Wednesday, March 26, 2014

Buffett the Market Timer? Part 3: The Berkshire Years 1981-1990

OK, so this was a little longer than I thought, so I will make Part 3 1981-1990.  There's more stuff here than I thought.

Anyway, let's see what Buffett has to say:

BRK LTS 1981
Buffett talks about trying to find whole businesses to buy but sees better opportunities in the stock market:
Currently, we find values most easily obtained through the open-market purchase of fractional positions in companies with excellent business franchises and competent, honest managements.  We never expect to run these companies, but we do expect to profit from them. 
And again, in 1981, he talks an awful lot about inflation and how bad it is for equities (emphasis mine):
In past reports we have explained how inflation has caused our apparently satisfactory long-term corporate performance to be illusory as a measure of true investment results for our owners.  We applaud the efforts of Federal Reserve Chairman Volcker and note the currently more moderate increases in various price indices.  Nevertheless, our views regarding long-term inflationary trends are as negative as ever.  Like virginity, a stable price level seems capable of maintenance, but not of restoration.
Despite the overriding importance of inflation in the investment equation, we will not punish you further with another full recital of our views; inflation itself will be punishment enough.  (Copies of previous discussions are available for masochists.) But, because of the unrelenting destruction of currency values, our corporate efforts will continue to do a much better job of filling your wallet than of filling your stomach. 
And yet, as sure as he is that high inflation will continue and it will be bad for stocks/businesses, he continues investing in the stock market.  Much of the country ran the other way into inflation investments like gold.

(What I experienced in the recent crisis is that people who don't want to buy stocks because they are too expensive, or not cheap, won't buy stocks when they are cheap because they will tell you that there is a valid reason why it is cheap and why it may get cheaper!   Of all the people that look at a long term chart of the S&P 500 index and valuations that say that 1982 was a great buying opportunity, I suspect most of them wouldn't have done it if they were there at the time. It was too scary to buy stocks!  But that's a different issue.)

This is interesting because Buffett was wrong about inflation; Volcker did succeed in getting inflation back down.  If he was right and inflation kept going at a high rate, BRK would have still achieved decent returns keeping up with inflation (which as he says would be "illusory").  But if he went into gold (as many did) and was wrong, he would have lost a lot of money (as many did).  So his decision to stay in stocks seems to be a heads I win and make a killing or tails I lose and I give you illusory profits (but at least keep up with inflation).

So in that sense, it seems like a good bet.  He stayed with a position where it didn't matter if he was right or wrong on inflation.  Others made bets (gold) where they had to be right about inflation or else they would end up losing tons of money (and they did).

BRK LTS 1982
After almost a decade of bargain prices, Buffett is already starting to worry about the level of the stock market.  He does say that stock prices were crazy in 1972 (referring to the nifty-fifty) when BRK owned very little stocks compared to 1982.
     Our partial-ownership approach can be continued soundly only as long as portions of attractive businesses can be acquired at attractive prices.  We need a moderately-priced stock market to assist us in this endeavor.  The market, like the Lord, helps those who help themselves.  But, unlike the Lord, the market does not forgive those who know not what they do.  For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments. 
     Should the stock market advance to considerably higher levels, our ability to utilize capital effectively in partial-ownership positions will be reduced or eliminated.  This will happen periodically:  just ten years ago, at the height of the two-tier market mania (with high-return-on-equity businesses bid to the sky by institutional investors), Berkshire's insurance subsidiaries owned only $18 million in market value of equities, excluding their interest in Blue Chip Stamps.  At the time, such equity holdings amounted to about 15% of our insurance company investments versus the present 80%. There were as many good businesses around in 1972 as in 1982, but the prices the stock market placed upon those businesses in 1972 looked absurd.  While high stock prices in the future would make our performance look good temporarily, they would hurt our long-term business prospects rather than help them.  We currently are seeing early traces of this problem. 
He says equities is 80% of total insurance company investments, but I don't know what percentage it would be versus the net worth of the insurance company.  At 80%, it's possible that some of the float itself was invested in equities too, but I can't confirm that without a BRK 1982 balance sheet.

