Warren Buffett
1978 Shareholder Letter

There's a lot to learn from the Warren Buffett 1978 shareholder letter originally published in that year's Berkshire Hathaway annual report. The shareholder letter is dated March 26, 1979, and I discuss below what I consider to be the most important and insightful highlights of the letter for long term investors.

Why Buffett Loves the Insurance Company Model

In the Warren Buffett 1977 shareholder letter, Buffett refers to both the cyclical nature of the insurance business as well as its structural advantages. Despite its periodic cyclical downturns, the insurance model was instrumental in allowing Berkshire Hathaway to become what it is today.

The reason? The high free cash flow model provides two sources of income: present operations and future investment returns:

In contrast to this cautious view about near term return from operations, we are optimistic about prospects for long term return from major equity investments held by our insurance companies. We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do. In the longer run, however, we feel that many of our major equity holdings are going to be worth considerably more money than we paid, and that investment gains will add significantly to the operating returns of the insurance group.

The above quote is also consistent with Buffett's lifelong lack of interest in attempting to time the market. While 95% of the trading and investing community is obsessed with the near term trend and day to day behavior of the markets in general, Buffett's focus has always been on individual high quality companies.

And he's made no secret of his criteria of what type of businesses he'll reinvest his float, earnings, and other free cash flow into . . .

Warren Buffett's Investing Criteria

Can investing success really be as simple as the Warren Buffett 1978 shareholder letter makes it sound?

We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively.

But Buffett readily admits that critera 4 - finding high quality businesses attractively priced - is the biggest obstacle. He cites as an example the 1971 period in which "there were equities of identifiably excellent companies available - but very few at interesting prices."

But for the patient value investor, tremendous opportunities will eventually present themselves:

The past few years have been a different story for us. At the end of 1975 our insurance subsidiaries held common equities with a market value exactly equal to cost of $39.3 million. At the end of 1978 this position had been increased to equities (including a convertible preferred) with a cost of $129.1 million and a market value of $216.5 million. During the intervening three years we also had realized pre-tax gains from common equities of approximately $24.7 million. Therefore, our overall unrealized and realized pre-tax gains in equities for the three year period came to approximately $112 million. During this same interval the Dow-Jones Industrial Average declined from 852 to 805. It was a marvelous period for the value-oriented equity buyer.

The Opportunities of Common Stock

In the 1977 shareholder letter, Warren Buffett discussed the advantages he saw in acquiring shares of indivudal high quality businesses as opposed to buying the companies outright.

The primary reason is that, depending upon the stock price, it allowed Buffett the opportunity to purchase a stake in a business for a significantly discounted price compared to how much it would cost to buy the company outright at a negotiated price.

The Warren Buffett 1978 shareholder letter further addresses the topic:

We continue to find for our insurance portfolios small portions of really outstanding businesses that are available, through the auction pricing mechanism of security markets, at prices dramatically cheaper than the valuations inferior businesses command on negotiated sales.

This program of acquisition of small fractions of businesses (common stocks) at bargain prices, for which little enthusiasm exists, contrasts sharply with general corporate acquisition activity, for which much enthusiasm exists. It seems quite clear to us that either corporations are making very significant mistakes in purchasing entire businesses at prices prevailing in negotiated transactions and takeover bids, or that we eventually are going to make considerable sums of money buying small portions of such businesses at the greatly discounted valuations prevailing in the stock market.

The Case for a Concentrated Portfolio

I really like this section of the Warren Buffett 1978 shareholder letter, even though the quote I'm pulling out is fairly short.

The idea of a concentrated portfolio in today's mass media investing environment is nothing short of shocking and heretical. That's because we've been so inundated over the years with a self-serving message from the managed money industry that we must be diversified at all costs. And that cost is usually to our own portfolio.

The managed money industry provides diversification - mutual funds, index funds, ETFs, etc. - but what it doesn't provide is a very competent track record of investing returns.

