Part 8 in our series investigating the words of wisdom in Warren Buffett's annual letter to Berkshire Hathaway shareholders. This time we look at Buffett's assessment of the year 1984.

Buffett's take on 1984 includes the warning that Berkshire has grown to such a size that its remarkable returns can't be sustained. As usual, Buffett offers a little self-deprecation here:

"Our historical 22% rate is just that - history. To earn even 15% annually over the next decade (assuming we continue to follow our present dividend policy, about which more will be said later in this letter) we would need
profits aggregating about $3.9 billion. Accomplishing this will require a few big ideas - small ones just won't do. Charlie Munger, my partner in general management, and I do not have any such ideas at present, but our experience has been that they pop up occasionally. (How's that for a strategic plan?)"

Buffett's view on companies that repurchase outstanding stock when they feel the stock is undervalued:

"By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are entirely rational. Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer."

On the difficulty of remaining inactive when the market offers little of value to buy:

"One English statesman attributed his country's greatness in the nineteenth century to a policy of 'masterly inactivity'. This is a strategy that is far easier for historians to commend than for participants to follow."

Buffett discusses Berkshire Hathaway's insurance operations, and finds a bright side to poor industry performance:

"...our business is concentrated in lines that have experienced poorer-than-average results during the past several years, and that circumstance has begun to subdue many of our competitors and even eliminate some. With the competition shaken, we were able during the last half of
1984 to raise prices significantly in certain important lines with little loss of business.

For some years I have told you that there could be a day coming when our premier financial strength would make a real difference in the competitive position of our insurance operation. That day may have arrived. We are almost without question the strongest property/casualty insurance operation in the country, with a capital position far superior to that of well-known companies of much greater size."

Another example of Buffett's focus on the intrinsic worth of a business versus its market value comes when he discusses GEICO, whose stock had soared in the previous years. (At this point Berkshire Hathaway owned 36% of GEICO shares.):

"I warned you that over performance by the stock relative to the performance of the business obviously could not occur every year, and that in some years the stock must under perform the business. In 1984 that occurred and the carrying value of our interest in GEICO changed hardly at all, while the intrinsic business value of that interest increased substantially. Since 27% of Berkshire's net worth at the beginning of 1984 was represented by GEICO, its static market value had a significant impact upon our rate of gain for the year. We are not at all unhappy with such a result: we would far rather have the business value of GEICO increase by X during the year, while market value decreases, than have the intrinsic value increase by only 1/2 X with market value soaring. In GEICO's case, as in all of our investments, we look to business performance, not market performance. If we are correct in expectations regarding the business, the market eventually will follow along."

Another restating of Buffett's view on stock purchasing, with a dig at "academics" who might disagree:

"As you know, we buy marketable stocks for our insurance companies based upon the criteria we would apply in the purchase of an entire business. This business-valuation approach is not widespread among professional money managers and is scorned by many academics. Nevertheless, it has served its followers well (to which the academics seem to say, "Well, it may be all right in practice, but it will never work in theory.") Simply put, we feel that if we can buy small pieces of businesses with satisfactory underlying economics at a fraction of the per-share value of the entire business, something good is likely to happen to us - particularly if we own a group of such securities."

Buffett offers his view on whether companies should pay dividends and how much those dividends should be. It's a lengthy discussion--here's the most pertinent paragraph:

"For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when
appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners."

Here's a very interesting take on where Berkshire Hathaway began and where it was in 1984--all of Berkshire's original core businesses were close to worthless, but the investments made with the past profits of those companies had allowed Berkshire to adapt and thrive:

"Charlie and I then controlled and managed three companies, Berkshire Hathaway Inc., Diversified Retailing Company, Inc., and Blue Chip Stamps (all now merged into our present operation). Blue Chip paid only a small dividend, Berkshire and DRC paid nothing. If, instead, the companies had paid out their entire earnings, we almost certainly would have no earnings at all now - and perhaps no capital as well. The three companies each originally made their money from a single business: (1) textiles at Berkshire; (2) department stores at
Diversified; and (3) trading stamps at Blue Chip. These cornerstone businesses (carefully chosen, it should be noted, by your Chairman and Vice Chairman) have, respectively, (1) survived but earned almost nothing, (2) shriveled in size while incurring large losses, and (3) shrunk in sales volume to about 5% its size
at the time of our entry. (Who says "you can't lose 'em all"?) Only by committing available funds to much better businesses were we able to overcome these origins. (It's been like overcoming a misspent youth.) Clearly, diversification has served us well."

Having now dissected 8 of Buffett's letters, my most unexpected takeaway is that Buffett isn't just a great investor, he's a great businessman, which I think many people don't really get. Yes, it stands to reason that you couldn't be the type of successful investor that Buffett is without understanding a lot about how businesses are run. But Buffet is basically CEO of a massive conglomerate. While he doesn't run day-to-day operations of the businesses Berkshire owns, his letters show that he's extremely well aware of each business's strengths and weaknesses, what the future will most likely bring, and what Berkshire is going to do to remain at the top of its game in terms of return on its sizable capital.

Hey, this guy really is smart!