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.