Warren Buffett
1979 Shareholder Letter

There's plenty to learn fom the Warren Buffett 1979 shareholder letter originally published in that year's Berkshire Hathaway annual report. The shareholder letter is dated March 3, 1980.

These shareholder letters are an incredible educational resource for long term investors. Subjects that Buffett addresed in the 1979 letter include:

• The importance of Return on Equity (ROE) as an investing metric
• Important commentary about inflation (which could soon be very relevant to us)
• More insights on selecting the best businesses to invest in
• Discipline in the insurance industry (which really translates well to option trading)

Return on Equity - One of Buffett's Favorite Metrics

Warren Buffett spent some time in his 1977 shareholder letter discussing the importance of Return on Equity, and he returns to the subject in his 1979 letter to shareholders:

The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.

He's also pointed out in these letters that money left in an interest bearing savings account (remember those?) will produce positive yearly "earnings growth" in a similar way to how a company's earnings growth is calculated on a per share basis.

But, he keeps pointing out, that doesn't always give the most accurate picture of financial performance or whether you're better or worse off for the investment.

And that's especially true during periods of high inflation . . .

Warren Buffett on Inflation

There's a lot to be gleaned from the Warren Buffett 1979 shareholder letter on the subject of inflation. In fact, he devotes significant portions of the letter to the topic, which makes sense since inflation affected Berkshire Hathaway negatively in a couple of different ways:

#1 - Inflation and Equities - As impressive as Berkshire Hathaway ROE rates had been, Buffett was very forthright in stating that inflation could and would mitigate those returns in terms of real purchasing power:

Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives, a business earning 20% on capital can produce a negative real return for its owners under inflationary conditions not much more severe than presently prevail . . . We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.

And a little later he addes:

We intend to continue to do as well as we can in managing the internal affairs of the business. But you should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.

It's important to really think about what you want to be invested in during inflationary environments. It's unlikely that savings accounts, CDs, etc. will be able to keep up with inflation, and keeping your money in these vehicles may result in the loss of real buying power over time.

And even though Buffett warns that high inflation won't increase ROE, I still believe that equity investments in high quality, high ROE businesses will nevertheless give you the best chance for "keeping up" with inflation.

Traditionally, it's gold, oil, and other commodities that provide you the best hedge during high inflation periods since inflation is essentially a devaluation of a currency. When a currency loses value, the net effect is that the price of commodities and other "stuff" materials increases. It's not that these materials have grown more valuable - it's that the money used to purchase it has grown less valuable.

The one place you don't want to be in a period of rising inflation is long term debt . . .

#2 - Inflation and Bonds - This is where inflation really wreaks havoc on future purchasing power.

In a rising inflationary environment, interest rates increase, and on long-dated debt instruments already in existence, the market value of those securities will decrease, thus increasing their yield for new purchasers of the debt.

Inflation had become such an issue that Buffett wondered if the long bond was even valid any more:

We have severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day. Those dollars, as well as paper creations of other governments, simply may have too many structural weaknesses to appropriately serve as a unit of long term commercial reference. If so, really long bonds may turn out to be obsolete instruments and insurers who have bought those maturities of 2010 or 2020 could have major and continuing problems on their hands. We, likewise, will be unhappy with our fifteen-year bonds and will annually pay a price in terms of earning power that reflects that mistake.

Buffett had attempted to navigate this inflationary environment by buying debt with shorter maturities and adding convertible bonds to the mix, but in the end, he admitted that he underestimated the seriousness of the problem:

For the last few years our insurance companies have not been a net purchaser of any straight long-term bonds (those without conversion rights or other attributes offering profit possibilities). There have been some purchases in the straight bond area, of course, but they have been offset by sales or maturities. Even prior to this period, we never would buy thirty or forty-year bonds; instead we tried to concentrate in the straight bond area on shorter issues with sinking funds and on issues that seemed relatively undervalued because of bond market inefficiencies.