BRK LTS 1985
1985 was a great year for BRK and Buffett says this kind of return won't be repeated; neither the one year nor the twenty year returns (emphasis mine):
     Our gain in net worth during the year was $613.6 million, or 48.2%.  It is fitting that the visit of Halley's Comet coincided with this percentage gain: neither will be seen again in my lifetime.  Our gain in per-share book value over the last twenty-one years years (that is, since present management took over) has been from $19.46 to $1632.71, or 23.2% compounded annually, another percentage that will not be repeated. 
     Two factors make anything approaching this rate of gain unachievable in the future.  One factor probably transitory - is a stock market that offers very little opportunity compared to the markets that prevailed throughout much of the 1964-1984 period.  Today we cannot find significantly-undervalued equities to purchase for our insurance company portfolios.  The current situation is 180 degrees removed from that existing about a decade ago, when the only question was which bargain to choose. 
     This change in the market also has negative implications for our present portfolio.  In our 1974 annual report I could say: "We consider several of our major holdings to have great potential for significantly increased values in future years."  I can't say that now.  It's true that our insurance companies currently hold major positions in companies with exceptional underlying economics and outstanding managements, just as they did in 1974.  But current market prices generously appraise these attributes, whereas they were ignored in 1974.  Today's valuations mean that our insurance companies have no chance for future portfolio gains on the scale of those achieved in the past. 
And here's another interesting point.  Buffett no longer sees equities as cheap but what is notable is that he is not selling stocks.  He doesn't say stocks are fully valued and then just sell out and go to cash (or buy puts or other hedges).

This veers a little bit off topic again but I thought it is an interesting comment.  We often hear arguments that it is harder now to make money in markets because there are so many hedge funds and other professional market participants picking over the market that things aren't often mispriced anymore. This may be true in some areas (merger arbitrage, for example) but Joel Greenblatt once said that despite all the MBA's / professional money managers out there, we still had the 1999/2000 bubble and collapse so how much more efficient is the market these days?

Buffett made this comment in the 1985 letter:
     You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets.  They are not:  stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued. 
     Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do:  An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news.  "You've qualified for residence", said St. Peter, "but, as you can see, the compound reserved for oil men is packed.  There's no way to squeeze you in."  After thinking a moment, the prospector asked if he might say just four words to the present occupants.  That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, "Oil discovered in hell."  Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions.  Impressed, St. Peter invited the prospector to move in and make himself comfortable.  The prospector paused.  "No," he said, "I think I'll go along with the rest of the boys.  There might be some truth to that rumor after all."
First, a correction.  In Part 2 of this series, I mentioned that Buffett bought Washington Post (WPC) in 1972, but the 1985 letter says that he bought all the WPC shares in mid-1973.  Anyway, here is a comment on WPC.  This is one of the first times he starts to talk about holding stuff 'forever', I think.
     Our Capital Cities purchase, described in the next section, required me to leave the WPC Board early in 1986.  But we intend to hold indefinitely whatever WPC stock FCC rules allow us to.  We expect WPC's business values to grow at a reasonable rate, and we know that management is both able and shareholder-oriented.  However, the market now values the company at over $1.8 billion, and there is no way that the value can progress from that level at a rate anywhere close to the rate possible when the company valuation was only $100 million.  Because market prices have also been bid up for our other holdings, we face the same vastly-reduced potential throughout our portfolio. 
Of course the obvious question is, why wouldn't he sell some of this stuff if he didn't see a lot of potential?  Over the years, Buffett has responded to similar questions by asking where else he would put the capital.  He wouldn't want to sell out and hold cash (well, cash back then earned more then in recent years).  He often said that he would have to sell, pay taxes on that and then find something that is just as good, qualitatively, at a better price (to offset the tax paid on realized gains).  That is hard to do.

So just because something becomes fully priced for Buffett is not an automatic reason to sell.

