Thursday, June 23, 2011

Buffett on "The Inevitables": Berkshire Shareholder Letter Highlights

From Warren Buffett's 1996 Berkshire Hathaway (BRKashareholder letter:

I was recently studying the 1896 report of Coke (and you think that you are behind in your reading!). At that time Coke, though it was already the leading soft drink, had been around for only a decade. But its blueprint for the next 100 years was already drawn. Reporting sales of $148,000 that year, Asa Candler, the company's president, said: "We have not lagged in our efforts to go into all the world teaching that Coca-Cola is the article, par excellence, for the health and good feeling of all people." Though "health" may have been a reach, I love the fact that Coke still relies on Candler's basic theme today - a century later. Candler went on to say, just as Roberto could now, "No article of like character has ever so firmly entrenched itself in public favor." Sales of syrup that year, incidentally, were 116,492 gallons versus about 3.2 billion in 1996.

I can't resist one more Candler quote: "Beginning this year about March 1st . . . we employed ten traveling salesmen by means of which, with systematic correspondence from the office, we covered almost the territory of the Union." That's my kind of sales force.

Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables." Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.

In the letter, Buffett mentions that the stock prices of businesses like Coca-Cola (KO) and Gillette (now part of Procter & Gamble: PG) end up out of line with value. He also says that even outstanding businesses have historically been susceptible to management that become distracted and unfocused from time to time.

You can, of course, pay too much for even the best of businesses. The overpayment risk surfaces periodically and, in our opinion, may now be quite high for the purchasers of virtually all stocks, The Inevitables included. Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.

A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged. Unfortunately, that is precisely what transpired years ago at both Coke and Gillette. (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette?) Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding. All too often, we've seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.

Around the time that letter was written, stocks like Coca-Cola were beginning to sell at multiples of earnings that made little sense. Even an outstanding business like Coca-Cola, if bought at 40-50x earnings, almost guarantees the investor a stagnant or worse decade ahead (in terms of stock performance) as the intrinsic value* of the business catches up to market price (or market price falls more in line with current value).

These are value creating machines but paying too much in anticipation of future worth will naturally damage investor returns.

Many stocks, of course, would go on to get even more expensive after he wrote that letter and it certainly was not just the tech stocks.

These days, Wal-Mart (WMT) is often cited as a stock that has gone nowhere in the past decade. The listless performance has more to do with the price paid by market participants for Wal-Mart's stock, especially in the 1st half of the past decade, not business performance over that time.

The business itself did just fine.

Over that time the Wal-Mart's business more than tripled its earning power. Not a bad decade of work especially for a company that size.

A decade ago market participants were willing to pay around forty dollars for every dollar of Wal-Mart's earnings. Now, investors are paying less than 12 dollars for every dollar of earnings.

Unless something material is going to happen to Wal-Mart's moat, at current market price the next decade should be a much different story as far as that stock goes.

Adam

Long all stocks mentioned

* From the Berkshire Hathaway owner's manual:
"Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are 5 revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures."
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