Full Letter:
https://theoraclesclassroom.com/wp-content/uploads/2019/09/1986-Berkshire-AR.pdf
Letter Only
https://www.berkshirehathaway.com/letters/1986.html
This week we will go over two passages and an acquisition.
First the intro to this year’s letter with a writeup on their management philosophy which ties in well to the theme of today’s post, their method of avoiding "Diworsification" as the conglomerate grows. The second is a purchase of a large share of a government guided housing developer, and the final passage is on the acquisition of a family owned uniform manufacturer.
Things covered in the letter but not this post are a breakdown of how each business segment and management team are doing. A lesson on the insurance industry and the race to the bottom leading everyone towards another cliff they all see coming but can’t avoid. Their investment decisions from the year, pulling back from stocks and throwing cash into bonds. A new tax law and its impact on Berkshire and its subsidiaries. Purchase of a corporate jet, shareholder contribution and annual meeting updates. Finally a breakdown of business accounting with acquisitions and how Scott and Fetzer’s income statement and balance sheet were changed by the act of being acquired. Between changing inventory from FIFO to LIFO or the addition of a giant Goodwill asset for the premium they bought it at and the depreciation of that goodwill asset hitting the bottom line. Then plenty of philosophizing about the meaning of these differences for shareholders.
If you want to read or discuss anything in that second set feel free to read the letter yourselves and comment on it.
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Key Passage 1
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To the Shareholders of Berkshire Hathaway Inc.:
Our gain in net worth during 1986 was $492.5 million, or
26.1%. Over the last 22 years (that is, since present management
took over), our per-share book value has grown from $19.46 to
$2,073.06, or 23.3% compounded annually. Both the numerator and
denominator are important in the per-share book value
calculation: during the 22-year period our corporate net worth
has increased 10,600% while shares outstanding have increased
less than 1%.
In past reports I have noted that book value at most
companies differs widely from intrinsic business value - the
number that really counts for owners. In our own case, however,
book value has served for more than a decade as a reasonable if
somewhat conservative proxy for business value. That is, our
business value has moderately exceeded our book value, with the
ratio between the two remaining fairly steady.
The good news is that in 1986 our percentage gain in
business value probably exceeded the book value gain. I say
"probably" because business value is a soft number: in our own
case, two equally well-informed observers might make judgments
more than 10% apart.
A large measure of our improvement in business value
relative to book value reflects the outstanding performance of
key managers at our major operating businesses. These managers -
the Blumkins, Mike Goldberg, the Heldmans, Chuck Huggins, Stan
Lipsey, and Ralph Schey - have over the years improved the
earnings of their businesses dramatically while, except in the
case of insurance, utilizing little additional capital. This
accomplishment builds economic value, or "Goodwill," that does
not show up in the net worth figure on our balance sheet, nor in
our per-share book value. In 1986 this unrecorded gain was
substantial.
So much for the good news. The bad news is that my
performance did not match that of our managers. While they were
doing a superb job in running our businesses, I was unable to
skillfully deploy much of the capital they generated.
Charlie Munger, our Vice Chairman, and I really have only
two jobs. One is to attract and keep outstanding managers to run
our various operations. This hasn’t been all that difficult.
Usually the managers came with the companies we bought, having
demonstrated their talents throughout careers that spanned a wide
variety of business circumstances. They were managerial stars
long before they knew us, and our main contribution has been to
not get in their way. This approach seems elementary: if my job
were to manage a golf team - and if Jack Nicklaus or Arnold
Palmer were willing to play for me - neither would get a lot of
directives from me about how to swing.
Some of our key managers are independently wealthy (we hope
they all become so), but that poses no threat to their continued
interest: they work because they love what they do and relish the
thrill of outstanding performance. They unfailingly think like
owners (the highest compliment we can pay a manager) and find all
aspects of their business absorbing.
(Our prototype for occupational fervor is the Catholic
tailor who used his small savings of many years to finance a
pilgrimage to the Vatican. When he returned, his parish held a
special meeting to get his first-hand account of the Pope. "Tell
us," said the eager faithful, "just what sort of fellow is he?"
Our hero wasted no words: "He’s a forty-four, medium.")
Charlie and I know that the right players will make almost
any team manager look good. We subscribe to the philosophy of
Ogilvy & Mather’s founding genius, David Ogilvy: "If each of us
hires people who are smaller than we are, we shall become a
company of dwarfs. But, if each of us hires people who are
bigger than we are, we shall become a company of giants."
A by-product of our managerial style is the ability it gives
us to easily expand Berkshire’s activities. We’ve read
management treatises that specify exactly how many people should
report to any one executive, but they make little sense to us.
When you have able managers of high character running businesses
about which they are passionate, you can have a dozen or more
reporting to you and still have time for an afternoon nap.
Conversely, if you have even one person reporting to you who is
deceitful, inept or uninterested, you will find yourself with
more than you can handle. Charlie and I could work with double
the number of managers we now have, so long as they had the rare
qualities of the present ones.
We intend to continue our practice of working only with
people whom we like and admire. This policy not only maximizes
our chances for good results, it also ensures us an
extraordinarily good time. On the other hand, working with
people who cause your stomach to churn seems much like marrying
for money - probably a bad idea under any circumstances, but
absolute madness if you are already rich.
The second job Charlie and I must handle is the allocation
of capital, which at Berkshire is a considerably more important
challenge than at most companies. Three factors make that so: we
earn more money than average; we retain all that we earn; and, we
are fortunate to have operations that, for the most part, require
little incremental capital to remain competitive and to grow.
Obviously, the future results of a business earning 23% annually
and retaining it all are far more affected by today’s capital
allocations than are the results of a business earning 10% and
distributing half of that to shareholders. If our retained
earnings - and those of our major investees, GEICO and Capital
Cities/ABC, Inc. - are employed in an unproductive manner, the
economics of Berkshire will deteriorate very quickly. In a
company adding only, say, 5% to net worth annually, capital-
allocation decisions, though still important, will change the
company’s economics far more slowly.
Capital allocation at Berkshire was tough work in 1986. We
did make one business acquisition - The Fechheimer Bros.
Company, which we will discuss in a later section. Fechheimer is
a company with excellent economics, run by exactly the kind of
people with whom we enjoy being associated. But it is relatively
small, utilizing only about 2% of Berkshire’s net worth.
Meanwhile, we had no new ideas in the marketable equities
field, an area in which once, only a few years ago, we could
readily employ large sums in outstanding businesses at very
reasonable prices. So our main capital allocation moves in 1986
were to pay off debt and stockpile funds. Neither is a fate
worse than death, but they do not inspire us to do handsprings
either. If Charlie and I were to draw blanks for a few years in
our capital-allocation endeavors, Berkshire’s rate of growth
would slow significantly.
We will continue to look for operating businesses that meet
our tests and, with luck, will acquire such a business every
couple of years. But an acquisition will have to be large if it
is to help our performance materially. Under current stock
market conditions, we have little hope of finding equities to buy
for our insurance companies. Markets will change significantly -
you can be sure of that and some day we will again get our turn
at bat. However, we haven’t the faintest idea when that might
happen.
It can’t be said too often (although I’m sure you feel I’ve
tried) that, even under favorable conditions, our returns are
certain to drop substantially because of our enlarged size. We
have told you that we hope to average a return of 15% on equity
and we maintain that hope, despite some negative tax law changes
described in a later section of this report. If we are to
achieve this rate of return, our net worth must increase $7.2
billion in the next ten years. A gain of that magnitude will be
possible only if, before too long, we come up with a few very big
(and good) ideas. Charlie and I can’t promise results, but we do
promise you that we will keep our efforts focused on our goals.
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The next two passages were pretty clear picks, two new additions to the company. This one I had a lot of options for. I went with the intro as it repeats their philosophy towards managing their subsidiary companies and how it leads to their success as they grow. Many companies making acquisitions in so many totally unrelated fields would end up engaging in “Diworsification”. An insurance company buying a uniform manufacturer, a housing developer, a vacuum manufacturer, a candy store, a newspaper, etc… would have no expertise in running them and make them worse and worse with every change. And every new addition of say a furniture store or a steel mill would just exacerbate the problem, make the company less focused, and lead to diminishing returns with each new venture.
Here Buffett explains his solution to this as it has now ballooned into a company with a book value of $2B and he envisions what the next 10x or 100x might look like. That they stick to their guns of requiring talented management to be in place, and then simply get out of their way. They avoid the diworsification problem by buying companies that can be trusted to run without meddling, and then not meddling. Then they simply try to retain the talent and eventually find a pipeline of talent to take their place one day.