Which investor do you think will generate higher returns at lower risk? The investor who invests all his or her money in only the 5 best businesses he or she can identify, or the investor who "diversifies" by investing smaller amounts in, say, 100 companies - which includes those same 5 great businesses, another 15-20 overall solid or good businesses, and the remainder, 75-80, consisting of mediocre and average businesses.

The main reason why the managed money industry has been able to brainwash us with their diversification theology is that they first brainwashed us with the cynical message that we, as individuals, are too stupid to be able to identify a great business or a good bargain.

But really, who has created more wealth for his followers over the course of a lifetime - Warren Buffett or John Bogle?

OK, with my ranting introduction out of the way, consider Buffett's take on the subject:

Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts.

I also recall a Charlie Munger (Buffett's business partner) quote at a Berkshire Hathaway annual shareholder meeting a while back: "No one ever got rich diversifying."

And that's true whether your talking about investing, starting your own business, or developing a specialized skill or competency.

To achieve any kind of success in any part of your life, you must first remove be willing to step away from the herd.

You Build More Wealth By Investing, Not Trading

The Warren Buffett 1978 shareholder letter also implies an old school value investing principle, namely that the purchase price of a stock is far more important than the selling price.

We are not concerned with whether the market quickly revalues upward securities that we believe are selling at bargain prices. In fact, we prefer just the opposite since, in most years, we expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up in stock prices to levels at which we are unwilling to continue buying.

The above really is a profound quote. And if you read it over a few times you really begin to understand two things about Buffett: that he always knew exactly what he was doing, and that it was no accident that he built such an enormous amount of wealth over the years.

It's Not Always Just About the Money

I found the section of the Warren Buffett 1978 shareholder letter related to the company's textile operations to be fascinating.

You'll recall, of course, that Berkshire Hathaway was originally a simple New England textile company. And by the time of these early letters, textiles was an industry that was clearly in decline.

Also, by this time, Buffett didn't need the textile business. He'd already successfully transitioned into the much higher cash flow insurance industry and began establishing those long term equity investments that would help grow the company into the conglomerate that it is today.

A more numbers driven and cutthroat operator would have either sold off the textile business or simply liquidated it. The writing was very clearly on the wall:

The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.

And yet Buffett resisted shuttering the declining textile business:

We hope we don't get into too many more businesses with such tough economic characteristics. But, as we have stated before: (1) our textile businesses are very important employers in their communities, (2) management has been straightforward in reporting on problems and energetic in attacking them, (3) labor has been cooperative and understanding in facing our common problems, and (4) the business should average modest cash returns relative to investment. As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital.

Buffett was hardly running a non-profit here, but the above quote seems out of place, almost naive, by today's standards.

The 4th factor - that the textile operations continue to produce positive, albeit modest, cash flow - is significant. Obviously, Buffett would refuse to continue a losing operation and destroy shareholder value, but I find Buffett's decency here to be remarkable.

Maybe I'm just too cynical, but I find it hard to imagine many corporate executives today factoring in those first 3 criteria when it comes to determining a company's operational strategy or direction.

The important takeaway here - you don't always have to be obsessed with the bottom line in order to achieve success or build wealth.

Buffett's Humor

Buffett's humor is one of the reasons he's such an effective communicator. I found a couple of quotes from the 1978 shareholder letter that made me smile.

The first is an example of his self-deprecating style:

We continue to look for ways to expand our insurance operation. But your reaction to this intent should not be unrestrained joy. Some of our expansion efforts - largely initiated by your Chairman have been lackluster, others have been expensive failures.

And the second is a humanizing and respectful look at the contributions exceptional individuals can make regardless of age:

Ben [Rosner] is now 75 and, like Gene Abegg, 81, at Illinois National and Louie Vincenti, 73, at Wesco, continues daily to bring an almost passionately proprietary attitude to the business. This group of top managers must appear to an outsider to be an overreaction on our part to an OEO bulletin on age discrimination. While unorthodox, these relationships have been exceptionally rewarding, both financially and personally. It is a real pleasure to work with managers who enjoy coming to work each morning and, once there, instinctively and unerringly think like owners. We are associated with some of the very best.

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