LESSONS FROM THE GREAT WARREN E. BUFFET

Lessons from the master - I

 For the practitioners of value investing, the one name that probably comes above all else is 'Warren E Buffett', the legendary value investor who arguably played the biggest part in executing the teachings of masters like Graham and Philip Fisher in the real world and making an extraordinary success story out of it. While it is true that he has learnt a lot from the master we have just mentioned, his own larder of investment wisdom is anything but empty. And fortunately for us, over the past many years he has been dishing it out in the form of letters that he religiously writes to the shareholders of Berkshire Hathaway year after year. Many people reckon that careful analyses of these letters itself can make people a lot better investors and are believed to be one of the best sources of investment wisdom.

Hence, starting from today, we will make an attempt to highlight and explain certain key points with respect to investing in each of his letters and in the process try and become a better investor. Laid out below are few points from the master's 1977 letter to shareholders:

"Most companies define "record" earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding. Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital."

What Buffett intends to say here is the fact that while investors are enamored with a company that is growing its earnings at a robust pace, he is not a big fan of the management if the growth in earnings is a result of even faster growth in capital that the business has employed. In other words, the management is not doing a good job or the fundamentals of the business are not good enough if there is an improving earnings profile but a deteriorating ROE. This could happen due to rising competition eroding the margins of the company or could also be a result of some technology that is getting obsolete so fast that the management is forced to replace fixed assets, which needless to say, requires capital investments.

"It is comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved. In a sense, this is the opposite case from our textile business where even very good management probably can average only modest results. One of the lessons your management has learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds."

The above quote is a consequence of repeated failures by Buffett to try and successfully turnaround an ailing business of textiles called the Berkshire Hathaway, which eventually went on to become the holding company and has now acquired a great reputation. Indeed, no matter how good the management, if the fundamentals of the business are not good enough or in other words headwinds are blowing in the industry, then the business eventually fails or turns out to be a moderate performer. On the other hand, even a mediocre management can shepherd a business to high levels of profitability if the tailwinds are blowing in its favour.

If one were to apply the above principles in the Indian context, then the two contrasting industries that immediately come to mind are cement and the IT and the pharma sector. Despite being stalwarts in the industry, companies like ACC and Grasim, failed to grow at an extremely robust pace during the downturn that the industry faced between FY01 and FY05. But now, almost the same management are laughing all the way to the banks, thanks to a much improved pricing scenario. Infact, even small companies in the sector have become extremely profitable. On the other hand, such was the demand for low cost skilled labor, that many success stories have been spawned in the IT and the pharma sector, despite the fact that a lot of companies had management with little experience to run the business.

It is thus amazing, that although the letter has been written way back in 1977, the principles have stood the test of times and are still applicable in today's environment. We will come out with more investing wisdom in the forthcoming weeks.

 Lessons from the master - II

Last week, we had started a series on the study of annual letters that legendary investor Warren Buffett wrote every year to the shareholders of his investment vehicle, Berkshire Hathaway. We discussed some key points in the letter for the year 1977 in the previous write up. In this write up, let us see what the master has to say to his shareholders in the 1978 letter:

"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. We hope we don't get into too many more businesses with such tough economic characteristics."

The above paragraph once again highlights the fact that no matter how good the management, if the economic characteristic of the business is tough, then the business will continue to earn inadequate returns on capital. This can be further gauged from the fact that despite all the capital allocation skills at his disposal, the master was not able to turnaround the ailing textile business that he had acquired in the early years of his investing career. He further adds that such businesses have little product differentiation and in cases where the supply exceeds production, producers are content recovering their operating costs rather than capital employed.

While the comment is reserved for the textile industry, we believe it can be extended to all commodities like cement, steel and sugar. Infact, the current downturn the sugar industry is facing has a lot to do with supply far exceeding demand and this in turn is having a great impact on returns on capital employed by these businesses. The only hope for them is a scenario where demand will exceed supply.

"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. We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire's insurance subsidiaries amounted to only US$ 10.7 m at cost and US$ 11.7 m at market. There were equities of identifiably excellent companies available - but very few at interesting prices."

Those of you, who are regular readers of content on our website, the above paragraph must have rang a bell or two. Indeed, time and again, in countless articles, we have been highlighting the importance of investing in good quality businesses run by honest and ethical management. That the master himself has been looking at similar qualities does go a long way in further reinforcing our beliefs. Buffett then goes on to make a very important comment on valuations and says that no matter how good the businesses are, there is a price to pay for it and he in his investing career has let many investing opportunities pass by because the valuations were just not right enough.