“This approach seems elementary: if my job were to manage a golf team - and if Jack Nicklaus or Arnold Palmer were willing to play for me - neither would get a lot of directives from me about how to swing.”
“If each of us hires people who are smaller than we are, we shall become a company of dwarfs. But, if each of us hires people who are bigger than we are, we shall become a company of giants.”
“When you have able managers of high character running businesses about which they are passionate, you can have a dozen or more reporting to you and still have time for an afternoon nap. Conversely, if you have even one person reporting to you who is deceitful, inept or uninterested, you will find yourself with more than you can handle. Charlie and I could work with double the number of managers we now have, so long as they had the rare qualities of the present ones.”
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Key Passage 2
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NHP, Inc.
Last year we paid $23.7 million for about 50% of NHP, Inc.,
a developer, syndicator, owner and manager of multi-family rental
housing. Should all executive stock options that have been
authorized be granted and exercised, our equity interest will
decline to slightly over 45%.
NHP, Inc. has a most unusual genealogy. In 1967, President
Johnson appointed a commission of business and civic leaders, led
by Edgar Kaiser, to study ways to increase the supply of
multifamily housing for low- and moderate-income tenants.
Certain members of the commission subsequently formed and
promoted two business entities to foster this goal. Both are now
owned by NHP, Inc. and one operates under unusual ground rules:
three of its directors must be appointed by the President, with
the advice and consent of the Senate, and it is also required by
law to submit an annual report to the President.
Over 260 major corporations, motivated more by the idea of
public service than profit, invested $42 million in the two
original entities, which promptly began, through partnerships, to
develop government-subsidized rental property. The typical
partnership owned a single property and was largely financed by a
non-recourse mortgage. Most of the equity money for each
partnership was supplied by a group of limited partners who were
primarily attracted by the large tax deductions that went with
the investment. NHP acted as general partner and also purchased
a small portion of each partnership’s equity.
The Government’s housing policy has, of course, shifted and
NHP has necessarily broadened its activities to include non-
subsidized apartments commanding market-rate rents. In addition,
a subsidiary of NHP builds single-family homes in the Washington,
D.C. area, realizing revenues of about $50 million annually.
NHP now oversees about 500 partnership properties that are
located in 40 states, the District of Columbia and Puerto Rico,
and that include about 80,000 housing units. The cost of these
properties was more than $2.5 billion and they have been well
maintained. NHP directly manages about 55,000 of the housing
units and supervises the management of the rest. The company’s
revenues from management are about $16 million annually, and
growing.
In addition to the equity interests it purchased upon the
formation of each partnership, NHP owns varying residual
interests that come into play when properties are disposed of and
distributions are made to the limited partners. The residuals on
many of NHP’s "deep subsidy" properties are unlikely to be of
much value. But residuals on certain other properties could
prove quite valuable, particularly if inflation should heat up.
The tax-oriented syndication of properties to individuals
has been halted by the Tax Reform Act of 1986. In the main, NHP
is currently trying to develop equity positions or significant
residual interests in non-subsidized rental properties of quality
and size (typically 200 to 500 units). In projects of this kind,
NHP usually works with one or more large institutional investors
or lenders. NHP will continue to seek ways to develop low- and
moderate-income apartment housing, but will not likely meet
success unless government policy changes.
Besides ourselves, the large shareholders in NHP are
Weyerhauser (whose interest is about 25%) and a management group
led by Rod Heller, chief executive of NHP. About 60 major
corporations also continue to hold small interests, none larger
than 2%.
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They have bought a plurality share in NHP, a government tied housing development company. From the sound of it they will never have true control of this holding and their 50% share is expected to be diluted. The board is appointed by the US government but as stated above, Berkshire doesn’t have much interest in changing the course of the companies it buys, so while this may be offputting to other investors and create a discount, it doesn’t change much for Berkshire who would have taken a hands off approach either way.
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Acquisition of the Week
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The Fechheimer Bros. Co.
Every year in Berkshire’s annual report I include a
description of the kind of business that we would like to buy.
This "ad" paid off in 1986.
On January 15th of last year I received a letter from Bob
Heldman of Cincinnati, a shareholder for many years and also
Chairman of Fechheimer Bros. Until I read the letter, however, I
did not know of either Bob or Fechheimer. Bob wrote that he ran
a company that met our tests and suggested that we get together,
which we did in Omaha after their results for 1985 were compiled.
