Warren Buffett
1981 Shareholder Letter

Highlights and Review - Berkshire Hathaway 1981 Annual Report

The Warren Buffett 1981 shareholder letter, dated February 26, 1982, covers a lot of ground. There are discussions regarding the different ramifications of outright acquisitions of other businesses vs partial, non-controlling ownership of other businesses via stock purchases. Additionally, there's an entertaining metaphor involving toads and princesses, a summary of the Berkshire Hathaway corporate acquisition philosophy, some important comments on inflation, and relevant commentary on the insurance business.

Controlled Ownership vs.
Non-Controlled Ownership

Warren Buffett spends a big part of his 1981 shareholder letter to Berkshire Hathaway investors discussing the differences between the businesses Berkshire owned and operated outright, and those in which the company was a partial, non-controlling owner (via stock ownership in those businesses).

The ramifications of these two different kinds of ownership models are significant. And in some ways, Buffett's lengthy discussion in the 1981 shareholder letter can be seen as a continuation of his conversation on what I termed The Importance of Retained Earnings in the 1980 Berkshire shareholder letter.

Part of the explanation of Buffett's success, I contend, is that he's not an either-or kind of thinker. In this particular case, for example, he recognized that there's value in both models, and he shrewdly understood that the models could be most effective by having them complement one another and work together.

Or as he stated in the 1981 shareholder letter:

As our history indicates, we are comfortable both with total ownership of businesses and with marketable securities representing small portions of businesses. We continually look for ways to employ large sums in each area.

But why exactly is that?

To really appreciate the answer to that question, you have to take a step back and look at the specific advantages of each model:

If you own a business outright and operate it as a subsidiary, then you control all the profits and cash flow. As a result you have significantly more funds to allocate toward other investment opportunities.

But . . . acquiring full control of a business almost always requires that you pay a premium to the current share price or valuation. In short, it's next to impossible to buy a company outright and get it for a steal.

In contrast, acquiring significant but still partial (and non-controlling) ownership of a company via share purchases can result in ownership stakes at dramatically cheaper valuations then would ever be possible with a full acquisition.

But the drawback here is that the only cash flow attributable to you from those partial share-oriented ownership stakes is limited to the income received from dividends.

Or in Buffett's words:

In aggregate, our non-controlled business interests have more favorable underlying economic characteristics than our controlled businesses. That's understandable; the area of choice has been far wider. Small portions of exceptionally good businesses are usually available in the securities markets at reasonable prices. But such businesses are available for purchase in their entirety only rarely, and then almost always at high prices.

The Oracle of Omaha on Toads and Princesses

The related section of the Warren Buffett 1981 shareholder letter on toads and princesses is an entertaining read. But it's also a great illustration of the discipline behind Berkshire's history of acquisitions.

Considering the lack of shareholder value that much of M&A (merger and acquisition) produces for the shareholders of the acquiring company, Berkshire Hathaway's acquisition track record has been impressive.

Buffett's willingness - even preference at times - to forgo acquisition and buy a partial interest in a company (via share purchases) rather than acquiring companies in their entirety, has, in hindsight, proven to be pretty smart.

Here's Buffett's reasoning:

Our acquisition decisions will be aimed at maximizing real economic benefits, not at maximizing either managerial domain or reported numbers for accounting purposes.(In the long run, managements stressing accounting appearance over economic substance usually achieve little of either.)
Regardless of the impact upon immediately reportable earnings, we would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share. Most corporate managers prefer just the reverse, and have no shortage of stated rationales for their behavior.

Buffett then goes on to suggest three possible motivations for what he calls "high-premium takeovers:"

The simple excitement and challenge of doing a big deal
The status of size - sales and market cap over profitability and return on equity
And my favorite explanation of the three - "Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad's body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T(arget)."

Buffett continues with the metaphor:

Such optimism is essential. Absent that rosy view, why else should the shareholders of Company A(cquisitor) want to own an interest in T at the 2X takeover cost rather than at the X market price they would pay if they made direct purchases on their own?
In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite. We've observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses - even after their corporate backyards are knee-deep in unresponsive toads.

Warren Buffett's Acquisition Philosophy

In light of the above pragmatic (cynical?) view of corporate M&A, how did Buffett rate Berkshire Hathaway's acquisition results at the time? With characteristic self-deprecating humor, he sizes himself up:

We have tried occasionally to buy toads at bargain prices with results that have been chronicled in past reports. Clearly our kisses fell flat. We have done well with a couple of princes - but they were princes when purchased. At least our kisses didn't turn them into toads. And, finally, we have occasionally been quite successful in purchasing fractional interests in easily-identifiable princes at toad-like prices.

Finally, Buffett succinctly sums up the Berkshire Hathaway acquisition philosophy and strategy:

We will continue to seek the acquisition of businesses in their entirety at prices that will make sense, even should the future of the acquired enterprise develop much along the lines of its past. We may very well pay a fairly fancy price for a Category 1 business if we are reasonably confident of what we are getting. But we will not normally pay a lot in any purchase for what we are supposed to bring to the party - for we find that we ordinarily don't bring a lot.

