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!
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.