left with about $692,000.

The sole reason for this difference in results would be the timing of tax payments. Deferred taxaxtion is great!

Undistributed Earnings

In 1989 Berkshire recieved about $45 million, after taxes in dividends from their five major investees. However, their share of the retained earnings of these investees totaled about $212 million, not counting large capital gains realized by GEICO and Coca-Cola.

Are these undistributed earnings as important as those that were reported?

Buffett believes so. His reasoning is that earnings retained by these investees will be deployed by talented, owner-oriented managers who sometimes have better uses for these funds in their own businesses than in Berkshire.

Thus, a better gauge of Berkshire’s fundamental earning power is by using a “look-through” approach, in which the share of the operating earnings retained by Berkshire’s investees are appended to their own reported operating earnings, excluding capital gains in both instances.


There is a story related by Buffett about Ike Friedman. It has nothing to do with investments but it’s so humourous that I’m reproducing it below for your reading pleasure:

A story will illustrate why I enjoy Ike so much: Every two years I’m part of an informal group that gathers to have fun and explore a few subjects. Last September, meeting at Bishop’s Lodge in Santa Fe, we asked Ike, his wife Roz, and his son Alan to come by and educate us on jewels and the jewelry business.

Ike decided to dazzle the group, so he brought from Omaha about $20 million of particularly fancy merchandise. I was somewhat apprehensive – Bishop’s Lodge is no Fort Knox – and I mentioned my concern to Ike at our opening party the evening before his presentation. Ike took me aside. “See that safe?” he said. “This afternoon we changed the combination and now even the hotel management doesn’t know what it is.” I breathed easier. Ike went on: “See those two big fellows with guns on their hips? They’ll be guarding the safe all night.” I now was ready to rejoin the party. But Ike leaned closer: “And besides, Warren,” he confided, “the jewels aren’t in the safe.”

Buffett offers the following insights for the continued success of Borsheim and Nebraska Furniture Mart:

(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
(5) friendly personalized service with family members on hand at all times

These are useful factors to consider when evaluating investments in retail businesses.

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Generally Accepted Accounting Principles (GAAP)

When an investor looks at financial statements, there are a few questions that he wants to know:

(1) Approximately how much is this company worth?
(2) What is the likelihood that it can meet its future obligations?
(3) How good a job are its managers doing, given the hand they have been dealt?

In most cases, answers to one or more of these questions are difficult from the minimum GAAP presentation.

Further complicating the problem is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to overcome.

Then there are managers who actively use GAAP to deceive and defraud.

I just read a book on “understanding financial statements for managers” the other day and indeed it is easy to “cook” the books as a lot of accounting is subjected to the interpretation of the accountant.

If the information presented is insufficient, it then falls on the investor to ask the management to provide data (whether GAAP, non-GAAP or extra-GAAP) that helps us to answer the three questions above.

Update on major non-insurance business operations

There follows the usual summary of the major non-insurance business operations. These included Nebraska Furniture Mart, The Buffalo News, See’s Candies, Fechheimer, World Book, Kirby, The Scott Fetzer Manufacturing Group and Borsheim’s.

A very interesting fact was that when Warren purchased Borsheim’s, they had no audited financial statement and he didn’t take inventory, verify receivables or audit the operation in any way.

A lot of it was based on trust in the Friedman family, who were siblings of Mrs Blumkins (founder of Nebraska Furniture).

And the Friedman family brings to the jewelry business precisely the same approach that the Blumkins bring to the furniture business. The cornerstone for both enterprises is Mrs. B’s creed: “Sell cheap and tell the truth.” Other fundamentals at both businesses are:

(1) Single store operations featuring huge inventories that provide customers with an enormous selection across all price ranges.
(2) Daily attention to detail by top management.
(3) Rapid turnover.
(4) Shrewd buying.
(5) Incredibly low expenses.

The combination of the last three factors lets both stores offer everyday prices that no one in the country comes close to matching.