Comparison can be drawn to the tech mania in India in the late nineties when good companies with excellent management like Infosys and Wipro were available at astronomical valuations. While these companies had excellent growth prospects, investors had become far too optimistic and had bid them too high. Thus, investors who would have bought into these stocks at those levels would have had to wait for five long years just to break even! Hence, no matter how good the stock is, please ensure that you do not pay too high a price for it.

Lessons from the master – III

Last week, we discussed how Warren Buffett in his 1978 letter to his shareholders places a great deal of importance on the quality of business and also the fact that he had to let go of many attractive investment opportunities just because the price was not right. In the following write up, let us see what the master has to offer in terms of investment wisdom in his 1979 letter:

"The inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) - can be thought of as an "investor's misery index". When this index exceeds the rate of return earned on equity by the business, the investor's purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity."

The above paragraph clearly demonstrates that in order to improve one's purchasing power, one will have to earn after tax returns that are higher than the inflation rate at all times. Imagine a scenario where the inflation rate touches 9%, which means that a commodity that you purchased at Rs 100 per unit last year will now cost you Rs 109. Further, assume that you put Rs 100 last year in a business that earns 10% return on equity and the tax rate that currently prevails is 20%.

Thus, while you earned Rs 10 by virtue of the 10% return on equity, the tax rate ensured that only Rs 8 has flown to your pocket. Not a good situation since your purchasing power has diminished as while your returns were only 8% post tax, you will have to shell out Re 1 extra for buying the commodity as inflation has remained higher than the after tax returns that you have earned. Further, high inflation does not help the business too unless it has some inherent competitive advantages, which enables it to pass on the hike in inflation to the end consumers. Little wonder, investors lay such high emphasis on businesses that earn returns way above inflation so that the purchasing power is enhanced rather than diminished.

"Both our operating and investment experience cause us to conclude that "turnarounds" seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price."

In the above paragraph, the master once again extols the virtues of a good quality business and says that he would rather pay a reasonable price for a good quality business than pay a bargain price for a poor business. It would be worthwhile to add that in the early part of his investing career, the master himself was a stock picker who used to rely only on quantitative cheapness rather than qualitative cheapness. However, somewhere down the line, he started gravitating towards good quality businesses and out of this thinking came such quality investments as 'Coca Cola' and 'American Express'. These were the companies that had virtually indestructible brands (a very good competitive advantage to have), generated superior returns on their capital and had ability to grow well into the future.

We prod you to find similar businesses in the Indian context, pick them up at a reasonable price and hold them for as long as you can. For if the master has made millions out of it, we don't see any reason as to why you can't.

Lessons from the master – IV

Last week, we touched upon the key points in Warren Buffett's 1979 letter to his shareholders. This week, let us see what the master has to offer in his 1980 letter to the shareholders of Berkshire Hathaway:

"The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage."

The maestro made the above statements because in those days he felt that the prevailing accounting convention/standards were not in sync with a value based investment approach (Infact, they still aren't). In the paragraphs preceding the one mentioned above, he painstakingly explains that while accounting convention requires that a partial ownership (ownership of say 20%) in a business be reflected on the owner's books by way of dividend payments, in reality, they are worth much more to the owner and their true value is determined by the 20% of the intrinsic value of the company and not by 20% of the dividends that are reflected on its books. In the Indian context, imagine someone valuing a company like say M&M -if it had say a 20% stake in Tech Mahindra- based on the 20% of dividends that the latter pays out to M&M. This will be a rather incorrect way of valuing M&M, which in effect should be valued taking into account 20% of the intrinsic value of Tech Mahindra and not the dividends.

"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."

Buffett, as most of us might know, is a strong advocate of buyback, especially at a time when the stock is trading significantly lower than its intrinsic value and the above paragraph is just a testimony to this principle of his. Indeed, when stock prices are low, what better way to utilize capital than to enhance ownership in the company by way of buy back. The master further goes on to add that one can buy a portion of a business at a much lower price, provided there is auction happening. In other words, when there is a panic in the market and everyone is offloading shares, the chances of getting an attractive price is much higher. On the other hand, when there is a competition between two or more companies for buying another enterprise, the competitive forces will more likely than not keep the acquisition price higher, in most cases, higher than even the intrinsic value of the company.

For discussion on the previous letters, please refer to the link below:

Lessons from the master - V...

Last week, we got to know the master's views on non-controlled ownership earnings and corporate acquisitions through his 1980 letter to shareholders. In the following write-up, let us see what he had to offer in his 1981 letter.

