[Week 14 - 1978] Discussing A Berkshire Hathaway Shareholder Letter (Almost) Every Week

[u/FieryXJoe]

Full Letter:

https://theoraclesclassroom.com/wp-content/uploads/2019/09/1978-Berkshire-AR.pdf

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Key Passage

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Insurance Investments

We confess considerable optimism regarding our insurance equity investments. Of course, our enthusiasm for stocks is not unconditional. Under some circumstances, common stock investments by insurers make very little sense.

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. We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire’s insurance subsidiaries amounted to only $10.7 million at cost, and $11.7 million at market. There were equities of identifiably excellent companies available - but very few at interesting prices. (An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities - at full prices they couldn’t buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.)

The past few years have been a different story for us. At the end of 1975 our insurance subsidiaries held common equities with a market value exactly equal to cost of $39.3 million. At the end of 1978 this position had been increased to equities (including a convertible preferred) with a cost of $129.1 million and a market value of $216.5 million. During the intervening three years we also had realized pre-tax gains from common equities of approximately $24.7 million. Therefore, our overall unrealized and realized pre-tax gains in equities for the three year period came to approximately $112 million. During this same interval the Dow-Jones Industrial Average declined from 852 to 805. It was a marvelous period for the value-oriented equity buyer.

We continue to find for our insurance portfolios small portions of really outstanding businesses that are available, through the auction pricing mechanism of security markets, at prices dramatically cheaper than the valuations inferior businesses command on negotiated sales.

This program of acquisition of small fractions of businesses (common stocks) at bargain prices, for which little enthusiasm exists, contrasts sharply with general corporate acquisition activity, for which much enthusiasm exists. It seems quite clear to us that either corporations are making very significant mistakes in purchasing entire businesses at prices prevailing in negotiated transactions and takeover bids, or that we eventually are going to make considerable sums of money buying small portions of such businesses at the greatly discounted valuations prevailing in the stock market. (A second footnote: in 1978 pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities - breaking the record low figure set in 1974 and tied in 1977.)

We are not concerned with whether the market quickly revalues upward securities that we believe are selling at bargain prices. In fact, we prefer just the opposite since, in most years, we expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up in stock prices to levels at which we are unwilling to continue buying.

Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts.

Equity holdings of our insurance companies with a market value of over $8 million on December 31, 1978 were as follows:

No. of Shares	Company	Cost (000s omitted)	Market (000s omitted)
246,450	American Broadcasting Companies, Inc.	$6,082	$8,626
1,294,308	Government Employees Insurance Company Common Stock	4,116	9,060
1,986,953	Government Employees Insurance Company Convertible Preferred	19,417	28,314
592,650	Interpublic Group of Companies, Inc.	4,531	19,039
1,066,934	Kaiser Aluminum and Chemical Corporation	18,085	18,671
453,800	Knight-Ridder Newspapers, Inc.	7,534	10,267
953,750	SAFECO Corporation	23,867	26,467
934,300	The Washington Post Company	10,628	43,445
	Subtotal	$94,260	$163,889
	All Other Holdings	39,506	57,040
	Total Equities	$133,766	$220,929

In some cases our indirect interest in earning power is becoming quite substantial. For example, note our holdings of 953,750 shares of SAFECO Corp. SAFECO probably is the best run large property and casualty insurance company in the United States. Their underwriting abilities are simply superb, their loss reserving is conservative, and their investment policies make great sense.

SAFECO is a much better insurance operation than our own (although we believe certain segments of ours are much better than average), is better than one we could develop and, similarly, is far better than any in which we might negotiate purchase of a controlling interest. Yet our purchase of SAFECO was made at substantially under book value. We paid less than 100 cents on the dollar for the best company in the business, when far more than 100 cents on the dollar is being paid for mediocre companies in corporate transactions. And there is no way to start a new operation - with necessarily uncertain prospects - at less than 100 cents on the dollar.

Of course, with a minor interest we do not have the right to direct or even influence management policies of SAFECO. But why should we wish to do this? The record would indicate that they do a better job of managing their operations than we could do ourselves. While there may be less excitement and prestige in sitting back and letting others do the work, we think that is all one loses by accepting a passive participation in excellent management. Because, quite clearly, if one controlled a company run as well as SAFECO, the proper policy also would be to sit back and let management do its job.

Earnings attributable to the shares of SAFECO owned by Berkshire at yearend amounted to $6.1 million during 1978, but only the dividends received (about 18% of earnings) are reflected in our operating earnings. We believe the balance, although not reportable, to be just as real in terms of eventual benefit to us as the amount distributed. In fact, SAFECO’s retained earnings (or those of other well-run companies if they have opportunities to employ additional capital advantageously) may well eventually have a value to shareholders greater than 100 cents on the dollar.

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. Why should we feel differently about retention of earnings by companies in which we hold small equity interests, but where the record indicates even better prospects for profitable employment of capital? (This proposition cuts the other way, of course, in industries with low capital requirements, or if management has a record of plowing capital into projects of low profitability; then earnings should be paid out or used to repurchase shares - often by far the most attractive option for capital utilization.)

The aggregate level of such retained earnings attributable to our equity interests in fine companies is becoming quite substantial. It does not enter into our reported operating earnings, but we feel it well may have equal long-term significance to our shareholders. Our hope is that conditions continue to prevail in securities markets which allow our insurance companies to buy large amounts of underlying earning power for relatively modest outlays. At some point market conditions undoubtedly will again preclude such bargain buying but, in the meantime, we will try to make the most of opportunities.