And Warren’s major contribution? Leave them alone and let them do their job.

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Good Business Economics

Buffett has a view that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.

Other than improvements to products, services, etc, which should be done, other major changes means chances for major errors. A fortress-like business franchise usually the key to sustained high returns, one which would be difficult to build with frequent changes.

Indeed a Fortune study of 25 top companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics. Most of them sell non-sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both).

Flexible Operating Budgets

Charlie Munger and Warren Buffett do not believe in flexible operating budgets, as in “Non-direct expenses can be X if revenues are Y, but must be reduced if revenues are Y – 5%.” Should the news hole at the Buffalo News, or the quality of product and service at See’s be cut, simply because profits are down during a given year or quarter? Or, conversely, should a staff economist, a corporate strategist, an institutional advertising campaign or something else that does Berkshire no good be added simply because the money is rolling in?

The adding of unneeded people or activities because profits are booming, or the cutting of essential people or activities because profitability is shrinking makes no sense and is neither business-like nor humane.

Purchase of Securities

Whenever Buffett buy common stocks for Berkshire’s insurance companies (leaving aside arbitrage purchases, discussed later), he approaches the transaction as if he was buying into a private business. He looks at the economic prospects of the business, the people in charge of running it, and the price that he must pay. There is neither a time or price for sale in mind. Indeed, he is willing to hold a stock indefinitely so long as he expects the business to increase in intrinsic value at a satisfactory rate.

When investing, he views himself as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts. While an active trading market would provide many opportunities, it is not essential.

Benjamin Graham said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains.

At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

And Mr. Market doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

Mr. Market is there to serve you, not to guide you. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.

An investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.

As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give you the chance to buy more of a good thing at a bargain price.

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, Buffett will sell their holdings. Sometimes, also, he will sell a security that is fairly valued or even undervalued because he requires funds for a still more undervalued investment or one that he understands better.

Controlled Company

Owning a controlled company offers two advantages. The first is the ability to allocate capital. This point can be important because the heads of many companies are not skilled in capital allocation.

CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers (sometimes with unsatisfactory results). In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)

The second advantage of a controlled company over a marketable security has to do with taxes, a point which I will not elaborate here.

The disadvantages of owning marketable securities are sometimes offset by a huge advantage: Occasionally the stock market offers us the chance to buy non-controlling pieces of extraordinary businesses at truly ridiculous prices – dramatically below those commanded in negotiated transactions that transfer control.

An interesting accounting irony overlays a comparison of the reported financial results of controlled companies with those of the permanent minority holdings.

Accounting rules dictate that only the dividends that minority companies pay are considered as income. On the other hand, accounting rules provide that the carrying value of these holdings owned, as they are, by insurance companies – must be recorded on our balance sheet at current market prices. The result: GAAP accounting reflects the up-to-date net worth underlying values of the businesses that are partially own, but not their underlying earnings.

In the case of Berkshire’s controlled companies, just the opposite is true. Here, the full earnings is shown in the income account but not the asset values on the balance sheet, no matter how much the value of a business might have increased since the purchase.

The way to approach this accounting madness is to forget about GAAP figures and to focus solely on the future earning power of both our controlled and non-controlled businesses.

As this letter is particularly long, I will cover the rest in a second installment.

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The Job of Warren Buffett

Warren Buffett really has only two jobs. One is attracting and keeping outstanding managers to run the various operations. This he has no problems doing as one of the criteria that he uses for buying any business is an outstanding management team.

And he never gets in the way of these managerial stars. They got to where they were because they knew what they were doing. If you were managing a top soccer team and had world class players, would you be teaching them technical skills like how to kick a ball?

Rather, the value a soccer manager bring to the team lies in team selection and formulation of tactics. This is what Buffett’s second job is. The task of capital allocation. This is a challenge as Berkshire generates a lot of capital.

