How to Think Like Warren Buffett, Part 7

Filed in archive Investing on August 29, 2006

Number seven in our series on the Sage of Omaha, Warren Buffett. This time we inspect his letter to Berkshire Hathaway shareholders for the year 1983...

The first thing that jumps out from this letter is how small Berkshire Hathaway still was in terms of number of shareholders:

"This past year our registered shareholders increased from about 1900 to about 2900. Most of this growth resulted from our merger with Blue Chip Stamps, but there also was an acceleration in the pace of "natural" increase that has raised us from the 1000 level a few years ago."

I'm not sure how many Berkshire shareholders there are now, but there are 1,128,301 Class A shares and 12,413,453 Class B shares, so I'm guessing there's been a bit of an increase there.

Ever hear the advice to buy companies where insiders hold lots of shares?

In line with this owner-orientation, our directors are all major shareholders of Berkshire Hathaway. In the case of at least four of the five, over 50% of family net worth is represented by holdings of Berkshire. We eat our own cooking.

More and more, Berkshire's worth is becoming the worth of Buffett's wise investments in other companies. So, while Berkshire owns insurance companies and other companies, it is the investments Buffett is making with the insurance companies' premiums that are an increasing source of his and Berkshire's success. And that's OK with Buffett:

"When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains."

On debt:

"We rarely use much debt and, when we do, we attempt to structure it on a long-term fixed rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, depositors, lenders and
the many equity holders who have committed unusually large portions of their net worth to our care."

In 1983, Berkshire Hathaway acquired Nebraska Furniture Mart, which came with an inspiring story of the Mart's founder:

"About 67 years ago Mrs. Blumkin, then 23, talked her way past a border guard to leave Russia for America. She had no formal education, not even at the grammar school level, and knew no English. After some years in this country, she learned the language when her older daughter taught her, every evening, the words she had learned in school during the day.

In 1937, after many years of selling used clothing, Mrs. Blumkin had saved $500 with which to realize her dream of opening a furniture store. Upon seeing the American Furniture Mart in Chicago - then the center of the nation's wholesale furniture activity - she decided to christen her dream Nebraska Furniture Mart.

She met every obstacle you would expect (and a few you wouldn't) when a business endowed with only $500 and no locational or product advantage goes up against rich, long-entrenched competition. At one early point, when her tiny resources ran out, "Mrs. B" (a personal trademark now as well recognized in Greater Omaha as Coca-Cola or Sanka) coped in a way not taught at business schools: she simply sold the furniture and appliances from her home in order to pay creditors precisely as promised.

Omaha retailers began to recognize that Mrs. B would offer customers far better deals than they had been giving, and they pressured furniture and carpet manufacturers not to sell to her. But by various strategies she obtained merchandise and cut prices sharply. Mrs. B was then hauled into court for violation of Fair Trade laws. She not only won all the cases, but received invaluable publicity. At the end of one case, after demonstrating to the court that she could profitably sell carpet at a huge discount from the prevailing price, she sold the judge $1400 worth of carpet."

Buffett always love to throw in some quotes from the literati:

"Red lights should start flashing if the five-year average annual gain falls much below the return on equity earned over the period by American industry in aggregate. (Watch out for our explanation if that occurs as Goethe observed, "When ideas fail, words come in very handy.")"

On the relative importance of book value:

"Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child's
education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value."

In this letter, Buffett has a fairly lengthy discussion of why the stock never splits. For me, his reasoning is summed up in this paragraph:

"Through our policies and communications - our "advertisements" - we try to attract investors who will understand our operations, attitudes and expectations. (And, fully as important, we try to dissuade those who won't.) We want those who think of themselves as business owners and invest in companies with the intention of staying a long time. And, we want those who keep their eyes focused on business results, not market prices."