Berkshire’s collection of managers is unusual in several important ways. As one example, a very high percentage of these men and women are independently wealthy, having made fortunes in the businesses that they run. They work neither because they need the money nor because they are contractually obligated to—we have no contracts at Berkshire. Rather, they work long and hard because they love their businesses. And I use the word “their” advisedly, since these managers are truly in charge—there are no show-and-tell presentations in Omaha, no budgets to be approved by headquarters, no dictums issued about capital expenditures. We simply ask our managers to run their companies as if these are the sole asset of their families and will remain so for the next century.
Charlie and I try to behave with our managers just as we attempt to behave with Berkshire’s shareholders, treating both groups as we would wish to be treated if our positions were reversed. Though “working” means nothing to me financially, I love doing it at Berkshire for some simple reasons: It gives me a sense of achievement, a freedom to act as I see fit and an opportunity to interact daily with people I like and trust. Why should our managers—accomplished artists at what they do—see things differently?
In their relations with Berkshire, our managers often appear to be hewing to President Kennedy’s charge, “Ask not what your country can do for you; ask what you can do for your country.” Here’s a remarkable story from last year: It’s about R. C. Willey, Utah’s dominant home furnishing business, which Berkshire purchased from Bill Child and his family in 1995. Bill and most of his managers are Mormons, and for this reason R. C. Willey’s stores have never operated on Sunday. This is a difficult way to do business: Sunday is the favorite shopping day for many customers. Bill, nonetheless, stuck to his principles—and while doing so built his business from $250,000 of annual sales in 1954, when he took over, to $342 million in 1999.
Bill felt that R. C. Willey could operate successfully in markets outside of Utah and in 1997 suggested that we open a store in Boise. I was highly skeptical about taking a no-Sunday policy into a new territory where we would be up against entrenched rivals open seven days a week. Nevertheless, this was Bill’s business to run. So, despite my reservations, I told him to follow both his business judgment and his religious convictions.
Bill then insisted on a truly extraordinary proposition: He would personally buy the land and build the store—for about $9 million as it turned out—and would sell it to us at his cost if it proved to be successful. On the other hand, if sales fell short of his expectations, we could exit the business without paying Bill a cent. This outcome, of course, would leave him with a huge investment in an empty building. I told him that I appreciated his offer but felt that if Berkshire was going to get the upside it should also take the downside. Bill said nothing doing: If there was to be failure because of his religious beliefs, he wanted to take the blow personally.
The store opened last August and immediately became a huge success. Bill thereupon turned the property over to us—including some extra land that had appreciated significantly—and we wrote him a check for his cost. And get this: Bill refused to take a dime of interest on the capital he had tied up over the two years.
If a manager has behaved similarly at some other public corporation, I haven’t heard about it. You can understand why the opportunity to partner with people like Bill Child causes me to tap dance to work every morning.
A footnote: After our “soft” opening in August, we had a grand opening of the Boise store about a month later. Naturally, I went there to cut the ribbon (your Chairman, I wish to emphasize, is good for something). In my talk I told the crowd how sales had far exceeded expectations, making us, by a considerable margin, the largest home furnishings store in Idaho. Then, as the speech progressed, my memory miraculously began to improve. By the end of my talk, it all had come back to me: Opening a store in Boise had been my idea.
Circle of competence
If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries—and seem to have their claims validated by the behavior of the stock market—we neither envy nor emulate them. Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it’s almost certain there will be opportunities from time to time for Berkshire to do well within the circle we’ve staked out.
Right now, the prices of the fine businesses we already own are just not that attractive. In other words, we feel much better about the businesses than their stocks. That’s why we haven’t added to our present holdings. Nevertheless, we haven’t yet scaled back our portfolio in a major way: If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price.
Our reservations about the prices of securities we own apply also to the general level of equity prices. We have never attempted to forecast what the stock market is going to do in the next month or the next year, and we are not trying to do that now. But, as I point out in the enclosed article, equity investors currently seem wildly optimistic in their expectations about future returns.
We see the growth in corporate profits as being largely tied to the business done in the country (GDP), and we see GDP growing at a real rate of about 3%. In addition, we have hypothesized 2% inflation. Charlie and I have no particular conviction about the accuracy of 2%. However, it’s the market’s view: Treasury Inflation-Protected Securities (TIPS) yield about two percentage points less than the standard treasury bond, and if you believe inflation rates are going to be higher than that, you can profit by simply buying TIPS and shorting Governments.
If profits do indeed grow along with GDP, at about a 5% rate, the valuation placed on American business is unlikely to climb by much more than that. Add in something for dividends, and you emerge with returns from equities that are dramatically less than most investors have either experienced in the past or expect in the future. If investor expectations become more realistic—and they almost certainly will—the market adjustment is apt to be severe, particularly in sectors in which speculation has been concentrated.
Berkshire will someday have opportunities to deploy major amounts of cash in equity markets—we are confident of that. But, as the song goes, “Who knows where or when?” Meanwhile, if anyone starts explaining to you what is going on in the truly-manic portions of this “enchanted” market, you might remember still another line of song: “Fools give you reasons, wise men never try.”