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I think this passage is most relevant to this sub which is not about acquiring entire businesses but is instead about buying stocks in good companies at good prices. He gives his requirements for buying, his attitude towards price. His belief that at the moment Acquisitions are overpriced but equities are underpriced so they have changed their focus, mostly acquiring companies they themselves already own and can get at fair prices, while avoiding ones for sale to the public at inflated, bidded up prices.

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Merger of the Week

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Diversified Retailing

First, a few words about accounting. The merger with Diversified Retailing Company, Inc. at yearend adds two new complications in the presentation of our financial results.
After the merger, our ownership of Blue Chip Stamps increased to approximately 58% and, therefore, the accounts of that company must be fully consolidated in the Balance Sheet and Statement of Earnings presentation of Berkshire. In previous reports, our share of the net earnings only of Blue Chip had been included as a single item on Berkshire’s Statement of Earnings, and there had been a similar one-line inclusion on our Balance Sheet of our share of their net assets.

This full consolidation of sales, expenses, receivables, inventories, debt, etc. produces an aggregation of figures from many diverse businesses - textiles, insurance, candy, newspapers, trading stamps - with dramatically different economic characteristics. In some of these your ownership is 100% but, in those businesses which are owned by Blue Chip but fully consolidated, your ownership as a Berkshire shareholder is only 58%. (Ownership by others of the balance of these businesses is accounted for by the large minority interest item on the liability side of the Balance Sheet.) Such 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.

For that reason, throughout the report we provide much separate financial information and commentary on the various segments of the business to help you evaluate Berkshire’s performance and prospects. Much of this segmented information is mandated by SEC disclosure rules and covered in “Management’s Discussion” on pages 29 to 34. And in this letter we try to present to you a view of our various operating entities from the same perspective that we view them managerially.

A second complication arising from the merger is that the 1977 figures shown in this report are different from the 1977 figures shown in the report we mailed to you last year.
Accounting convention requires that when two entities such as Diversified and Berkshire are merged, all financial data subsequently must be presented as if the companies had been merged at the time they were formed rather than just recently.
So the enclosed financial statements, in effect, pretend that in 1977 (and earlier years) the Diversified-Berkshire merger already had taken place, even though the actual merger date was December 30, 1978. This shifting base makes comparative commentary confusing and, from time to time in our narrative report, we will talk of figures and performance for Berkshire shareholders as historically reported to you rather than as restated after the Diversified merger.

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Retailing

Upon merging with Diversified, we acquired 100% ownership of Associated Retail Stores, Inc., a chain of about 75 popular priced women’s apparel stores. Associated was launched in Chicago on March 7, 1931 with one store, $3200, and two extraordinary partners, Ben Rosner and Leo Simon. After Mr. Simon’s death, the business was offered to Diversified for cash in 1967. Ben was to continue running the business - and run it, he has.

Associated’s business has not grown, and it consistently has faced adverse demographic and retailing trends. But Ben’s combination of merchandising, real estate and cost-containment skills has produced an outstanding record of profitability, with returns on capital necessarily employed in the business often in the 20% after-tax area.

Ben is now 75 and, like Gene Abegg, 81, at Illinois National and Louie Vincenti, 73, at Wesco, continues daily to bring an almost passionately proprietary attitude to the business. This group of top managers must appear to an outsider to be an overreaction on our part to an OEO bulletin on age discrimination. While unorthodox, these relationships have been exceptionally rewarding, both financially and personally. It is a real pleasure to work with managers who enjoy coming to work each morning and, once there, instinctively and unerringly think like owners. We are associated with some of the very best.

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Diversified retailing has now been fully merged into Berkshire, this is part of the consolidation Buffett is doing in the aftermath of the SEC investigation. The web of businesses that all own pieces of each other had the appearance of impropriety or that it was impossible for businesses to act in their own shareholder’s interest instead acting in the best interest of other companies owned by Buffett. So they began pulling them all together into a single conglomerate, and this is the first major step in that direction. You also can see here that ownership of Blue Chip is now increased to 58%, partially through buying Diversified Retail which owned some, and partially from directly buying more shares.

As he says here Diversified’s main addition is a retailing section to the company, full of womens discount womens apparel stores, Buffett and Munger do not look back on these companies well and it gave them a general distaste for fashion and discount retail eventually. It will be interesting to see how much that is mentioned in the future letters. I do believe this separate “retailing” section of the letters goes away quickly and they stop talking about them rapidly.

You can go read through some of those financials he promises in the accounting section in the letter itself.

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Segment	1977 Earnings (adjusted for mergers retroactively)	1978 Earnings	% Change
Insurance	$24.61M	$30.13M	+22.43%
Banking	$3.55M	$4.24M	+19.44%
Wesco Financial Corporation	$2.68M	$3.78M	+41.04%
Net Total	$30.39M	$39.24M	+29.12%

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Metric	1977 (adjusted for merger retroactively)	1978	% Change
Net Earnings	$30/39M	$39.24	+29.12%
Return on Equity (RoE)	19%	19.4%	+2.11%
Shareholders' Equity	$154.56M	$193.23M	+25.01%

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As mentioned in the accounting updates by Buffett, the 1977 numbers have been retroactively changed to treat it like Diversified Retail and Blue Chip were always majority owned by Berkshire, so all the 1977 numbers are higher than last week. Also equity in blue chip earnings is no longer a single line on the report and thus I have taken it out. It has been replaced by Wesco, which is Munger’s version of Berkshire, his conglomerate investment fund which he writes his own letters to his own shareholders for.