And here's a comment on Buffett doing some risk arbitrage (now called merger arbitrage):
     You will notice that we had a significant holding in Beatrice Companies at year-end.  This is a short-term arbitrage holding - in effect, a parking place for money (though not a totally safe one, since deals sometimes fall through and create substantial losses).  We sometimes enter the arbitrage field when we have more money than ideas, but only to participate in announced mergers and sales.  We would be a lot happier if the funds currently employed on this short-term basis found a long-term home.  At the moment, however, prospects are bleak. 
This is also interesting.  Notice that he says "prospects are bleak" to deploy capital in the market.  And yet he still owns a bunch of stocks.  Just because prices are not attractive enough to buy is not a reason to sell, and just because something is good enough to own is not a reason to buy.  I know that's a little confusing.  People always ask why Buffett doesn't just buy more Coke or whatever other stocks he happily owns.

He wants to buy when things are cheap, but is happy to own at full value and even when it is overvalued as long as the business is doing well.  We will see more comments about that later.

So, just because there aren't any bargains in the market is not a reason to go to cash.   Just because there isn't much to buy is not a reason that you shouldn't own stocks.

BRK LTS 1986
This lack of opportunities in the stock market continues:
     Meanwhile, we had no new ideas in the marketable equities field, an area in which once, only a few years ago, we could readily employ large sums in outstanding businesses at very reasonable prices.  So our main capital allocation moves in 1986 were to pay off debt and stockpile funds.  Neither is a fate worse than death, but they do not inspire us to do handsprings either.  If Charlie and I were to draw blanks for a few years in our capital-allocation endeavors, Berkshire's rate of growth would slow significantly.
And an extended comment on the markets:
     During 1986, our insurance companies purchased about $700 million of tax-exempt bonds, most having a maturity of 8 to 12 years.  You might think that this commitment indicates a considerable enthusiasm for such bonds.  Unfortunately, that's not so: at best, the bonds are mediocre investments.  They simply seemed the least objectionable alternative at the time we bought them, and still seem so.  (Currently liking neither stocks nor bonds, I find myself the polar opposite of Mae West as she declared: "I like only two kinds of men - foreign and domestic.")
     We must, of necessity, hold marketable securities in our insurance companies and, as money comes in, we have only five directions to go: (1) long-term common stock investments; (2) long-term fixed-income securities; (3) medium-term fixed-income securities; (4) short-term cash equivalents; and (5) short-term arbitrage commitments. 
     Common stocks, of course, are the most fun.  When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value - stocks sometimes provide grand-slam home runs.  But we currently find no equities that come close to meeting our tests.  This statement in no way translates into a stock market prediction: we have no idea - and never had had - whether the market is going to go up, down, or sideways in the near- or intermediate term future
     What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community.  The timing of these epidemics will be unpredictable.  And the market aberrations produced by them will be equally unpredictable, both as to duration and degree.  Therefore, we never try to anticipate the arrival or departure of either disease.  Our goal is more modest:  we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful. 
     As this is written, little fear is visible on Wall Street.  Instead, euphoria prevails - and why not?  What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves?  Unfortunately, however, stocks can't outperform businesses indefinitely. 
Again, it's important to note that some people with a similar view as Buffett would sell stuff and go to cash, but Buffett doesn't.  He doesn't buy stocks with new cash coming in, but he is not rushing to sell stocks in anticipation of a sell-off to buy back cheaper either.  Nor is he putting his private businesses on the block.  Just because times are not good to buy stocks doesn't mean that it's a bad idea to own stocks.

