How to Think Like Warren Buffett, Part 23

Filed in archive Investing on June 29, 2007

Time once again for another installment in our 30-part series dissecting Warren Buffett's Letters to Berskshire Hathaway shareholders.

In Part 23, we look at the year 1999...

1999 was the worst year in Berkshire Hathaway's history, due mostly to a rough year in the insurance businesses, and so perhaps there are lessons to be learned from that. Buffett:

We had the worst absolute performance of my tenure and, compared to the S&P, the worst relative performance as well. Relative results are what concern us: Over time, bad relative numbers will produce unsatisfactory absolute results. Even Inspector Clouseau could find last year's guilty party: your Chairman. My performance reminds me of the quarterback whose report card showed four Fs and a D but who nonetheless had an understanding coach. "Son," he drawled, "I think you're spending too much time on that one subject."

Buffett took this opportunity to remind shareholders that he was "all in":

Despite our poor showing last year, Charlie Munger, Berkshire's Vice Chairman and my partner, and I expect that the gain in Berkshire's intrinsic value over the next decade will modestly exceed the gain from owning the S&P. We can't guarantee that, of course. But we are willing to back our conviction with our own money. To repeat a fact
you've heard before, well over 99% of my net worth resides in Berkshire. Neither my wife nor I have ever sold a share
of Berkshire and - unless our checks stop clearing - we have no intention of doing so.

Still, Buffett was not promising miracles (of course, we've learned over the course of studying his Letters that he likes to manage expectations to the downside):

Please note that I spoke of hoping to beat the S&P "modestly." For Berkshire, truly large superiorities over
that index are a thing of the past. They existed then because we could buy both businesses and stocks at far more
attractive prices than we can now, and also because we then had a much smaller capital base, a situation that allowed
us to consider a much wider range of investment opportunities than are available to us today. Our optimism about Berkshire's performance is also tempered by the expectation - indeed, in our minds, the virtual certainty - that the S&P will do far less well in the next decade or two than it has done since 1982.

It should be noted that only recently has the S&P gotten back to the level it was at when Buffett wrote these words. No one could have foreseen the impact of 9/11, but it's safe to say that Buffett probably saw the oncoming dot-com bust that would take the market for a ride down.

One of the consistent messages that Buffett likes to deliver is about the relationship between Berkshire Hathaway the parent company and the companies that make up its portfolio. Buffett's style is to be as hands-off as possible, as he relates again in the 1999 letter:

Berkshire's collection of managers is unusual in several important ways. As one example, a very high percentage of these men and women are independently wealthy, having made fortunes in the businesses that they run. They work neither because they need the money nor because they are contractually obligated to - we have no contracts at Berkshire. Rather, they work long and hard because they love their businesses. And I use the word "their" advisedly, since these managers are truly in charge - there are no show-and-tell presentations in Omaha, no budgets to be approved by headquarters, no dictums issued about capital expenditures. We simply ask our managers to run their companies as if these are the sole asset of their families and will remain so for the next century.

Charlie and I try to behave with our managers just as we attempt to behave with Berkshire's shareholders, treating
both groups as we would wish to be treated if our positions were reversed. Though "working" means nothing to me
financially, I love doing it at Berkshire for some simple reasons: It gives me a sense of achievement, a freedom to act as I see fit and an opportunity to interact daily with people I like and trust. Why should our managers - accomplished
artists at what they do - see things differently?

In their relations with Berkshire, our managers often appear to be hewing to President Kennedy's charge, "Ask
not what your country can do for you; ask what you can do for your country."

To demonstrate the type of managers Berkshire has enjoyed having running its businesses, Buffett relates this story (which you can't imagine happening too often in Corporate America):

Here's a remarkable story from last year:

It's about R. C. Willey, Utah's dominant home furnishing business, which Berkshire purchased from Bill Child and his
family in 1995. Bill and most of his managers are Mormons, and for this reason R. C. Willey's stores have never
operated on Sunday. This is a difficult way to do business: Sunday is the favorite shopping day for many customers.
Bill, nonetheless, stuck to his principles -- and while doing so built his business from $250,000 of annual sales in 1954,
when he took over, to $342 million in 1999.

Bill felt that R. C. Willey could operate successfully in markets outside of Utah and in 1997 suggested that we open
a store in Boise. I was highly skeptical about taking a no-Sunday policy into a new territory where we would be up
against entrenched rivals open seven days a week. Nevertheless, this was Bill's business to run. So, despite my
reservations, I told him to follow both his business judgment and his religious convictions.

