1978 Letter – Berkshire Hathaway – Zaid Writings

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This is my learning from 1978 letter of Berkshire Hathaway. This is the second letter in the series. You can visit the 1977 letter here.

My two cents –

“A grouping of Balance Sheet and Earnings items – some wholly owned, some partly owned – tends to obscure economic reality more than illuminate it.  In fact, it represents a form of presentation that we never prepare for internal use during the year and which is of no value to us in any management activities.”

The full consolidation of sales, expenses, receivables, inventories, debt, etc. produces an aggregation of figures from many diverse businesses. We should always look at the segmental product performance.

I with few of my friends did a segmental analysis of HSIL (Hindustan Sanitaryware & Industries Limited) back in 2019 before the demerger. Let me share my findings –

Note: There are other segments like consumer products, retail business, others. It contributes a small portion to the revenue hence not considered here for analysis.

Building product contributes around 47% of the revenue since FY14 to FY18. Packaging products contribute around 44% of the revenue since FY14 to FY18.

Building product contributes around 47% of the total assets since FY14 to FY18. Packaging products contribute around 54% of the revenue since FY14 to FY18.

Let’s look at the EBIT margins of both the segments.

Weighted Average EBIT Margin = (Total EBIT – Others segment EBIT) / (Total revenue – Others segment revenue)

Packaging product is relatively a lower margin business. Even the Return on Asset shows the same picture.

Blended RoA = Weighted Average EBIT Margin * Weighted Average Asset Turnover

The company is spending good money after the bad. The company spent about ₹385.85 crores as Cap-ex in the building product (which is relatively profitable than Packaging product). But it also spent about ₹329.21 crores in the packaging product. In my opinion, this doesn’t seem good.

We should always look for the segmental data (if given by the company). We should check whether the company is not spending good money after the bad. If I quote Mr Buffett here, “A grouping of Balance Sheet and Earnings items – some wholly owned, some partly owned – tends to obscure economic reality more than illuminate it.”

“We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do.”

One should not forecast the market in the short term. One of my friends asked me a while back that why should we forecast an individual company rather the market? What is the logic behind that? I replied that if you define the market by the Index (Nifty, Sensex), then there are many moving variables. Some moving variables I can define as per my limited knowledge is the politics, view on the interest rate, performance of GDP & the sectors (as the index i.e. Nifty, Sensex has many sectors which define the value) etc. which in my view is next to impossible to predict.

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Forecasting an individual company is relatively easy. We need to forecast revenue, profit, margins, market size/growth, suppliers/customers attitude towards the company etc.

We should also bifurcate our prediction in three baskets – Short term, Medium term, Long term. In short term, everything changes. In the medium term, things slowly get back to normal. In the long term, hardly anything changes. This way, we need to implement the forecasting of the numbers say revenue, margins etc. in our model.

“Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc.  Our management is diligent in pursuing such objectives.  The problem, of course, is that our competitors are just as diligently doing the same thing.”

Competition is one of the important aspects one should look forward to the industry. One will not compete in a business where the current companies earn say 8% margin. See companies like Relaxo Footwear, Avenue Supermarts (D-mart) etc. See the multiples (say P/E) they are getting in the market.

You’ll see the competition where the current companies are earning say 20%+ margins in the business. People want to enter that kind of business. Although there comes the moat part which protects the company’s profit.

Textile is the prime example of the competition. There is minimal product differentiation + there’s the unorganized market too. Xiaomi introduced price competition in the smart-phone market. Oppo, Vivo, Realme (BBK Electronics – a parent company of Oppo, Vivo, Realme, OnePlus and iQOO) made the smart-phone market even more competitive.

“We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively.”

Same ideology in the 1977 letter. Do not change your investment philosophy. Stick to one. Try to be the best in it.

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Mr Buffett said in the letter that he can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. This shows how much importance one should give to valuation while making an investment decision. We should always remember what Mr Buffett famously quoted “It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”

“If one controlled a company run as well as SAFECO (an insurance company), the proper policy also would be to sit back and let management do its job.”

If the management is doing a good job, then even if we have a majority stake in business, we should not harass it or try to control them.

In these times, when there’s uncertainty everywhere, many people are just asking the management about their future projections & how it will grow. I believe that in this kind of uncertain time, it is still good if the business survives.

One should not always focus on the predictions. Look at the current situation. No one can predict perfectly. If we as a human can’t predict it, how would the management of the company be able to forecast? Sometimes, it is painful for management to answer the questions which eventually distract their mind from the business.

“We are not at all unhappy when our wholly-owned businesses retain all of their earnings if they can utilize internally those funds at attractive rates.”

If the company can grow the capital at a decent say 12-15% return, then we should not bother about the dividends. I know dividends give a cash flow to the investor. But again, there comes a reinvestment risk. At what rate, one will invest the dividend? If it is less than the company’s rate of return, then don’t you think it is better to give/keep the money to the company which can grow your money at a better rate?

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That is why we should always check RoIIC (Return on Incremental Invested Capital). The formula of RoIIC is (Change in EBIT – Change in other income) / (Change in fixed assets + Change in working capital). We should see the trend of RoIIC. If it is decreasing, then we may conclude that the new assets are generating less return than previous years.

Remember, if some ratio is bad, one should ask two questions – 1) Is it a bad time in the market? Or 2) Is it a bad business?

If the overall market is not in a good position, then we should not worry much about the business. The market/economy will revive & eventually, the business will follow. If the ratio is bad because of the business, then it is a sign of worry.

End – 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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