And here he starts to talk more about stocks as businesses:
     We should note that we expect to keep permanently our three primary holdings, Capital Cities/ABC, Inc., GEICO Corporation, and The Washington Post.  Even if these securities were to appear significantly overpriced, we would not anticipate selling them, just as we would not sell See's or Buffalo Evening News if someone were to offer us a price far above what we believe those businesses are worth. 
     This attitude may seem old-fashioned in a corporate world in which activity has become the order of the say.  The modern manager refers to his "portfolio" of businesses - meaning that all of them are candidates for "restructuring" whenever such a move is dictated by Wall Street preferences, operating conditions or a new corporate "concept."  (Restructuring is defined narrowly, however: it extends only to dumping offending businesses, not to dumping the officers and directors who bought the businesses in the first place. "Hate the sin but love the sinner" is a theology as popular with the Fortune 500 as it is with the Salvation Army.)
     Investment managers are even more hyper-kinetic:  their behavior during the trading hours makes whirling dervishes appear sedated by comparison.  Indeed, the term "institutional investor" is becoming one of those self-contradictions called an oxymoron, comparable to "jumbo shrimp", "lady mudwrestler: and "inexpensive lawyer."
     Despite the enthusiasm for activity that has swept business and financial America, we will stick with out 'til-death-do-us-part policy.  It's the only one with which Charlie and I are comfortable, it produces decent results, and it lets our managers and those of our investees run their businesses free of distractions. 
So this explains why Buffett didn't sell Coke at 40-50x earnings in 1999.  I'm not saying that he shouldn't have sold it (didn't he later make a comment regretting it?).

BRK LTS 1987
And a letter from an interesting year:
Marketable Securities - Permanent Holdings
     Whenever Charlie and I buy common stocks for Berkshire's insurance companies (leaving aside arbitrage purchases, discussed later) we approach the transaction as if we were buying into private business.  We look at the economic prospects of the business, the people in charge of running it, and the price me must pay.  We do not have in mind any time or price for sale.  Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate.  When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts. 
     Our approach makes an active trading market useful, since it periodically presents us with mouth-watering opportunities.  But by no means is it essential:  a prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotations on World Book of Fechheimer.  Eventually, our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total. 

He talks a lot about Benjamin Graham and Mr. Market and then (emphasis mine):
     We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time.  (Of Wall Street maxims the most foolish may be "You can't go broke taking a profit.")  We are quite content to hold any security indefinitely, so long as prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business
     However, our insurance companies own three marketable common stocks that we would not sell even though they became far overpriced in the market.  In effect, we view these investments exactly like our successful controlled businesses - a permanent part of Berkshire rather than merchandise to be disposed of once Mr. Market offers us a sufficiently high price.  To that, I will add one qualifier:  These stocks are held by our insurance companies and we would, if absolutely necessary, sell portions of our holdings to pay extraordinary insurance losses.  We intend, however, to manage our affairs so that sales are never required.
      A determination to have and to hold, which Charlie and I share, obviously involves a mixture of personal and financial considerations.  To some, our stand may seem highly eccentric.  (Charlie and I have long followed David Ogilvy's (this is misspelled as Oglivy in the letter at the Berkshire Hathaway website and book!)  advice:  "Develop your eccentricities while you are young.  That way, when you get old, people won't think you're going ga-ga.")  Certainly, in the transaction-fixated Wall Street of recent years, our posture must seem odd:  To many in that arena, both companies and stocks are seen only as raw material for trades. 
     Our attitude, however, fits our personalities and the way we want to live our lives.  Churchill once said, "You shape your houses and then they shape you."  We know the manner in which we wish to be shaped.   For that reason, we would rather achieve a return of X while associating with people whom  we strongly like and admire than realize 110% of X by exchanging these relationships for uninteresting or unpleasant ones.  And we will never find people we like and admire more than some of the main participants at the three companies - our permanent holdings - shown below: 

No. of Shares                                          Cost       Market
-------------                                       ----------  ----------
                                                        (000s omitted) 
  3,000,000    Capital Cities/ABC, Inc. ...........  $517,500   $1,035,000 
  6,850,000    GEICO Corporation ..................    45,713      756,925 
  1,727,765    The Washington Post Company ........     9,731      323,092 

...and here is a comment that applies equally well today.  Back in 1987 they had insider trading scandals, portfolio insurance and other derivatives that caused market volatility etc.
    Many commentators, however, have drawn an incorrect conclusion upon observing recent events:  They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys.  This conclusion is dead wrong:  Such markets are ideal for any investor - small or large - so long as he sticks to his investment knitting.  Volatility caused many money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves.  He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times. 