"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."

By making the above statements, Buffett is trying to highlight the difference between acquisition rationale for Berkshire Hathaway and most of the other corporate managers. While for the latter group of people, the motivation behind high premium acquisitions could range from reasons like penchant for adventure, misplaced compensations and a fair degree of overconfidence in their managerial skills, for Berkshire Hathaway, the maximisation of real economic benefits is the sole aim behind acquisitions.

Infact, the company is even happy to deploy large sums where there is a high probability of long-term economic benefits but an absence of ownership control. In other words, the company is comfortable both with total ownership of businesses and with marketable securities representing small ownership of businesses.

The paragraphs that follow bring to the fore some of the biggest qualities of the man and what makes him an extraordinary investor. Warren Buffett has a knack of knowing his circle of competence better than most and also a rather unmatched ability to learn from past mistakes. These could be gauged from the following comment:

"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."

In the above paragraph, the master uses a childhood analogy and likens managers to princesses who kiss toads (ordinary businesses) to convert them into princes (attractive businesses). Put differently, there are certain managers who believe that their managerial kiss will do wonders for the profitability of a company and convert them from toads to princes. While the master has gone on to add that there are indeed certain managers that can achieve this feat, his own track record is nothing to write home about and hence, he would rather prefer buying 'easily-identifiable princes at toad-like prices'.

Although the opportunities for finding these types of companies are very rare, the master is willing to commit a large sum once such opportunities surface. According to him, such businesses must have two favored characteristics:

1.       An ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilised) without fear of significant loss of either market share or unit volume, and

2.       An ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Indeed, an ability to preserve margins and generate attractive return on capital year after year are the qualities that one should seek in a firm that one wants to invest in.

Lessons from the master – VI

While the world of stocks seems to be tearing apart on US subprime woes, what could be better than to indulge in some thought provoking lessons that can help you, as an investor, in staying calm in such situations of panic. In a previous write-up, we saw Buffett (the 'master') talk about his policies for making acquisitions and how managers tend to overestimate themselves. In this write-up let us see what the investing genius had to offer in his 1982 letter to shareholders.

In what was probably a bull market, Berkshire Hathaway, the master's investment vehicle faced a peculiar problem. By that time, the company had acquired meaningful stakes in a lot of other companies but not meaningful enough for these companies' earnings to be consolidated with that of Berkshire Hathaway's. This is because accounting conventions then allowed only for dividends to be recorded in the earnings statement of the acquiring company if it acquired a stake of less than 20%. This obviously did not go down well with the master as earnings of Berkshire in the 'accounting sense' depended upon the percentage of earnings that were distributed by these companies as dividends.

"We prefer a concept of 'economic' earnings that includes all undistributed earnings, regardless of ownership percentage. In our view, the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used - and not by the size of one's ownership percentage."

As for some examples in the Indian context, companies like M&M and Tata Chemicals, which hold small stakes in many companies should not be valued based on what dividends these companies pay to M&M and Tata Chemicals but instead one should arrive at the fair value of these companies independently and that value should be attributed on a pro-rata basis to all the shareholders, whether minority or majority.

While the master tackled accounting related issues in the first few portions of the 1982 letter, the next few portions were once again devoted to the excesses that take place in the market time and again. This is what he had to say on corporate acquisitions and price discipline.

"As we look at the major acquisitions that others made during 1982, our reaction is not envy, but relief that we were non-participants. For in many of these acquisitions, managerial intellect wilted in competition with managerial adrenaline. The thrill of the chase blinded the pursuers to the consequences of the catch. Pascal's observation seems apt: 'It has struck me that all men's misfortunes spring from the single cause that they are unable to stay quietly in one room.'"

He further goes on to state, "The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments."

The above comments once again bring to the fore a strict discipline that the master employs when it comes to paying an appropriate price. Infact, as much as his success is built on finding some very good picks like Coca Cola and Gillette, he has never had to sustain huge losses on any of his investment. The math is simple, if you lose say 50% on an investment, to make good these losses, one will have to unearth a stock that will have to rise atleast 100% and that too in quick time. A very difficult task indeed! No wonder the master pays so much attention to maintaining a strict price discipline.

Lessons from the master – VII

While corporate excesses and the concept of economic earnings, different from accounting earnings remained the focal points in the master's 1982 letter to shareholders, let us see what he has to offer in his 1983 letter.