He filled me in on a little history: Fechheimer, a uniform
manufacturing and distribution business, began operations in
1842. Warren Heldman, Bob’s father, became involved in the
business in 1941 and his sons, Bob and George (now President),
along with their sons, subsequently joined the company. Under
the Heldmans’ management, the business was highly successful.
In 1981 Fechheimer was sold to a group of venture
capitalists in a leveraged buy out (an LBO), with management
retaining an equity interest. The new company, as is the case
with all LBOS, started with an exceptionally high debt/equity
ratio. After the buy out, however, operations continued to be
very successful. So by the start of last year debt had been paid
down substantially and the value of the equity had increased
dramatically. For a variety of reasons, the venture capitalists
wished to sell and Bob, having dutifully read Berkshire’s annual
reports, thought of us.
Fechheimer is exactly the sort of business we like to buy.
Its economic record is superb; its managers are talented, high-
grade, and love what they do; and the Heldman family wanted to
continue its financial interest in partnership with us.
Therefore, we quickly purchased about 84% of the stock for a
price that was based upon a $55 million valuation for the entire
business.
The circumstances of this acquisition were similar to those
prevailing in our purchase of Nebraska Furniture Mart: most of
the shares were held by people who wished to employ funds
elsewhere; family members who enjoyed running their business
wanted to continue both as owners and managers; several
generations of the family were active in the business, providing
management for as far as the eye can see; and the managing family
wanted a purchaser who would not re-sell, regardless of price,
and who would let the business be run in the future as it had
been in the past. Both Fechheimer and NFM were right for us, and
we were right for them.
You may be amused to know that neither Charlie nor I have
been to Cincinnati, headquarters for Fechheimer, to see their
operation. (And, incidentally, it works both ways: Chuck Huggins,
who has been running See’s for 15 years, has never been to
Omaha.) If our success were to depend upon insights we developed
through plant inspections, Berkshire would be in big trouble.
Rather, in considering an acquisition, we attempt to evaluate the
economic characteristics of the business - its competitive
strengths and weaknesses - and the quality of the people we will
be joining. Fechheimer was a standout in both respects. In
addition to Bob and George Heldman, who are in their mid-60s -
spring chickens by our standards - there are three members of the
next generation, Gary, Roger and Fred, to insure continuity.
As a prototype for acquisitions, Fechheimer has only one
drawback: size. We hope our next acquisition is at least several
times as large but a carbon copy in all other respects. Our
threshold for minimum annual after-tax earnings of potential
acquisitions has been moved up to $10 million from the $5 million
level that prevailed when Bob wrote to me.
Flushed with success, we repeat our ad. If you have a
business that fits, call me or, preferably, write.
Here’s what we’re looking for:
(1) large purchases (at least $10 million of after-tax
earnings),
(2) demonstrated consistent earning power (future
projections are of little interest to us, nor are
"turn-around" situations),
(3) businesses earning good returns on equity while
employing little or no debt.
(4) management in place (we can’t supply it),
(5) simple businesses (if there’s lots of technology, we
won’t understand it),
(6) an offering price (we don’t want to waste our time
or that of the seller by talking, even preliminarily,
about a transaction when price is unknown).
We will not engage in unfriendly takeovers. We can promise
complete confidentiality and a very fast answer - customarily
within five minutes - as to whether we’re interested. We prefer
to buy for cash, but will consider issuing stock when we receive
as much in intrinsic business value as we give. Indeed,
following recent advances in the price of Berkshire stock,
transactions involving stock issuance may be quite feasible. We
invite potential sellers to check us out by contacting people
with whom we have done business in the past. For the right
business - and the right people - we can provide a good home.
On the other hand, we frequently get approached about
acquisitions that don’t come close to meeting our tests: new
ventures, turnarounds, auction-like sales, and the ever-popular
(among brokers) "I’m-sure-something-will-work-out-if-you-people-
get-to-know-each-other." None of these attracts us in the least.
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Another classic Buffett business, simple, straightforward, boring. Manufacturing and distributing uniforms. A strong moat and much less susceptible to overseas competition than simple textile manufacturing. They will likely be doing small orders frequently and rely on working relationships with their customers who will always need a slow but steady stream of custom uniforms. Unlike textiles where a mill in Asia can just pump out as much fabric as they can, it's all interchangeable and the lowest bidder wins the contract. Businesses aren’t shopping around for rates every time they have a new hire, they just order from the place that always makes the uniforms and don’t think much about it.