And for the first time since the early 1970's, it looks like Buffett is finally 'out' of the stock market: 
      At Berkshire, we have found little to do in stocks during the past few years.  During the break in October, a few stocks fell to prices that interested us, but we were unable to make meaningful purchases before they rebounded.  At year-end 1987 we had no major common stock investments (that is, over $50 million) other than those we consider permanent or arbitrage holdings.  However, Mr. Market will offer us opportunities - you can be sure of that - and, when he does, we will be willing and able to participate. 
But wait a second.  BRK has no major common stock investments other than the permanent three.  Plus he still owns the wholly owned businesses, which to him are the same as permanent stock holdings. 

So he dumped all of his other stocks, so it does look like he ran for the hills.  But if you look back at the equity portfolio, the permanent three was already 76% of total stock holdings in 1985 and 93% in 1986.  This became 100% in 1987 (excluding arbitrage holdings as there is no total table for 1987 in the report like the other years).  So his selling out of stocks doesn't account for very much; it's a minor adjustment to the portfolio; not a big liquidation and run to cash from stocks by any means.  

And here's a sort of macro view of Buffett's that does keep him away from long-term bonds: 
     We continue to have an aversion to long-term bonds (and may be making a serious mistake by not disliking medium-term bonds as well).  Bonds are no better than the currency in which they are denominated, and nothing we have seen in the past year - or past decade - makes us enthusiastic about the long-term future of U.S. currency. 
He goes on to explain the problem with trade deficits and the other problems we had in the 80's.  So he is very aware of all the things that the bears were touting as reasons to get out of the market, short the market, buy gold and run for the hills.  Even in the recent crisis, otherwise sane people were confused as to why Buffett doesn't see what is so obvious; that the world is about to end. 

And how many of the gloom and doomers of the 80's have a good track record since then (either in fund performance or accuracy of predictions?).  OK, some hedge funds have done well since then with macro, but very few, I think.

So again, like his call on inflation in the 1970's, he makes a good macro call on the dollar.  But by sticking to his "investment knitting", it doesn't really matter much if he is right or wrong on the call.  His investment success is not dependent on his making the right call on interest rates or the dollar.  This is one of the key things to learn from this exercise. 

And here's an interesting section on the beginning of Buffett's nightmare to come.  Economically, I think, this worked out OK. But what unfolded later was not ideal to put it mildly.  But I bring this up because it gives us an example of how he comes to certain investment decisions: 
     By far our largest - and most publicized - investment in 1987 was a $700 million purchase of Salomon Inc 9% preferred stock.  This preferred is convertible after three years into Salomon common stock at $38 per share and, if not converted, will be redeemed ratably over five years beginning October 31, 1995.  From most standpoints, this commitment fits into the medium-term fixed-income securities category.  In addition, we have an interesting conversion possibility. 
      We, of course, have no special insights regarding the direction or future profitability of investment banking.  By their nature, the economics of this industry are far less predictable than those of most other industries in which we have major commitments.  This unpredictability is one of the reasons why our participation is in the form of a convertible preferred.   
     What we do have a strong feeling about is the ability and integrity of John Gutfreund, CEO of Salomon Inc.  Charlie and I like, admire and trust John.  We first got to know him in 1976 when he played a key role in GEICO's escape from near-bankruptcy.  Several times since, we have seen John steer clients away from transactions that would have been unwise, but that the client clearly wanted to make - even though his advice provided no fee to Salomon and acquiescence would have delivered a large fee.  Such service-above-self behavior is far from automatic in Wall Street. 
So it is interesting that despite the mania he saw in the stock market, he was willing to buy preferreds of an investment bank that would obviously be hurt in a bear market.   Despite bubble conditions, he said that they have "no special insights regarding the direction or future profitability of investment banking", and bought the preferreds on the character / integrity of the CEO, John Gutfreund, and the structure of the preferred.  

