1977 Letter – Berkshire Hathaway – Zaid Writings

Reading Time: 6 minutes

There’s always a word in the investment industry about Mr Buffett’s letters to shareholder.

I am intrigued by the fact that there’s a lot to learn from the experience of a well-known personality in the investment industry.

This is my first reading of the letter. I will try my best to read one letter every week.

My two cents –

Capital gains or losses realized directly by Berkshire Hathaway Inc. or its insurance subsidiaries are not included in our calculation of operating earnings.  While too much attention should not be paid to the figure for any single year, over the longer term the record regarding aggregate capital gains or losses obviously is of significance.

It is okay if one overlooks a single year profit/loss. Maybe for some reason, there could be a dent in the profitability. One should always look for the longer-term track record. Will the dent in the profit reoccur or it is just a one-time event? I believe that one should know the reason behind that dent & check whether it has long term impact on the industry or not.

While I was reading this, I had a question in my mind that why Mr Buffett is quoting operating earnings (EBIT)? I did some research & came across the debate of EBIT vs EBITDA (Difference being Depreciation & Amortization in the calculation of earnings). Always remember “Depreciation & Amortization cost is real”. Warren Buffett is credited with having said, “Does management think the tooth fairy pays for capital expenditures?” Although the depreciation and amortization expense is not an actual cash outflow, it does, in effect, reduce the value of a company’s total assets. This reduction in value is intended to closely mimic the true nature and value of the asset.

A company that spends zero money on capital expenditures could be well suited to use EBITDA metrics as the non-cash depreciation and amortization part does not have to be replaced with Cap-ex, but this applies to almost no companies. I have checked many companies (even the top 100 by market cap) via screener. They all have a CWIP (Capital Work in Progress) portion in the balance sheet.

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Knowing this, many manufacturing companies show EBITDA in their annual report. I have tried to go through the annual reports few of cement companies.

I am not demeaning any company. I just want to say that we should observe the broader picture rather than just focusing on the known metrics.

“Most companies define “record” earnings as a new high in earnings per share.  Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share.  After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.”

Earnings per share is Net Profit/Total outstanding shares. A company can grow by raising more capital and investing the same in their business (assuming the business is profitable). We should not just become happy by seeing EPS growth. We should always observe from where did the company source the capital to get this growth. If the company hiked (raised capital) say 10% in the equity capital by seasoned offering or rights issue etc. & then it invested the money into the business & got 5% growth in EPS, it’s not a big thing. The company will need to raise more capital to grow.

Thinking a bit on this point, I came to a point that why asset turnover less than 1 is dangerous for the company. Asset turnover is Revenue/Total assets. If the ratio is one, it means that the company is producing the same revenue as assets. If it is less than 1, then the company is not even producing enough revenue to its assets. It needs to keep adding capital to generate revenue. To do so, it needs to raise debt to dilute equity & the vicious circle goes on.

I had run a simple screener which shows the companies which have an asset turnover of less than 1. You can view it here. Majority of the companies are heavy manufacturing.

We should look at the growth in earnings with the growth in capital.

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It is stated in the letter that except for companies with too much debt, Return on Equity is a more appropriate measure. RoE measures the profitability of business concerning equity. If there’s debt in the company, one must also look to RoCE.

“The textile business again had a very poor year in 1977.  We have mistakenly predicted better results in each of the last two years.  This may say something about our forecasting abilities, the nature of the textile industry, or both.”

Famous quote by Philip Fisher summarizes this point – “Profitability of a company depends 90% on the industry, 9% on the management and 1% on the company.”

One should always invest in profitable industries. This (link) is a brilliant analysis of the Industry-wise profit analysis. They have summarized the profitability of each industry in India.

I don’t get the point of investing in a loss-making business. A person is doing business to earn from it. Why would anyone invest in a loss-making business? Here, there can be a debate on the turnaround part. But remember Buffett’s famous quote on turnaround – “Turnarounds seldom turn.”

One needs to be in a business where even average management can earn good returns rather than investing in a business where good management can earn average/poor results. It is important to be in businesses where there are more tailwinds prevail rather than headwinds.

Being very young in my investing journey, I will restrict myself from investing in loss-making companies or turnaround bets.

Insurance companies offer standardized policies which can be copied by anyone.  Their only products are promises.  It is not difficult to be licensed, and rates are an open book.  There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition.” 

Insurance is a business of trust. In India too, many people believe in getting insured by LIC only. People quote LIC like – (Hinglish) “Government hai to paisa milega hi” (English) “We will get our money for sure if there’s the government in between.” No doubt why LIC is one of the biggest insurers in India.

We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.

Mr Buffett said that when prices are appropriate, Berkshire is willing to take very large positions in selected companies, not with any intention of taking control and not foreseeing sell-out or merger, but with the expectation that excellent business results by corporations will translate over the long term into correspondingly excellent market value and dividend results for owners, minority as well as the majority.

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This was my understanding of Mr Buffett’s 1977 letter to shareholder. Even prior to buying Berkshire, Mr Buffett had an investment partnership on his own. He was a small fund manager before Berkshire.

Deepak Venkatesh sir had summarized few letters which Mr Buffett wrote before joining Berkshire. Here’s the link.

Thanks for reading this far 🙂

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Zaid Munshi

Zaid Munshi

Zaid started his journey in the Indian market in April 2018. He is always keen to understand the business and check whether the business is worth investing or not.
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