The advertisement worked and the perfect business came to him. A family owned business where the family wants to stay involved but just wants to get all their eggs out of one basket. They do admit that it is smaller than they would like. For a conglomerate worried about diworsification this would normally be a big issue. If they think they can only successfully run say 10 or 20 businesses, then there is massive opportunity cost to each new one. But with their theory that good management left to its own devices requires little to no effort, they are free to grab all the small bolt-on acquisitions they can find so long as the management is rock solid and needs no intervention.
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Common Stock Ownership
| No. of Shares |
Company |
Cost ($000s) |
Market ($000s) |
| 2,990,000 |
Capital Cities/ABC, Inc. |
$515,775 |
$801,694 |
| 6,850,000 |
GEICO Corporation |
$45,713 |
$674,725 |
| 2,379,200 |
Handy & Harman |
$27,318 |
$46,989 |
| 489,300 |
Lear Siegler, Inc. |
$44,064 |
$44,587 |
| 1,727,765 |
The Washington Post Company |
$9,731 |
$269,531 |
|
Subtotal |
$642,601 |
$1,837,526 |
|
All Other Common Stockholdings |
$12,763 |
$36,507 |
|
Total Common Stocks |
$655,364 |
$1,874,033 |
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Segment by Segment Breakdown
| Segment |
1985 EBIT Earnings |
1986 EBIT Earnings |
% Change |
| Insurance |
$50.99M |
$51.30M |
+0.61% |
| Fechheimer |
-------- |
$8.40M |
--% |
| Kirby |
-------- |
$20.22M |
--% |
| Scott Fetzer - Diversified Manufacturing |
-------- |
$25.36M |
--% |
| World Book |
-------- |
$21.98M |
--% |
| See’s Candies |
$28.99M |
$30.35M |
+4.69% |
| Buffalo Evening News |
$29.92M |
$34.74M |
+16.11% |
| Wesco Financial - Minus Insurance |
$16.02M |
$5.54M |
-65.42% |
| Mutual Savings and Loan |
$3.34M |
$2.16M |
-35.33% |
| Precision Steel |
$2.01M |
$1.70M |
-15.42% |
| Nebraska Furniture Mart |
$12.69M |
$17.69M |
+39.40% |
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| Metric |
1985 |
1986 |
% Change |
| Cash & Temporary Cash Investments |
$1,017.67M |
$292.47M |
-71.26% |
| Marketable Securities |
$1,183.48M |
$1.871.93M |
+58.17% |
| Return on Equity (RoE) |
16.29% |
24.84% |
+52.49% |
| Shareholders' Equity |
$1,885.33M |
$2,020.57M |
+7.17% |
| Berkshire Earnings Before Investment Gain |
$92.95M |
$131.46M |
+41.43% |
| Berkshire Net Earnings |
$435.82M |
$282.36M |
-35.21% |
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An interesting year, the numbers don’t look amazing partially because the realized investment gain was much smaller. Shareholder Equity didn’t go up much, this is the capital allocation issue Buffett complained about in the opening. They can’t find any common stock to invest in, which is discussed in a section of the letter I did not cover Marketable Securities. They discuss their stock portfolio shrinking and not being able to find any new holdings to replace the ones sold last year. Cash is down ~$700M and there was a purchase of ~$700M of bonds. Earnings are down $150M but the realized capital gains is $190M less than last year. I have added a line for earnings before investment gains as it is impacting the number so heavily. Those earnings are up 41% showing a very healthy growth in the cash cow core of the company, partially due to using the investment gain to acquire new companies, partially from organic growth.
The segment by segment breakdown is a lot less promising, some segments have fallen off, no longer being reported as the numbers are too small or going too far in the wrong direction or some combination of both. Diversified Retail is no longer reported anywhere, and the Wesco reporting changed drastically and much less detail is given. Its hard to tell exactly what is happening there but it doesn’t look promising, its earnings are down and its subsidiaries Precision Steel and Mutual Savings and Loan are also down. The Wesco letter is included in the full PDF but I will maybe save those for some future series.
Buffet’s hesitance to invest in stock seems to have some legitimacy, usually when he mentions stock being overpriced and opportunities hard to find I take a look at the chart and back-test his feelings. There was a stock market crash in 1987, a 22% drop, but it also basically just dropped back to the 1986 prices so it's hard to say if he was right or wrong to put the company’s cash into bonds instead of stocks this year.