Market timers might say that this is a bad deal; the market is going to crash, the dollar is plunging, and investment banks are going to go bust.  Or something like that.  We hear that every time (and once in a while it happens, like in 2008!). 

BRK LTS 1988
And in 1988, it looks like he starts to buy stocks again.  Remember that 1988 was not necessarily a bear market low or anything like that.  Many at the time wanted to wait for the stock market to get back to 7-8x p/e ratio (just like it did in 1982) before buying stocks again.  In fact, that's what I heard in 2009 too.  People said that the market won't bottom out until the p/e ratio gets to 7x because that's what happened in 1932, 1974 and 1982. 

Lucky for BRK shareholders, Buffett doesn't look at things that way: 
     In 1988 we made major purchases of Federal Home Loan Mortgage Pfd. (Freddie Mac) and Coca Cola.  We expect to hold these securities for a long time.  In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.  We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint.  Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.  Our holdings of Freddie Mac are the maximum allowed by law, and are extensively described by Charlie in his letter. 
And this is a cue for us to go and get Charlie's letter and read it.  I don't know if I've ever read his 1988 letter.

Here's the BRK equity portfolio as of 1988: 

   Shares   Company                                    Cost       Market
   ------   -------                                 ----------  ----------
                                                        (000s omitted) 
 3,000,000  Capital Cities/ABC, Inc. ..............  $517,500   $1,086,750
14,172,500  The Coca-Cola Company .................   592,540      632,448
 2,400,000  Federal Home Loan Mortgage 
               Corporation Preferred* .............    71,729      121,200
 6,850,000  GEICO Corporation .....................    45,713      849,400
 1,727,765  The Washington Post Company ...........     9,731      364,126

*Although  nominally a preferred stock, this security is 
 financially equivalent to a common stock.

And he still doesn't like long-term bonds: 
     We have not lost our aversion to long-term bonds.  We will become enthused about such securities only when we become enthused about the prospects for long-term stability in the purchasing power of money.  And that kind of stability isn't in the cards:  Both society and elected officials simply have too many higher-ranking priorities that confict with purchasing-power stability. 
So he still doesn't like the dollar, but notice that he doesn't rush into gold, emerging markets or other non-dollar assets like some of the people who yell and scream to get out of U.S. dollar assets (and curiously, they are only on TV when the market is down more than 100 points!).  He isn't looking for investments that do well in inflationary times, or when the dollar weakens.  He is not looking to hedge his equity portfolio or business holdings despite his negative views on bonds and the dollar. 

For those interested in special situations investing, there is an extensive discussion of arbitrage (and merger arbitrage) in the 1988 letter.

BRK LTS 1989
Here's the table of BRK's large stock holdings in 1989: 

  Shares    Company                                      Cost       Market
  ------    -------                                   ----------  ----------
                                                          (000s omitted)
 3,000,000  Capital Cities/ABC, Inc. ................ $  517,500  $1,692,375
23,350,000  The Coca-Cola Co. .......................  1,023,920   1,803,787
 2,400,000  Federal Home Loan Mortgage Corp. ........     71,729     161,100
 6,850,000  GEICO Corp. .............................     45,713   1,044,625
 1,727,765  The Washington Post Company .............      9,731     486,366

He talks about how long it took him to buy Coca-Cola (having first had a Coke back in 1935 or 1936, and having made a business out of selling Coke in the neighborhood), and what he likes about it.

And then he talks about the valuation of his holdings (his italics, my underline):
     As I mentioned earlier, the year-end prices of our major investees were much higher relative to their intrinsic value than theretofore.  While those prices may not yet cause nosebleeds, they are clearly vulnerable to a general market decline.  A drop in their prices would not disturb us at all - it might in fact work to our eventual benefit - but it would cause at least a one-year reduction in Berkshire's net worth.  We think such a reduction is almost certain in at least one of the next three years.  Indeed, it would take only about a 10% year-to-year decline in the aggregate value of our portfolio investments to send Berkshire's net worth down. 
And note again that despite prices of his holdings being much higher than their intrinsic value, he doesn't sell.  Instead, he prepares himself and BRK shareholders for the eventual decline in price levels and a possible decline in BRK's net worth.   BRK's long term performance would be very different if he sold his holdings, even if he sold them at a level that is much higher than intrinsic value.

He thinks it is almost certain that there will be a drop in BRK's net worth in at last one of the next three years.

Just for reference, here's the BPS growth for BRK over the next few years after this:

1989:  +44.4%
1990:  +7.4%
1991:  +39.6%
1992:  +20.3%
1993:  +14.3%
1994:  +13.9%
1995:  +43.1%
1996:  +31.8%
1997:  +34.1%
1998:  +48.3%

And he didn't have a negative BPS change until the year 2001. So much for predicting the market/stock prices, even using valid valuation techniques.  BRK shareholders are lucky that he didn't sell out to avoid this possible drop in BPS and try to get back in later.  I was pretty active in the business in these years, and I think in every single year, people said that the market was overvalued and had many great, valid reasons why owning stocks were a bad idea.  A bear market was 'imminent' in every one of these years.   Food for thought.

LTS BRK 1990
Here's the table of holdings from the 1990 report (only the largest holdings):

  Shares    Company                                  Cost         Market 
  ------    -------                               ----------    ----------
                                                       (000s omitted)
 3,000,000  Capital Cities/ABC, Inc. ............ $  517,500    $1,377,375
46,700,000  The Coca-Cola Co. ...................  1,023,920     2,171,550
 2,400,000  Federal Home Loan Mortgage Corp. ....     71,729       117,000 
 6,850,000  GEICO Corp. .........................     45,713     1,110,556
 1,727,765  The Washington Post Company .........      9,731       342,097
 5,000,000  Wells Fargo & Company ...............    289,431       289,375

In 1990, he talks a lot about the Wells Fargo purchase, so I'll cut and paste a bunch about that here since it is relevant now too as Buffett has been buying a lot of WFC recently too.   
      Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.
      The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
      Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.
      With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen. In many ways the combination of Carl and Paul reminds me of another - Tom Murphy and Dan Burke at Capital Cities/ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: "I'm no genius," he said. "I'm smart in spots - but I stay around those spots.")
      Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
      Wells Fargo is big - it has $56 billion in assets - and has been earning more than 20% on equity and 1.25% on assets. Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. But were we to make such a purchase, we would have to pay about twice the $290 million we paid for Wells Fargo. Moreover, that $5 billion bank, commanding a premium price, would present us with another problem: We would not be able to find a Carl Reichardt to run it. In recent years, Wells Fargo executives have been more avidly recruited than any others in the banking business; no one, however, has been able to hire the dean.
      Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.
      None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
      A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.
      Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It's the seller of food who doesn't like declining prices.) Similarly, at the Buffalo News we would cheer lower prices for newsprint - even though it would mean marking down the value of the large inventory of newsprint we always keep on hand - because we know we are going to be perpetually buying the product.
      Identical reasoning guides our thinking about Berkshire's investments. We will be buying businesses - or small parts of businesses, called stocks - year in, year out as long as I live (and longer, if Berkshire's directors attend the seances I have scheduled). Given these intentions, declining prices for businesses benefit us, and rising prices hurt us.
      The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.
      None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." 

Conclusion for 1981 - 1990
So this is longer than I thought it would be, so I will have to cut it here for now.   This is very interesting because we see markets get very high and bubbly in 1986-1987 and yet Buffett hangs on to most of his stocks.  He did sell the stock that weren't 'permanent', but since he is so focused, other stocks were not that big so the increasing market valuation didn't really seem to cause a major asset reallocation out of stocks into something else.

And it is interesting that he said that he won't sell his permanent holdings even if they get substantially overvalued.

And we see the consequence of that in the late 1980's and early 1990's.  He seemed so sure that BRK's BPS will go down in one of the next three years in the 1989 letter.  He wasn't timing the market from a conventional point of view, but rather 'pricing' the market and noting the discrepancy between intrinsic value and market price.  And still, he proved to be wrong.