However, the mild degree of caution that we exercised was an improper response to the world unfolding about us. You do not adequately protect yourself by being half awake while others are sleeping. It was a mistake to buy fifteen-year bonds, and yet we did; we made an even more serious mistake in not selling them (at losses, if necessary) when our present views began to crystallize.

More On Buffett's Investment Selection Process

I like this quote near the end of the Warren Buffett 1979 shareholder letter:

We continue to feel very good about our insurance equity investments. Over a period of years, we expect to develop very large and growing amounts of underlying earning power attributable to our fractional ownership of these companies. In most cases they are splendid businesses, splendidly managed, purchased at highly attractive prices.

Warren Buffett certainly makes successful long term inveesting sound easy, doesn't he?

Well, maybe it really isn't that hard afrer all. He's stated it in different ways, but he's been consistent over the years when it comes to how to build wealth in the stock market. The last sentence above is more useful and contains more insight that anything you'll hear all week on a 24 hour a day financial news channel.

Buy great businesses at great prices and then own them forever (or until they stop being great businesses).

There was one other comment earlier in the letter related to the business selection process that stood out. It was back in the section where he was discussing bonds and inflation and how Berkshire had inadequately handled the inflationary environment on the fixed income portion of the balance sheet:

Harking back to our textile experience, we should have realized the futility of trying to be very clever (via sinking funds and other special type issues) in an area where the tide was running heavily against us.

The poor prospects for the textile industry was discussed in length in the Warren Buffett 1978 shareholder letter, but the simple lesson bears repeating: invest in companies with tailwinds, not headwinds.

The Relevance of the Insurance Model to Option Writing

Writing naked puts has frequently been compared to an insurance company writing insurance policies. But instead of insuring personal property or individual lives, the put writer insures a stock's share price as it were.

I write a lot of puts myself as part of my Leveraged Investing approach to acquiring shares in quality businesses at steep discounts.

I've obviously been influenced a great deal by Warren Buffett's philosophy. I knew, after all, that my own stock selection process owed a great deal to him, and the basis for Leveraged Investing is using options to acquire those great companies at great prices (synthetic value investing, you might call it).

But it wasn't until I began methodically going through Buffett's shareholder letters and writing these pages about them, that I realized just how much in common Leveraged Investing has to Berkshire Hathaway's insurance operations.

Yes, Leveraged Investing lowers your cost basis on existing, new, or future share purchases, thereby increasing your future compounded returns, but the booked premium income also serves another important function - as an additional source of investing funds.

So in light of this epiphany, it becomes very interesting to listen to Buffett discuss insurance operations (really!).

An insurance company's combined ratio is a measure of its profitability (or lack thereof). For every dollar in premiums that the company receives, how much do they pay out in claims and other operational expenses?

Technically, a company could lose money on the insurance portion of the business, but still be profitable from their investment income. A company willing to go this route would, by definition, offer consumers lower premiums than its competitors and would therefore put pressure on those competitors to do the same.

Buffett's take:

Managers decry the folly of underwriting at a loss to obtain investment income, but we believe that many will. Thus we expect that competition will create a new threshold of tolerance for underwriting losses, and that combined ratios will average higher in the future than in the past.

To some extent, the day of reckoning has been postponed because of marked reduction in the frequency of auto accidents - probably brought on in major part by changes in driving habits induced by higher gas prices. In our opinion, if the habits hadn't changed, auto insurance rates would have been very little higher and underwriting results would have been much worse. This dosage of serendipity won't last indefinitely.

And earlier, when discussing the discipline exhibited by Berkshire Hathaway insurance companies, he stated:

You will notice that earned premiums in this segment were down somewhat from those of 1978. We hear a great many insurance managers talk about being willing to reduce volume in order to underwrite profitably, but we find that very few actually do so.

Lesson: it's important to remain disciplined when writing options, to not assume too much risk when premium levels are low, and to not feel like you need to consistently book a certain amount each month (see: The Myth of Monthly Cash Flow).

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