1979 Letter – Berkshire Hathaway – Zaid Writings

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This is my learning from 1979 letter of Berkshire Hathaway. You can visit my learning from previous papers here.

My two cents –

“The ratio of operating earnings (before securities gains or losses) to shareholders’ equity with all securities valued at cost is the most appropriate way to measure any single year’s operating performance.”

Mr Buffett is talking about Return on Equity (RoE). He said this statement because, in the year 1979, the accounting profession has decided that equity securities owned by insurance companies must be carried on the balance sheet at market value. The denominator in the ratio of RoE (Profit after tax/Shareholder’s equity) will rise because the market value is higher than the cost.

Look at it like this, a large decline in securities values could result in a very low “market value” net worth that, in turn, could cause mediocre operating earnings to look unrealistically good.  Alternatively, the more successful that equity investments have been, the larger the net worth base becomes and the poorer the operating performance figure appears.

Let’s take three scenarios –

RoE = PAT / Shareholder’s equity

Just because of the accounting change, the return metric & our perspective may change a lot.

Thus, one should keep a check on the accounting standards while analyzing & building a perspective on a company.

Although I believe is that such capital gains or losses, either realized or unrealized, are fully as important to shareholders over years.

“Earnings per share will rise constantly on a dormant savings account or on a U.S. Savings Bond bearing a fixed rate of return simply because “earnings” (the stated interest rate) are continuously ploughed back and added to the capital base.  Thus, even a “stopped clock” can look like a growth stock if the dividend payout ratio is low.”

By this, we learned the importance of reinvestment of the capital & the capital allocation of the promoter.

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The return may be good. But, one should look at the return on the incrementally invested capital. Let me show you data where I calculated the incremental returns of & the capital allocation of Essel Propack Ltd.

Note: I highly recommend reading this blog to get a better grasp of the table.

Over the years, the company invested its money into building new fixed assets. 40% of which is internally financed by CFO. Along with this, we need to check whether the company is earning a decent amount of return on its new capital.

Nopat = EBITDA – Cash taxes
Fixed assets = Tangible assets
WC = Working capital
IC (Invested capital) = Tangible assets + Working capital

One can easily conclude by seeing this data that the company is earning economic profit (ROIC > Cost of Capital).

The company is earning a good amount of return on its incremental capital base.

“The inflation rate, coupled with individual tax rates, will be the ultimate determinant as to whether our internal operating performance produces successful investment results.”

We must consider the investment return in tandem to inflation. If the inflation is 4-5% & the FD rate is about 7%, one should feel blessed & satisfied if equity gave the return of about 12-13%.

We should not risk the money to earn more & more return.

Like-wise the other side would be the negative returns. If the investment is earning us less than inflation, it will eat away the purchasing power of the money.

We must also take into account the tax rate on our investment. If the investment return (on paper) says 12% & the LTCG (assuming the return is earned in more than a year) is 10%, then the net return would be close to about 11%. We must compare this with inflation.

“Our textile business also continues to produce some cash, but at a low rate compared to capital employed.  This is not a reflection on the managers, but rather on the industry in which they operate.”

This statement shows the importance of the industry. We must not invest in an industry where almost all the companies are loss-making or earning a very less return.

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Comparing this line with the quote – “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

If an extraordinary person runs a business where industry-wide companies are not earning good returns (say Airline industry), then even that person cannot do anything. Likewise, if an average person runs a business where the industry-wide companies are earning good returns (say Pharma industry), then even that average person will earn a higher return than that extraordinary guy.

“We have severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day.”

In the changing inflation environment where the central bank can print money as per its wish, one should not go for 5/10 or more years of a bond investment (heavy % in the portfolio). The investor will earn a fixed return but the change in the purchasing power will be a real risk.

“Phil Fisher, a respected investor and author, once likened the policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A restaurant could seek a given clientele – patrons of fast foods, elegant dining, Oriental food, etc. – and eventually obtain an appropriate group of devotees. If the job were expertly done, that clientele, pleased with the service, menu, and price level offered, would return consistently. But the restaurant could not change its character constantly and end up with a happy and stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revolving door of confused and dissatisfied customers.”

Focus is the key. If one has a specialized skill in one thing, then one should not diverge his focus towards a different thing. By diverging focus, one may not excel in either of the two things. Same goes for the promoter of a company. He/she must not diversify into businesses he/she is not expertise in.

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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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