In this another enlightening letter, Warren Buffett, probably for the first time discussed at length the concept of 'goodwill' and believed it to be of great importance in understanding businesses. Further, he blames the discrepancies between the 'actual intrinsic value' and the 'accounting book value' of Berkshire Hathaway to have arisen because of the concept of 'goodwill'. This is what he has to say on the subject.

"You can live a full and rewarding life without ever thinking about goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission."

From the above quote, it is clear that the master's investment philosophy had undergone a sea change from when he first started investing. Further, with his company becoming too big, he could no longer afford to churn his portfolio as frequently as before. In other words, he wanted businesses where he could invest for the long haul and what better investments here than companies, where the economic goodwill is huge. The master had been kind enough in explaining this concept at length through an appendix laid out at the end of the letter. Since we feel that we couldn't have explained it better than the master himself, we have reproduced the relevant extracts below verbatim.

"True economic goodwill tends to rise in nominal value proportionally with inflation. To illustrate how this works, let's contrast a See's kind of business with a more mundane business. When we purchased See's in 1972, it will be recalled, it was earning about US$ 2 m on US$ 8 m of net tangible assets (book value). Let us assume that our hypothetical mundane business then had US$ 2 m of earnings also, but needed US$ 18 m in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic goodwill.

A business like that, therefore, might well have sold for the value of its net tangible assets, or for US$ 18 m. In contrast, we paid US$ 25 m for See's, even though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have been more, as our purchase price implied? The answer is "yes" - even if both businesses were expected to have flat unit volume - as long as you anticipated, as we did in 1972, a world of continuous inflation.

To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.

But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.

Remember, however, that See's had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large - a need for $18 million of additional capital.

After the dust had settled, the mundane business, now earning $4 m annually, might still be worth the value of its tangible assets, or US $36 m. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)

See's, however, also earning US$ 4 m, might be worth US$ 50 m if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained US$ 25 m in nominal value while the owners were putting up only US$ 8 m in additional capital - over US$ 3 of nominal value gained for each US$ 1 invested.

Remember, even so, that the owners of the See's kind of business were forced by inflation to ante up US$ 8 m in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom - long on tradition, short on wisdom - held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets. It doesn't work that way. Asset-heavy businesses generally earn low rates of return - rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment - yet its franchises have endured. During inflation, goodwill is the gift that keeps giving.

But that statement applies, naturally, only to true economic goodwill. Spurious accounting goodwill - and there is plenty of it around - is another matter. When an overexcited management purchases a business at a silly price, the same accounting niceties described earlier are observed. Because it can't go anywhere else, the silliness ends up in the goodwill account. Considering the lack of managerial discipline that created the account, under such circumstances it might better be labeled 'No-Will'. Whatever the term, the 40-year ritual typically is observed and the adrenalin so capitalized remains on the books as an 'asset' just as if the acquisition had been a sensible one."

Lessons from the master – VIII

Last week we saw Warren Buffett put forth his views on the concept of 'economic goodwill' and why he prefers companies that have a high amount of the same. Let us now see what the master has to offer in terms of investment wisdom in his 1984 letter to the shareholders.

While Buffett has devoted a lot of space in his 84' letter to discussing in detail, some of Berkshire's biggest investments in those times, but as usual, the letter is not short on some general investment related counsel either. In a rather simplistic way that only he can, the master gives his opinion on a couple of extremely important topics like 'investments in bonds' and 'corporate dividend policies'. On the former, he has to say the following:

"Our approach to bond investment - treating it as an unusual sort of "business" with special advantages and disadvantages - may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman's perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a "business" that earned about 1% on "book value" (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business."

Berkshire Hathaway in 1984 had purchased huge quantities of bonds in a troubled company, where the yields had gone upto as much as 16%. While usually not a huge fan of long term bond investments, the master chose to invest in the troubled company because he felt that the risk was rather limited and not many businesses during those times gave as much return on the invested capital. Thus, despite the rather limited upside potential, he went ahead with his bond investments. This is further made clear in his following comment:

"This ceiling on upside potential is an important minus. It should be realized, however, that the great majority of operating businesses have a limited upside potential also unless more capital is continuously invested in them. That is so because most businesses are unable to significantly improve their average returns on equity - even under inflationary conditions, though these were once thought to automatically raise returns."

Years and years of studying companies had led the master to conclude that there are very few companies on the face of this earth that are able to continuously earn above average returns without consuming too much of capital. Indeed, such brutal are the competitive forces that sooner or later and in this case, more sooner than later that returns for majority of the companies tend to gravitate towards their cost of capital. If we do a similar study on our Sensex, we will too come to the conclusion that there are not many companies that were a part of the index 15 years back and are still a part of the same index. Hence, while valuing companies, having a fair judgement of when the competitive position of the company, the one that enables it to consistently earn above average returns is likely to deteriorate. This will help you to avoid paying too much for the company's future growth.

