Part 6 in our series examining the Warren Buffett letters to Berkshire Hathaway shareholders focuses on the letter for the year 1982.

Not a great year for Berkshire, as:

Operating earnings of $31.5 million in 1982 amounted to only 9.8% of beginning equity capital (valuing securities at cost), down from 15.2% in 1981 and far below our recent high of 19.4% in 1978. This decline largely resulted from:

(1) a significant deterioration in insurance underwriting results;

(2) a considerable expansion of equity capital without a corresponding growth in the businesses we operate directly; and

(3) a continually-enlarging commitment of our resources to investment in partially-owned, nonoperated businesses; accounting rules dictate that a major part of our pro-rata share of earnings from such businesses must be excluded from Berkshire's reported earnings.

Buffett had warned about insurance earnings being on the wane the previous year. As for #3 on the list above, Buffett is talking about the fact that Berkshire Hathaway is buying up very significant stock positions in companies it likes, but because Berkshire does not operate these businesses, Berkshire's "share" of the earnings from these companies can not be reported as actual Berkshire earnings.

As a result, Buffett wants to get away from using return on equity as the standard for measuring performance, even though he argued for it previously. However, as he himself says:

"You should be suspicious of such an assertion. Yardsticks seldom
are discarded while yielding favorable readings. But when results deteriorate, most managers favor disposition of the yardstick rather than disposition of the manager."

Nevertheless, Buffett decides it would be a good idea to highlight the earnings of companies in which Berkshire has a greater than 20% share. These include General Foods, The Washington Post Company, R.J. Reynolds, Time Inc. and GEICO.

Buffett on buying into good companies at stock market lows:

"...fractional-interest purchases can be made in an auction market where prices are set by participants with behavior patterns that sometimes resemble those of an army of manic-depressive lemmings."

And another:

"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."

Despite Buffett's warnings, his past performance is impressive:

"During the 18-year tenure of present management, book value has grown from $19.46 per share to $737.43 per share, or 22.0% compounded annually. You can be certain that this percentage will diminish in the future."

Buffett spends a good deal of this letter explaining his philosophy around acquiring companies, or, perhaps more to the point, when not to buy a company. (Berkshire is planning to acquire the remainder of Blue Chip Stamps.) Buffett discusses the fact that many companies buy other companies during down market times, paying for the purchases with shares of their own companies. In effect, they're paying full price for the companies, but using "money" that is worth half of what it should be:

"The acquirer who nevertheless barges ahead ends up using an
undervalued (market value) currency to pay for a fully valued (negotiated value) property. In effect, the acquirer must give up $2 of value to receive $1 of value. Under such circumstances, a marvelous business purchased at a fair sales price becomes a terrible buy. For gold valued as gold cannot be purchased intelligently through the utilization of gold - or even silver - valued as lead.

If, however, the thirst for size and action is strong enough, the acquirer's manager will find ample rationalizations for such a value-destroying issuance of stock. Friendly investment bankers will reassure him as to the soundness of his
actions. (Don't ask the barber whether you need a haircut.)"

Got a company you'd like Berkshire to acquire? Here's Buffett's Rules (circa 1982):

"We prefer:

(1) large purchases (at least $5 million of after-tax earnings),

(2) demonstrated consistent earning power (future projections are of little interest to us, nor are "turn-around" situations),

(3) businesses earning good returns on equity while employing little or no debt,

(4) management in place (we can't supply it),

(5) simple businesses (if there's lots of technology, we won't understand it),

(6) an offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

We will not engage in unfriendly transactions. We can promise complete confidentiality and a very fast answer as to possible interest - customarily within five minutes. Cash purchases are preferred, but we will consider the use of stock when it can be done on the basis described in the previous section."

So far this letter might be the most interesting of Buffett's letters because it reinforces the philosophies he's become known for, and for the first time in our series Berkshire is starting to do some deals. Also, Buffett's recognition that its stock holdings are becoming as important if not more so than the businesses it owns outright is significant as the future unfolds.