Again, like his comments about bonds, inflation and the dollar, he made sort of a prediction, but his performance wasn't dependent on that prediction coming true.  If he had sold some stocks to 'lighten up' so that he can get back in at a lower price later, he would have hurt his own performance by being wrong.

There is a difference between noting something and managing your expectation and trying to exploit that insight and trying to profit from it.

Hopefully, Part 4 will be able to fit the years 1991 - 2013.  But a lot happened in those years so who knows.


  1. I wonder if the reason Buffett never sells is because overtime the expected return investors are willing to accept is going to decline over time. We have more capital in the markets chasing roughly the same amount of corporations. I mean sure there are more businesses, but how many more "high return on capital" businesses have been created over the last 30 years relative to the amount of additional capital in the markets?

  2. Your blog is first-rate, so thank you for the time and energy you have spent on your reader's behalf.

    I have a theory about Buffett's unwillingness to sell that I think may explain a few elements of BRK's history. You have probably said or implied this in these latest posts, so forgive me for saying it again. In my study of the 1965-2013 shareholder letters, I was amazed at how low his batting average was (especially with private companies) compared to what I would have guessed. In other words, Buffett made more mistakes than I would have thought (and I've followed BRK for many, many years). Yet, his track record is still fantastic. The commentary about the Scott & Fetzer acquisition in the 1985 letter is an example of my this idea... the primary value in that business evaporated in just a few short years despite WEB paying $410M EV.

    My theory is that WEB also realized quite early that predicting the future is hard... understanding competitive advantages, moats, management, is really, really hard. As a result, I think he began to realize that it makes zero sense to trade a business which you've owned and studied extensively just because a shiny new object appears on the horizon. There is a high probability that you are trading something for which you have some understanding for something for which you know little (though you'll of course tell yourself that you know them equally well). There is also a reasonable probability that you've once again misjudged the future prospects from that point forward.

    The solution to this problem is to simply not sell very often. Do your very best to understand and evaluate a business correctly before making the investment and then hold on for many, many years. You will make mistakes (Buffett made many of them despite operating as one of the best, if not the best, business analyst of all time). However, you'll make significantly more mistakes by selling things, paying taxes, and buying new things that you don't understand as well. Another important element of this strategy is that you need not worry about market levels... you're not selling anyway!

    Would love to read your thoughts on this idea... or just tell me that I've repeated what you've said in these great posts.


    1. That's a very good point. He did mention buying DIS and selling it at a small profit between 1966-1967 and missing out on a 20%/year return from 1966-1995 or something like that. He also sold McDonalds and regretted that too.

    2. The comment on Scott Fetzer couldn't be more off. Its earnings are broken out in every letter from 1986-2002, and they march steadily upwards from $46m in 1982 (first full year) to $83m in 2002. Buffett comments in the 2000 letter upon Schey's retirement that Berkshire purchased the company for $230m net in 1985 (Scott Fetzer had $80m+ cash that was immediately distributed upon purchase to Berkshire) and distributed $1.03b to Berkshire through 2000. This was easily one of Buffett's best investments. Note that Scott Fetzer had several pieces: World Book, Kirby, and Scott Fetzer Manufacturing. Each of these lines is broken out separately from 1986-1996. World Book earned $164m over that period, Kirby $246m, Scott Fetzer Manufacturing $225m.

      Contrary to this, I think Buffett's batting average on these private acquisitions is pretty high, especially in the early years. Looking at the big ones, See's in 1971, Buffalo News in 1977, and Scott Fetzer in 1985 were all home runs, and Nebraska Furniture Mart in 1983 was solid.

  3. You have it right about BRK & investing its float. Even in 1982, and every other period I have looked at, float is always covered by cash and fixed maturities. 80% of the portfolio could be in stocks because they only had $200 million in float at the time against net worth of $725 million.

    As always, great work with the posts.

    1. That's very interesting. Thanks for confirming that!

  4. KK, You are doing a wonderful job of aggregating the BRK letters on stocks valuations!


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