Warren Buffett
1980 Shareholder Letter

The Warren Buffett 1980 shareholder letter, dated February 27, 1981, includes insightful commentary on the power of retained earnings, intelligent share buybacks, inflation, and insurance operations.

The Importance of Retained Earnings

Warren Buffett begins his 1980 shareholder letter with a quick explanation of accounting rules pertaining to how companies who own, control, or otherwise invest in other companies are required to report the earnings derived from those investments.

Buffett cites three classifications of equity investments/ownership stake under GAAP accounting - more than 50% owned, 20%-50% owned, and stakes that equate to a less than 20% ownership.

It's that last designation that was of importance to Buffett because under the GAAP accounting rules, a company (like Berkshire Hathaway) who held less than a 20% ownership stake in another company was only required to report the dividends received as part of their own earnings.

The significance?

Our holdings in this third category of companies have increased dramatically in recent years as our insurance business has prospered and as securities markets have presented particularly attractive opportunities in the common stock area. The large increase in such holdings, plus the growth of earnings experienced by those partially-owned companies, has produced an unusual result; the part of "our" earnings that these companies retained last year (the part not paid to us in dividends) exceeded the total reported annual operating earnings of Berkshire Hathaway. Thus, conventional accounting only allows less than half of our earnings "iceberg" to appear above the surface, in plain view. Within the corporate world such a result is quite rare; in our case it is likely to be recurring.

It really comes down to being able to identify great investments or businesses where the use of retained earnings will have a big impact (i.e. resulting in the ability for those earnings to continue growing steadily into the future). A lot of companies retain a substantial amount of earnings, but that doesn't mean they create much value reinvesting those earnings into expansion or acquisition.

But still, by reading some of these early Warren Buffett shareholder letters, you really begin to understand the power of the Berkshire Hathaway model. Consider, for instance, that in 1980, that Berkshire's operating income was just $44.9 million (and in 1979, it was just $36 million).

Buffett didn't grow Berkshire Hathaway into the behemoth it is today simply by expanding his early core businesses. He did it by redeploying his ample free cash flow into other well run, structurally advantaged, high free cash flow businesses at attractive prices. And then he never stopped repeating the process.

This really is one of those simple but profound principles that most people miss, but if you truly "get" it, and if you're able in some way to emulate or incorporate it into your own long term investing process, then your future wealth is all but guaranteed.

Whether it's a second job, a really disciplined personal budget, a side business, or - in my case - additional option income - you really must find ways to increase your personal free cash flow if you really want to build long term investment wealth.

No disrespect to traders, but my own personal Leveraged Investing conviction is that you don't build wealth by trading alone - you build wealth by investing for the long haul and by using trading (e.g. short term low risk option trading) to acquire more and more shares (in high quality companies) at cheaper and cheaper prices.

Warren Buffett on Share Buybacks

Continuing on the topic of retained earnings, Buffett next discusses share repurchases as one way for a business to effectively deploy its retained earnings. In fact, he seems a big proponent of the practice:

One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price? The competitive nature of corporate acquisition activity almost guarantees the payment of a full - frequently more than full - price when a company buys the entire ownership of another enterprise. But the auction nature of security markets often allows finely-run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise.

I initially found Buffett's enthusiasm for share buybacks to be a little surprising. To put it diplomatically, I haven't come across a lot of evidence suggesting that the practice of a company buying back its own shares actually creates shareholder value. In fact, it more often than not destroys shareholder value.

That's because the practice is often used to achieve a couple of dubious goals (as opposed to Buffett's value-oriented ideal):

• First, share repurchases are a pretty standard way for certain companies that (over)compensate their executives with a lot of stock or stock options to mask the share dilution associated with those executive-generous, shareholder-hostile policies.
• Second, and probably more egregious, is that buybacks are often used to artificially bolster the share price or as an investor relations gimmick to signal corporate insider confidence in the near term future of the company.

But you'll often find that corporate share repurchases are highest near market peaks and are scaled way back near market bottoms - the absolute opposite of how buybacks should be implemented.