A business earning 23% annually and retaining it all will be far more affected by today’s capital allocations than a business earning 10% and distributing half of that to shareholders.

As far as Buffett is concerned, there are five options to deploy the capital: (1) long-term common stock investments; (2) long-term fixed-income securities; (3) medium-term fixed-income securities; (4) short-term cash equivalents; and (5) short-term arbitrage commitments.

Of these, he likes common stocks the most but in times of greed where stock prices are gloriously uncoupled from the underlying business itself, he would rather not take part in such foolishness. After all, stocks can’t outperform businesses indefinitely.

To have a material difference in the performance of Berkshire, any business acquisition would have to be of a significant amount. And as Berkshire gets larger, any returns are almost certain to drop.

News Hole in Newspapers

In any newspaper, there is an important statistic known as the news hole. This is the portion of the total space in the paper that is devoted to news. A typical newspaper has a news hole of about 40% compared to 50% for “The Buffalo News”.

While 10% might not sound like a lot, it is the reason why “The Buffalo New” has a much greater readership compared to it’s rivals.

A paper with 30 pages of advertisements and a 40% news hole delivers 20 pages of news a day, whereas another paper with a 50% news hole matches 30 pages of ads with 30 pages of news. For the same amount of ads, the latter has 50% more news content!

The Fechheimer Bros. Co

There was a purchase of a company called Fechheimer in the past year. It’s basically a uniform manufacturing and distribution business. The interesting point about this acquisition is that neither Buffett nor Charlie Munger went to Cincinnati, headquarters for Fechheimer, to see their operation.

This is actually Buffett’s usual practice. He does not rely on insights obtained from plant inspections to decide whether or not to purchase a company. Rather, he considers the economics of the business as well as the quality of the people running the show.


I will leave you with a question. If corporate taxes are increased, does it really affect the corporations? Do they pass on the increased taxes to the consumers by increasing prices? Or do they simply absorb the increased taxes?

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It has been a while since my last update as I had been busy with the Singapore elections. Don’t get me wrong; I was neither involved as a candidate nor a member of any political party. :)

Rather, I was reading the news and analysis by other bloggers. For a change, it was refreshing to read about some alternative views. There were also some in-depth articles which were much better than those in our local press.

Anyway, back to the Warren’s letter. This time round, I shall try to add in a bit of my writing style. (Past postings were mostly re-phrased from the actual letters.)

Limits of Growth

Anyone who has studied economics will know about the law of diminishing returns. The same principle applies when a company is growing. A company could be earning a very high return on equity. But as it gets bigger, it will have difficulty substaining this rate of return. “Growth eventually dampens exceptional economics.

In such a case, the company could try looking for other business to invest in (often with disasterous effects) or return the surplus cash generated to shareholders.

Business Value Vs Market Value

The Efficient Market Hypothesis (EMH) says that securities will be appropriately priced and reflect all available information. Which means to say that the market value will be close to business value.

Warren believes that is far from the truth. In his own words, “the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.

Of course, not forgetting three other points: the business must have fine underlying economics, an able management concentrating on the interests of shareholders, and a buyer willing to pay full business value at the time of divestment.

Shutdown of Textile Business

The unprofitability of the textile business was discussed previously. Rather than injecting huge amount of capital to keep it alive (which would have resulted in terrible returns on ever-growing amounts of capital), Warren decided to bite the bullet and shut down the business.

A few years ago, he wrote, “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” His views remain unchanged.

Another lesson learned during the diposal of the textile business was that the assets sold for much less than they were reflected on the books. If you are one of those investors who weigh book value heavily in your stock buying decision, make sure you don’t do it blindly!

Using Options as Compensation

A common argument in using options to reward management is that it puts them in the same boat as shareholders. Boat, yes. Same boat, no. Here are some reasons why:

1) Owners have a burden of capital cost; option holders need not pay nothing.

2) Owners have potential upside rewards as well as downside risk, option holders have no downside.