After touching upon the topic of bond investments, the master then gives his take on dividends and this is what he has to say:

"The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings "restricted" - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused."

While the master is definitely in favour of dividend payments, he is also aware of the fact that not all companies have similar capital needs in order to maintain their ongoing level of operations. Hence, in cases where businesses have high capital needs, a high payout ratio is likely to result in deterioration of the business or sooner or later will require additional capital to be infused. On the other hand, companies that have limited capital needs should distribute the remaining earnings as dividends and not pursue investments which drive down the overall returns of the underlying business. In a nutshell, capital should go where it can be put to earn maximum rate of return.

He then goes on to add how his own textile company, Berkshire Hathaway, had huge ongoing capital needs and hence was unable to pay dividends. He also further adds that had Berkshire Hathaway distributed all its earnings as dividends, the master would have left with no capital at all to be put into his other high return yielding investments. Thus, by not letting the operational performance of the company deteriorate by retaining earnings and not distributing it as dividends, he was able to avoid a situation in the future where he would have had too put in his own capital in the business.

Lessons from the master: IX

With volatility being the order of the day, we as investors indeed need some calming influence so as to help us stay rational and make sense of the crisis that has gripped the global capital markets currently. And what better way to do this than to turn to the man who answers to the name of Warren Buffett and who arguably, is one of the world's best practitioner of the art of rationality and objective thinking.

Few weeks back, we had embarked upon a series of write-ups based on the investment wisdom contained in the master's yearly letters to the shareholders of his investment vehicle, Berkshire Hathaway. So far, we have covered letters upto the year 1984. In the following few paragraphs, let us see what the master offers by way of investment wisdom in his 1985 letter.

This letter like his previous letters touches upon a variety of topics, some covered before while others brand new. What we would like to reproduce here is the biggest and the best of them all. The year 1985 was the year when the master finally chose to shut down his textile business by liquidating all of company's assets. While going through the brief history of the business and explaining his rationale behind the sale, the master has systemically busted some of the biggest myths related to investing and shown us why one should prefer business that generate returns with as little capital employed as possible. He has also shown why reliance on book values and replacement costs while valuing a company could turn to be dangerous.

While the discourse is indeed exhaustive, we believe that every sentence is worth its weight in gold. Laid out below is an edited account of his textile business shutdown:

"In July we decided to close our textile operation, and by year end this unpleasant job was largely completed. The history of this business is instructive.

When Buffett Partnership Ltd., an investment partnership of which I was general partner, bought control of Berkshire Hathaway 21 years ago, it had an accounting net worth of US$ 22 m, all devoted to the textile business. The company's intrinsic business value, however, was considerably less because the textile assets were unable to earn returns commensurate with their accounting value. Indeed, during the previous nine years (the period in which Berkshire and Hathaway operated as a merged company) aggregate sales of US$ 530 m had produced an aggregate loss of US$ 10 m. Profits had been reported from time to time but the net effect was always one step forward, two steps back.

We felt, however, that the business would be run much better by a long-time employee whom we immediately selected to be president, Ken Chace. In this respect we were 100% correct: Ken and his recent successor, Garry Morrison, have been excellent managers, every bit the equal of managers at our more profitable businesses.

We remained in the business for reasons that I stated in the 1978 annual report (and summarized at other times also): "(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 generate modest cash returns relative to investment." I further said, "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."

It turned out that I was very wrong about (4). Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.

The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage.

Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company's capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers.

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

There is an investment postscript in our textile saga. Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole. Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery.

The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about US$ 13 m, including US$ 2 m spent in 1980-84, and had a current book value of US$ 866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps US$30 to US$ 50 m.

Gross proceeds from our sale of this equipment came to US$ 163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for US$ 5,000 apiece in 1981 found no takers at US$ 50. We finally sold them for scrap at US$ 26 each, a sum less than removal costs."

Conclusion: The master's liquidation of his textile business shows what could potentially lie in store for a business with a rather poor economics, despite the presence of an excellent management. Thus, while Buffett was able to correct his mistake by devoting some of the textile company's capital to other more profitable businesses, no such luxuries await small investors. Hence, they can do their investment returns a world of good by refusing to invest in such businesses, no matter how cheap they might look based on book value and replacement costs.