That's certainly not the reality that Buffett envisions in his 1980 shareholder letter. I think it's important to understand the theoretical - albeit significant - benefits that share buybacks can have when used with a sense of discipline and responsibility for creating long term shareholder value.

If you can find companies that are run by value-oriented managers with an eye to the long term - and like Buffett they are out there, although perhaps not in any great number - then having your portion of that company's retained earnings be used to reduce the overall number of outstanding shares can have a very real material impact on your long term personal wealth.

Or as Buffett adds a little later:

But when purchase prices are sensible, some long-term market recognition of the accumulation of retained earnings almost certainly will occur.

Otherwise beware.

Warren Buffett on Inflation . . . Again

The previous year's Warren Buffett 1979 shareholder letter addressed inflation, especially in terms of how high inflation impacted both bonds and equities (and therefore, indirectly, Berkshire Hathaway).

1980 was another year of high inflation and Buffett cites a simple but specific analogy to illustrate the insidious nature of high inflation:

Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won't eat richer.

This is scary stuff, and not something that we in the western world have had to worry about much for the last 30 or so years. But we now find ourselves in a world overrun with debt and struggling to deal with it.

The reality is that there are only two ways that governments can deal with massive debt loads - either outright default or devaluation of one's currency and inflating their way out of the mess.

As I write this - December 2011 - that hasn't happened in the U.S. yet, and I'm not making specific inflationary or time specific predictions, but it does seem - despite the perpetual low interest rate environment we've had for the last several years - that there is a significant risk that we eventually experience a return of a potentially high inflationary environment.

I hope I'm wrong. But, like I said, this is scary stuff, and I'm going to take the liberty here of reprinting an extended quote from the Warren Buffett 1980 shareholder letter that describes the reality of a high inflation environment with great clarity:

Explicit income taxes alone, unaccompanied by any implicit inflation tax, never can turn a positive corporate return into a negative owner return. (Even if there were 90% personal income tax rates on both dividends and capital gains, some real income would be left for the owner at a zero inflation rate.) But the inflation tax is not limited by reported income. Inflation rates not far from those recently experienced can turn the level of positive returns achieved by a majority of corporations into negative returns for all owners, including those not required to pay explicit taxes. (For example, if inflation reached 16%, owners of the 60% plus of corporate America earning less than this rate of return would be realizing a negative real return - even if income taxes on dividends and capital gains were eliminated.)

Of course, the two forms of taxation co-exist and interact since explicit taxes are levied on nominal, not real, income. Thus you pay income taxes on what would be deficits if returns to stockholders were measured in constant dollars.

At present inflation rates, we believe individual owners in medium or high tax brackets (as distinguished from tax-free entities such as pension funds, eleemosynary institutions, etc.) should expect no real long-term return from the average American corporation, even though these individuals reinvest the entire after-tax proceeds from all dividends they receive. The average return on equity of corporations is fully offset by the combination of the implicit tax on capital levied by inflation and the explicit taxes levied both on dividends and gains in value produced by retained earnings.

As we said last year, Berkshire has no corporate solution to the problem. (We'll say it again next year, too.) Inflation does not improve our return on equity.

More on Insurance Operations (and Continued Relevance to Option Trading)

I'm particularly interested in Buffett's commentary on the operations of the insurance portion of Berkshire Hathaway because it really was insurance that was the initial fuel for Berkshire's growth.

But I'm even more intrigued for another reason - because I see a very real parallel between the early Berkshire Hathaway model and my own customized option-oriented investment approach that I call Leveraged Investing.

(In my page on the 1979 shareholder letter, I explore the relevance of the insurance model to option writing.)

In the 1979 shareholder letter, Buffett discusses the short-sighted practice by a lot of insurers who were willing to take losses on policies in the expectation (hope?) that they could still maintain overall profitability via investment income (the income generated from investing the float).