Bill then insisted on a truly extraordinary proposition: He would personally buy the land and build the store - for
about $9 million as it turned out - and would sell it to us at his cost if it proved to be successful. On the other hand,
if sales fell short of his expectations, we could exit the business without paying Bill a cent. This outcome, of course, would leave him with a huge investment in an empty building. I told him that I appreciated his offer but felt that if Berkshire was going to get the upside it should also take the downside. Bill said nothing doing: If there was to be failure because of his religious beliefs, he wanted to take the blow personally.

The store opened last August and immediately became a huge success. Bill thereupon turned the property over
to us - including some extra land that had appreciated significantly - and we wrote him a check for his cost. And get
this: Bill refused to take a dime of interest on the capital he had tied up over the two years.

If a manager has behaved similarly at some other public corporation, I haven't heard about it. You can understand
why the opportunity to partner with people like Bill Child causes me to tap dance to work every morning.

I think this is a good example of forward-thinking management---Buffett discusses compensation at GEICO:

At Berkshire, we want to have compensation policies that are both easy to understand and in sync with what we wish our associates to accomplish. Writing new business is expensive (and, as mentioned, getting more expensive). If we were to include those costs in our calculation of bonuses - as managements did before our arrival at GEICO - we would be penalizing our associates for garnering new policies, even though these are very much in Berkshire's interest. So, in effect, we say to our associates that we will foot the bill for new business. Indeed, because percentage growth in policyholders is part of our compensation scheme, we reward our associates for producing this initially unprofitable business.

A sign of the times, that still continues across all of manufacturing today:

Almost all of our manufacturing, retailing and service businesses had excellent results in 1999. The exception was dexter Shoe, and there the shortfall did not occur because of managerial problems: In skills, energy and devotion to their work, the Dexter executives are every bit the equal of our other managers. But we manufacture shoes primarily in the U.S., and it has become extremely difficult for domestic producers to compete effectively. In 1999, approximately 93% of the 1.3 billion pairs of shoes purchased in this country came from abroad, where extremely low-cost labor is the rule.

Counting both Dexter and H. H. Brown, we are currently the leading domestic manufacturer of shoes, and we are
likely to continue to be. We have loyal, highly-skilled workers in our U.S. plants, and we want to retain every job here
that we can. Nevertheless, in order to remain viable, we are sourcing more of our output internationally. In doing that,
we have incurred significant severance and relocation costs that are included in the earnings we show in the table.

In discussing the performance of its largest stock holdings in 1999, Buffett reiterated his well-known theory of only investing in companies he understands well. This may have protected Berkshire from the dot-com crash to come, and shows his consistency in not getting antsy while watching the tech boom happen around him:

We made few portfolio changes in 1999. As I mentioned earlier, several of the companies in which we have large investments had disappointing business results last year. Nevertheless, we believe these companies have important competitive advantages that will endure over time. This attribute, which makes for good long-term investment results, is one Charlie and I occasionally believe we can identify. More often, however, we can't - not at least with a high degree of conviction. This explains, by the way, why we don't own stocks of tech companies, even though we share the general view that our society will be transformed by their products and services. Our problem - which we can't solve by studying up - is that we have no insights into which participants in the tech field possess a truly durable competitive advantage.

Our lack of tech insights, we should add, does not distress us. After all, there are a great many business areas in
which Charlie and I have no special capital-allocation expertise. For instance, we bring nothing to the table when it
comes to evaluating patents, manufacturing processes or geological prospects. So we simply don't get into judgments
in those fields.

If we have a strength, it is in recognizing when we are operating well within our circle of competence and when
we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing
industries is simply far beyond our perimeter. If others claim predictive skill in those industries - and seem to have
their claims validated by the behavior of the stock market - we neither envy nor emulate them. Instead, we just stick
with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted
hope for rationality. Fortunately, it's almost certain there will be opportunities from time to time for Berkshire to do
well within the circle we've staked out.

Finally, Buffett spends a nice chunk of this letter discussing stock repurchases---talking about when they make sense and when they don't. Most of that discussion can be summed up with this sentence:

We will never make purchases with the intention of stemming a decline in Berkshire's price. Rather we will make them if and when we believe that they represent an attractive use of the Company's money. At best, repurchases are likely to have only a very minor effect on the future rate of gain in our stock's intrinsic value.