Recently, a number of shareholders have suggested to us that Berkshire repurchase its shares. Usually the requests were rationally based, but a few leaned on spurious logic.
There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds—cash plus sensible borrowing capacity—beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.
The business “needs” that I speak of are of two kinds: First, expenditures that a company must make to maintain its competitive position (e.g., the remodeling of stores at Helzberg’s) and, second, optional outlays, aimed at business growth, that management expects will produce more than a dollar of value for each dollar spent (R. C. Willey’s expansion into Idaho).
When available funds exceed needs of those kinds, a company with a growth-oriented shareholder population can buy new businesses or repurchase shares. If a company’s stock is selling well below intrinsic value, repurchases usually make the most sense. In the mid-1970s, the wisdom of making these was virtually screaming at managements, but few responded. In most cases, those that did made their owners much wealthier than if alternative courses of action had been pursued. Indeed, during the 1970s (and, spasmodically, for some years thereafter) we searched for companies that were large repurchasers of their shares. This often was a tipoff that the company was both undervalued and run by a shareholder-oriented management.
That day is past. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.
Charlie and I admit that we feel confident in estimating intrinsic value for only a portion of traded equities and then only when we employ a range of values, rather than some pseudo-precise figure. Nevertheless, it appears to us that many companies now making repurchases are overpaying departing shareholders at the expense of those who stay. In defense of those companies, I would say that it is natural for CEOs to be optimistic about their own businesses. They also know a whole lot more about them than I do. However, I can’t help but feel that too often today’s repurchases are dictated by management’s desire to “show confidence” or be in fashion rather than by a desire to enhance per-share value.
Sometimes, too, companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This “buy high, sell low” strategy is one many unfortunate investors have employed—but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully.
Of course, both option grants and repurchases may make sense—but if that’s the case, it’s not because the two activities are logically related. Rationally, a company’s decision to repurchase shares or to issue them should stand on its own feet. Just because stock has been issued to satisfy options—or for any other reason—does not mean that stock should be repurchased at a price above intrinsic value. Correspondingly, a stock that sells well below intrinsic value should be repurchased whether or not stock has previously been issued (or may be because of outstanding options).
You should be aware that, at certain times in the past, I have erred in not making repurchases. My appraisal of Berkshire’s value was then too conservative or I was too enthused about some alternative use of funds. We have therefore missed some opportunities—though Berkshire’s trading volume at these points was too light for us to have done much buying, which means that the gain in our per-share value would have been minimal. (A repurchase of, say, 2% of a company’s shares at a 25% discount from per-share intrinsic value produces only a ½% gain in that value at most—and even less if the funds could alternatively have been deployed in value-building moves.)
Some of the letters we’ve received clearly imply that the writer is unconcerned about intrinsic value considerations but instead wants us to trumpet an intention to repurchase so that the stock will rise (or quit going down). If the writer wants to sell tomorrow, his thinking makes sense—for him!—but if he intends to hold, he should instead hope the stock falls and trades in enough volume for us to buy a lot of it. That’s the only way a repurchase program can have any real benefit for a continuing shareholder.
We will not repurchase shares unless we believe Berkshire stock is selling well below intrinsic value, conservatively calculated. Nor will we attempt to talk the stock up or down. (Neither publicly or privately have I ever told anyone to buy or sell Berkshire shares.) Instead we will give all shareholders—and potential shareholders—the same valuation-related information we would wish to have if our positions were reversed.
Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report. If we do find that repurchases make sense, we will only rarely place bids on the New York Stock Exchange (“NYSE”). Instead, we will respond to offers made directly to us at or below the NYSE bid. If you wish to offer stock, have your broker call Mark Millard at 402-346-1400. When a trade occurs, the broker can either record it in the “third market” or on the NYSE. We will favor purchase of the B shares if they are selling at more than a 2% discount to the A. We will not engage in transactions involving fewer than 10 shares of A or 50 shares of B.
Please be clear about one point: We will never make purchases with the intention of stemming a decline in Berkshire’s price. Rather we will make them if and when we believe that they represent an attractive use of the Company’s money. At best, repurchases are likely to have only a very minor effect on the future rate of gain in our stock’s intrinsic value.
: Buffett wrote this in the late stage of the “Dot-com bubble“. Jason Zweig provides some context in his commentary to chapter 3 of Graham’s “The Intelligent Investor“: “In mid-1998, investors surveyed by the Gallup Organization for the PaineWebber brokerage firm expected their portfolios to earn an average of roughly 13% over the year to come. By early 2000, their average expected return had jumped to more than 18%. “Sophisticated sprofessionals” were just as bullish, jacking up their own assumptions of future returns. In 2001, for instance, SBC Communications raised the projected return on its pension plan from 8.5% to 9.5%. By 2002, the average assumed rate of return on the pension plans of companies in the Standard & Poor’s 500-stock index had swollen to a record-high 9.2%.” […] “Gallup found in 2001 and 2002 that the average expectation of one-year returns on stocks had slumped to 7%—even though investors could now buy at prices nearly 50% lower than in 2000.”