As Buffett expected, the industry's eagerness to compete on price hurt everyone in the industry, which he details in the 1980 shareholder letter:

The insurance industry's underwriting picture continues to unfold about as we anticipated, with the combined ratio . . . rising from 100.6 in 1979 to an estimated 103.5 in 1980. It is virtually certain that this trend will continue and that industry underwriting losses will mount, significantly and progressively, in 1981 and 1982.

Now, in the 1980 letter to Berkshire Hathaway investors, Buffett spells out another troubling threat to the insurance industry, again caused by short-sightedness and a refusal to be completely honest and transparent.

In this case, it had to do with plummeting bond prices. Remember, there is an inverse relationship between price and yield, and that in a high inflation and rising interest rate environment, yields on bonds and other debt instruments will also rise . . . by dropping in price.

This problem arises from the decline in bond prices and the insurance accounting convention that allows companies to carry bonds at amortized cost, regardless of market value. Many insurers own long-term bonds that, at amortized cost, amount to two to three times net worth. If the level is three times, of course, a one-third shrink from cost in bond prices - if it were to be recognized on the books - would wipe out net worth. And shrink they have. Some of the largest and best known property-casualty companies currently find themselves with nominal, or even negative, net worth when bond holdings are valued at market.

Again, a lot of it comes from short-sightedness and the unwillingness to take your medicine:

Under such circumstances, a great many investment options disappear, perhaps for decades. For example, when large underwriting losses are in prospect, it may make excellent business logic for some insurers to shift from tax-exempt bonds into taxable bonds. Unwillingness to recognize major bond losses may be the sole factor that prevents such a sensible move.

But it gets worse:

But the full implications flowing from massive unrealized bond losses are far more serious than just the immobilization of investment intellect. For the source of funds to purchase and hold those bonds is a pool of money derived from policyholders and claimants (with changing faces) - money which, in effect, is temporarily on deposit with the insurer. As long as this pool retains its size, no bonds must be sold. If the pool of funds shrinks - which it will if the volume of business declines significantly - assets must be sold to pay off the liabilities. And if those assets consist of bonds with big unrealized losses, such losses will rapidly become realized, decimating net worth in the process.

Buffett then goes on to layout the dilemma. An insurance company has two options, the first being for the company "to tell the underwriters to keep pricing according to the exposure involved - be sure to get a dollar of premium for every dollar of expense cost plus expectable loss cost."

But the problem there is that with the overall industry already operating with combined ratios in excess of 100 (i.e. eventually losing money on their own underwriting), then any company holding the line on premium pricing is going to lose business.

And once business begins shrinking, assets must be sold (remember the insurance model of collecting and investing premium prior to eventually paying out claims). So which assets would an insurance company sell? The bad ones that, if sold, would begin to reveal the true net worth picture of a company, or the good ones which, although it would continue to mask the deteriorating net worth condition of the company, even as those sales would continue to worsen the true financial health of the company?

Buffett then spells out the second option:

The second option is much simpler: just keep writing business regardless of rate levels and whopping prospective underwriting losses, thereby maintaining the present levels of premiums, assets and liabilities - and then pray for a better day, either for underwriting or for bond prices. There is much criticism in the trade press of "cash flow" underwriting; i.e., writing business regardless of prospective underwriting losses in order to obtain funds to invest at current high interest rates. This second option might properly be termed "asset maintenance" underwriting - the acceptance of terrible business just to keep the assets you now have.

Of course you know which option will be selected. And it also is clear that as long as many large insurers feel compelled to choose that second option, there will be no better day for underwriting. For if much of the industry feels it must maintain premium volume levels regardless of price adequacy, all insurers will have to come close to meeting those prices. Right behind having financial problems yourself, the next worst plight is to have a large group of competitors with financial problems that they can defer by a "sell-at-any-price" policy.

Warren Buffett's Best Quote from the 1980 Shareholder Letter

Finally, I found this quote in the 1980 shareholder letter from Buffett the most amusing (and no doubt pretty accurate as well):

We believe that short-term forecasts of stock or bond prices are useless. The forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.

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