- 1975: Lessons from letters to shareholders of Berkshire Hathaway
With this lesson, we are on to the 10th letter written by Warren Buffet to the shareholders of Berkshire Hathaway.
Letters prior to 1977 are not available for download and hence I am unable to exactly reproduce the relevant sections of the report for the takeaways. For ease, wherever necessary, I have summarized the relevant text from the annual reports.
Now, we begin with this year’s lessons.
This year’s letter stands out because Buffett deals with decreased profitability and severe losses of the insurance subsidiaries. Disclosing good news is easy but how do you disclose bad news and that too when there are many of them. This is where history and honesty matters. The bad results were predicted in the last year’s letter, so they are not a surprise. The losses are well explained and managements stand is also made clear regarding the long term viability of the insurance business. The letter is so good that it outshines the letters which many companies wrote to their shareholders during the recession of 2007–2009.
“Operating results for 1974 overall were unsatisfactory due to the poor performance of the insurance business… for a return on beginning shareholders’ equity of 10.3%. This is the lowest return on equity realized since 1970…insurance underwriting, which has been mentioned in the last several annual reports as running at levels of unsustainable profitability, turned dramatically worse as the year progressed.”
“The outlook for 1975 is not encouraging…Insurance underwriting is a large question mark at this time…during this period we plan to continue to build financial strength and liquidity, preparing for the time when insurance rates become adequate and we can once again aggressively pursue opportunities for growth in this area.”
The first thing to notice is that Buffett could have ignored comparing the returns to 1970s. With that first statement, he builds the trust that disclosure is going to be candid and the concerns are going to be addressed. Also, the results are not a surprise as Buffett had already indicated lowered profitability/loss in the insurance operations in last year’s letter.
Note the emphasis on building financial strength. He knows that the present situation won’t last forever and when things turn better he wants to be in a position to capitalize. This is called being ready. We too are presented with several opportunities in our lives but often we fail to capitalize because we were not prepared. We too should be ready to face the future rather than letting it surprise us inconveniently.
“We currently are operating at about one-third of our capacity. Obviously, at such levels operating losses must result.”
I was immediately captured by the one-third word. Buffett could have said something like “we are operating significantly below our capacity.” But he chose to disclose such severe under capacity. In addition, he also explains the reasons for under capacity (weak demand due to consumer uncertainty, products offering, low housing levels etc). It is this openness in disclosure that one should look for when evaluating management quality.
“In the last few years we consistently have commented on the unusual profitability in insurance underwriting. This seemed certain eventually to attract unintelligent competition with consequent inadequate rates. It also has been apparent that many insurance organizations, major as well as minor, have been guilty of significant under reserving of losses, which inevitably produces faulty information as to the true cost of the product being sold. In 1974, these factors along with a high rate of inflation, combined to produce a rapid erosion in underwriting results.”
For the reinsurance business, he says:
“Intense competition in the reinsurance business has produced major losses for practically every company operating in the area. We have been no exception. Our underwriting loss was something over 12% — a horrendous figure, but probably little different from the average of the industry.”
The rationale for bad performance is explained in simple language. The loss in reinsurance division is not an isolated case for Berkshire. It is at the levels of industry average. The reasoning is complete and as stated earlier, bad performance was expected. This is the kind of reporting that you should expect when the company is treading rough waters.
In reference to National Indemnity, Buffett says:
“Volume increased somewhat but we are not encouraging such increases until rates are more adequate. At some point in the cycle, after major insurance companies have had their fill of red ink, history indicates that we will experience an inflow of business at compensatory rates…we believe it will provide excellent earnings in most future years, as it has in the past.”
Buffett has over and over said that he will not chase volumes/growth at the cost of profitability. With the above statement, this point is again confirmed. By repeating the same things Buffett has come forward as a person who will walk the talk. So even if there is a bad news, he can be trusted to disclose it and that right measures will be taken.
In reference to the insurance division at Texas, Buffett says:
“The Texas problem which was commented upon in last year’s report seems to be improving”
This marks a bridge between last year’s report and this year’s. Many times management skips the problems, goals and objectives stated in earlier reports. But a good management does not. Look for this kind of management when evaluating a company for investment.
“Our efforts to expand Home and Automobile Insurance Company into Florida proved disastrous…We can’t blame external insurance industry conditions for this mistake. In retrospect, it is apparent that our management simply did not have the underwriting information and the pricing knowledge necessary to be operating in the area.”
Buffett not only discloses the horrendous performance but also does not hesitate to accept that the performance is attributed to inept management and lists out the factors that went wrong. It is convenient to attribute bad performance to market factors because it shields the management from criticism. But obviously, this is not the case with Buffett. This reminds me of the following lines by Rudyard Kipling from his poem If:
If you can meet with Triumph and Disaster
And treat those two impostors just the same
These lines accurately capture the management philosophy of Buffett.
At the end of the insurance underwriting section, Buffett says:
“While the tone…is pessimistic as to 1974 and 1975, we consider the insurance business to be inherently attractive. Our overall return on capital employed in this area — even including the poor results of 1974 — remain high. We have made every effort to be realistic in the calculation of loss and expense reserves. Many of our competitors are in a substantially weakened financial position, and our strong capital picture leaves us prepared to grow significantly when conditions become right.”
In respect of the widespread losses with the insurance industry, this message is critical. It reassures the shareholders that the problems are short-term and the company is prepared to grow when things settle down.
Insurance Investment Results
With respect to the bond holdings, Berkshire says:
“Because of our large liquid position and inherent operating characteristics of our financial businesses, it is quite unlikely that we will be required to sell any quantity of such bonds under disadvantageous conditions. Rather, it is our expectation that these bonds either will be held to maturity or sold at times believed to be advantageous.”
With respect to the interest rate changes and its effect on the bonds value, Buffett says:
“The market value of our bond portfolio will continue to move in both directions in response to changes in the general level of yields but we do not consider such movements, and the unrealized gains and losses that they produce, to be of great importance as long as adequate liquidity is maintained.”
For stock holdings, Buffett says:
“Our portfolio declined again in 1974…it was worth approximately $17 million less than its carrying value. Again, we are under no pressure to sell such securities except times that we deem advantageous and it is our belief that, over a period of years, the overall portfolio will prove to be worth more than its cost.”
The two paragraphs re-emphasize the importance of maintaining liquidity in times of distress. We already know that absence of liquidity caused the collapse of Lehman and other banks. While the collapse is an extreme example, severe losses and missed opportunities are a bigger probability.
Bonds, which are considered safe investments, are not so safe when interest rates rise and cause the value of the bonds to fall. Buffett says that since his holding period is long term, he is unfazed by the daily movements in the bond’s price. However, he is able to do this because of the superior liquid position of Berkshire.
Also note that Buffett is unfazed by the losses on his stock holdings which have extended for second year in a row. He is okay with it because of his long term view and liquid position.
We too should manage our finances this way. Keeping all money in bonds and stocks without first creating a sufficient cash/liquid money buffer exposes us to market vagaries. Without sufficient liquidity we may be forced to sell our holdings at a loss. Keeping a long term view also helps in overcoming the stress of short-term fluctuations in value. But you to ask yourself what will you do if your investments bring you losses for two years in a row?
Lastly, here is how Berkshire looked on paper in 1974.
- Date of publication:
- Tue, 02/13/2018 - 23:44
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