3) The dividend policy of the company has an opposite effect on owners and option holders. For an option holder, he would prefer that no dividends are paid out so that the earnings (and share price) increase year after year.

Warren prefers using a system of cash reward pegged to performance. The managers can then use these money to purchase the stock of the company from the open market. By accepting both the risks and the carrying costs that go with outright purchases, these managers truly walk in the shoes of owners.

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In the past year, there was an increase in the number of registered shareholders (due to the merger with Blue Chip Stamps) from 1900 to 2900. As such, Warren started this year’s letter with a summary of his key principles:

1) Shareholders are treated as owner-partners; Warren and Charlie Munger are simply managing partners. The company is simply a conduit through which shareholders own the assets of the business.

2) Company directors are all major shareholders of Berkshire Hathaway.

3) The long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. This is not measured by the size but more on per-share basis.

4) The preference for achieving point three above is by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. The second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by insurance subsidiaries.

5) Consolidated reported earnings may reveal relatively little about the true economic performance due to accounting rules.

6) Warren would rather prefer to purchase $2 of earnings that is not reportable under standard accounting principles than to purchase $1 of earnings that is reportable. Capital-allocation decisions are not influenced by accounting rules.

7) To prevent over-leverage, debt is seldom used.

8) A managerial “wish list” will not be filled at shareholder expense.

9) Common stock will be issued only when business value received is as much as the one given.

10) Regardless of price, Warren has no interest in selling any good businesses that Berkshire owns, and is very reluctant to sell sub-par businesses as long as he expects them to generate at least some cash and as long as he feels good about their managers and labor relations.

11) Investment ideas will normally not be discussed as good ideas are hard to come by.

Nebraska Furniture Mart

The letter goes on to highlight the main point of 1983; the acquisition of a majority interest in Nebraska Furniture Mart and the resulting association with Rose Blumkin and her family.

Rose started the business with $500 of her savings (after having arrived in USA with no money and no knowledge of English many years earlier) and grew it to over $100 million of sales annually out of one 200,000 square-foot store. One question that Warren always ask himself in appraising a business is how he would like, assuming he had ample capital and skilled personnel, to compete with it.

In his own words, “I’d rather wrestle grizzlies than compete with Mrs. B and her progeny.”

Book Value Vs Intrinsic Value

In the past year, the book value of Berkshire increased by 32%. Warren never takes the one-year figure very seriously. Why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Rather, a five year yard stick should be used.

While performance is usually reported in book value, the one that really counts is intrinsic business value. Book value only serves as a conservative but reasonably adequate proxy for growth in intrinsic business value.

Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

Using a simple analogy, assume you spend identical amount of money putting two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously – from zero to many times the cost of the education.

Similarly, businesses having equal financial input may end up with wide variations in value.

Stock Splits

One of Warren goals is to have Berkshire Hathaway stock sell at a price rationally related to its intrinsic business value. The key to a rational stock price is rational shareholders, both current and future owners.

High quality shareholders can be attracted and maintained if there is consistent communication of the business and ownership philosophy – along with no other conflicting messages.

With a stock split or some other actions focusing on stock price rather than business value, an entering class of buyers inferior to the exiting class of sellers would be attracted.

Would a potential one-share purchaser be better off if the shares were split 100 for 1 so he could buy 100 shares?

Those who think so and who would buy the stock because of the split or in anticipation of one would definitely downgrade the quality of the present shareholder group.

Thus, Warren will avoid policies that attract buyers with a short-term focus on the stock price and try to follow policies that attract informed long-term investors focusing on business values.


Another thing that Warren frowns on is the emphasis on the liquidity of a stock by brokers. A high turnover in shares simply means that the ownership is changing. And the more of this ‘musical chairs’, the higher the commissions will be paid to the stock brokers out of the pockets of investors.

In my next post, I will cover economic and accounting goodwill that was discussed as an appendix to this year’s letter.

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