Two value investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about value investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we go over the 1990 letter.
The 1990 Berkshire shareholder letter mentions the term “intrinsic value” 12 times in total, which is a key concept for value investing. Calculating intrinsic value can be tricky, so it is good to know that when Buffett says Berkshire's intrinsic value exceeds its book value by a substantial margin, he cannot say by how much exactly because “intrinsic value is necessarily an estimate; Charlie [Munger] and I might, in fact, differ by 10% in our appraisals.” This is the first lesson; when even two smart investors on the same team can be 10% apart on valuation, then we should not stress over exact valuations, but instead focus on a margin of safety.
We can do this by investing within our area of expertise. If banking is your thing, I should point out that Buffett said Charlie Munger (Trades, Portfolio)’s 1990 Wesco letter “contains the clearest and most insightful discussion of the banking industry that I have seen.”
Insurance operations
Buffett goes into a lengthy commentary on the insurance industry and predicts more volatility in Berkshire’s insurance results because it has become a large seller of insurance against major catastrophes ("super-cats"), - hurricanes, windstorms, earthquakes, etc. Counterparts to this insurance demand financially strong sellers and this is where Berkshire has a major competitive advantage: In the insurance industry, Berkshire’s strength is unmatched.
The guru explained even if other insurance companies have the financial strength, very often they do not like the business because either super-cat payouts are too highly correlated with payouts from their large property insurance underwriting or managements believe their shareholders dislike volatility in results.
Buffett noted that Berkshire’s business in primary property insurance was small and that he and Munger “always have preferred a lumpy 15% return to a smooth 12%.”
The Oracle of Omaha said that although Berkshire expected to write significant quantities of super-cat business, they will do so only at prices "we believe to be commensurate with risk." At the time of writing, Berkshire believed itself to be the largest U.S. writer of super-cat business.
The reason I highlight this discussion is because it reminds me that one large element of Berkshire’s success is down to its insurance business. Insurance at its heart is about probability and statistics and asset-liability management. Berkshire’s expertise in these areas, as well as its risk appetite and stomach for volatility give it a huge edge. We should look to Buffett’s writing if we are interested in investing in insurance businesses to understand what makes a good insurer. We can also try to make sure our own assets are arranged in such a way that we can withstand volatility over the long term. After all, over the long term, higher risk equals higher returns.
Marketable securities
One of my favourite expressions in life is “don’t be a lemming.” So I was pleased to see Buffett use the lemming analogy when revisiting the theme of the "institutional imperative." He wrote:
"The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the 'institutional imperative:' the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate."
However, with Wells Fargo (WFC, Financial), Buffett said he thought Berkshire had obtained the best managers in the business, Carl Reichardt and Paul Hazen. He said:
"In many ways the combination of Carl and Paul reminds me of another - Tom Murphy and Dan Burke at Capital Cities/ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt."
The guru then returned to the theme of volatility, writing:
"Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases."
Pessimism is the most common cause of low prices, and this can be pervasive or specific to a company or industry. Buffett said he likes to do business in this environment because it produces opportunities for buying stocks. He also noted that optimism is the enemy of the rational buyer. The investor wrote:
"None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: 'Most men would rather die than think. Many do.'"
Debt mania and the margin of satefy
The 1980s saw massive growth in debt capital markets. Debt was marketed as a good thing, as operating managers focused their efforts as never before.
Buffett shared an analogy often cited for the use of debt that it would be like having a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. However, Buffett reminded investors that: “The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster.”
He continued:
"In the final chapter of 'The Intelligent Investor,' Ben Graham forcefully rejected the dagger thesis: 'Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.' Forty-two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses as the 1990s began."
Convertible preferred stocks
Weighing interest rates, credit quality and prices of the related common stocks, Berkshire assessed its holdings in Salomon and Champion International at year-end 1990 as worth about what it paid, Gillette as worth somewhat more and USAir as worth substantially less.
Buffett described an interesting case study of an investment “unforced error,” writing:
"I plunged into the business at almost the exact moment that it ran into severe problems. The company's troubles were brought on both by industry conditions and by the post-merger difficulties it encountered in integrating Piedmont, an affliction I should have expected since almost all airline mergers have been followed by operational turmoil. In short order, Ed Colodny and Seth Schofield resolved the second problem: The airline now gets excellent marks for service. Industry-wide problems have proved to be far more serious. Since our purchase, the economics of the airline industry have deteriorated at an alarming pace, accelerated by the kamikaze pricing tactics of certain carriers. The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competitor."
Buffett says the USAir investment should work out all right as “Ed and Seth have decisively addressed the current turbulence by making major changes in operations.” However, he acknowledged the investment was “now less secure than at the time I made it.”