Warren Buffett on Inflation . . . Yet Again

As with previous shareholder letters (e.g. the Warren Buffett 1979 shareholder letter and the Warren Buffettet 1980 shareholder letter), Buffett here seems almost obligated to spend a significant portion of his 1981 shareholder letter discussing inflation.

It's true that inflationary pressures in the United States were finally just beginning to subside (Buffett even gives a shout out to then Fed Chairman Paul Volcker for his efforts to slow inflation), but at the time of this letter, inflation was still a major problem.

Or as Buffett describes the inflationary situation: "Nevertheless, our views regarding long-term inflationary trends are as negative as ever. Like virginity, a stable price level seems capable of maintenance, but not of restoration."

Buffett then makes a couple of important points.

The first point is essentially that unless a company's return on equity significantly outpaces inflation, an investment in that company actually destroys value rather than creates it.

In fact, compared to the then recent astronomical 14% rate on long term tax exempt bonds, it was very difficult for most U.S. corporations to compete with that:

And most American businesses are currently "bad" businesses economically - producing less for their individual investors after-tax than the tax-exempt passive rate of return on money. Of course, some high-return businesses still remain attractive, even under present conditions. But American equity capital, in aggregate, produces no value-added for individual investors.
It should be stressed that this depressing situation does not occur because corporations are jumping, economically, less high than previously. In fact, they are jumping somewhat higher: return on equity has improved a few points in the past decade. But the crossbar of passive return has been elevated much faster. Unhappily, most companies can do little but hope that the bar will be lowered significantly; there are few industries in which the prospects seem bright for substantial gains in return on equity.

Buffett's second point is a little more complicated but just as impactful.

It's a longer passage but worth the read:

A further, particularly ironic, punishment is inflicted by an inflationary environment upon the owners of the "bad" business. To continue operating in its present mode, such a low-return business usually must retain much of its earnings - no matter what penalty such a policy produces for shareholders.
Reason, of course, would prescribe just the opposite policy. An individual, stuck with a 5% bond with many years to run before maturity, does not take the coupons from that bond and pay one hundred cents on the dollar for more 5% bonds while similar bonds are available at, say, forty cents on the dollar. Instead, he takes those coupons from his low-return bond and - if inclined to reinvest - looks for the highest return with safety currently available. Good money is not thrown after bad.
What makes sense for the bondholder makes sense for the shareholder. Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas. (The Scriptures concur. In the parable of the talents, the two high-earning servants are rewarded with 100% retention of earnings and encouraged to expand their operations. However, the non-earning third servant is not only chastised - "wicked and slothful" - but also is required to redirect all of his capital to the top performer. Matthew 25:14-30)
But inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the "bad" business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past - and most entities, including businesses, do - it simply has no choice.
For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.
Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or "real" dividends. The tapeworm of inflation simply cleans the plate. (The low-return company's inability to pay dividends, understandably, is often disguised. Corporate America increasingly is turning to dividend reinvestment plans, sometimes even embodying a discount arrangement that all but forces shareholders to reinvest. Other companies sell newly issued shares to Peter in order to pay dividends to Paul. Beware of "dividends" that can be paid out only if someone promises to replace the capital distributed.)

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

I also included this section last time around in the Warren Buffett 1980 Berkshire shareholder letter page because I'm always fascinated by Buffett's commentary on Berkshire Hathaway's insurance operations.

I can't help but find a parallel between those insurance operations and the Leveraged Investing approach (aka value investing with options) that I advocate on this site.

In many ways, I find that the individual value-oriented investor and options trader who emulates Buffett's model actually has some significant structural advantages over Buffett (a topic for another day and page)

I find that during this period, Warren Buffett frequently bemoans the state of the property-casualty insurance industry, especially regarding the pricing of policies.

In this 1981 shareholder letter, Buffett summarizes the state of affairs:

In the 1980 annual report we discussed the investment policies that have destroyed the integrity of many insurers' balance sheets, forcing them to abandon underwriting discipline and write business at any price in order to avoid negative cash flow. It was clear that insurers with large holdings of bonds valued, for accounting purposes, at nonsensically high prices would have little choice but to keep the money revolving by selling large numbers of policies at nonsensically low prices. Such insurers necessarily fear a major decrease in volume more than they fear a major underwriting loss.
But, unfortunately, all insurers are affected; it's difficult to price much differently than your most threatened competitor. This pressure continues unabated and adds a new motivation to the others that drive many insurance managers to push for business; worship of size over profitability, and the fear that market share surrendered never can be regained.

Warren Buffett's Best Quote from the 1981 Shareholder Letter

Finally, one of the notable quotes in the Warren Buffett 1981 shareholder letter, in reference to Buffett's "forecast" and recognition of the need to acquire full or partial ownership in "businesses that are particularly well adapted to an inflationary environment," Buffett quips: