Warren Buffett's Early Letters: 1975

Two modern-day value investors I admire, Whitney Tilson (Trades, Portfolio) and Bill Ackman (Trades, Portfolio), have recommended that to learn about value investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we go over the 1975 letter.

Summary of the 1975 letter

Berkshire produced a return on beginning shareholder’s equity of 7.6%, the lowest return on equity experienced since 1967. This also included a large part of earnings coming from federal income tax refunds, which were a one-off. Buffett predicted, tentatively, that 1976 would be better, but noted that the major variable, and the one most difficult to predict with any confidence, was the insurance underwriting results. Buffett noted that underwriting was driving Berkshire’s overall earnings at that time.

Textiles

1975 was a story of two halves for textiles, as a short but sharp V-shaped textile depression hit the industry. Most producers cut back production, which prevented inventory from getting too large, and then when demand came back, business rebounded quickly.

In April of that year, Berkshire acquired Waumbec Mills Inc. and Waumbec Dyeing and Finishing Co. Inc. These companies had been underperforming and running at 50% to 55% of capacity. Berkshire managed to produce major improvements in manufacturing, administration and sales, moving the company into profit – along with help from the general textile revival. Berkshire is using this new business to increase productivity, and without using the word, create synergies. Buffett noted that Berkshire continued to look for ways to further increase the scale of its textile operations without making major capital investment in new fixed assets. He noted that would be unwise given the historically low returns on textile equipment. Buffett said he had great confidence in Ken Chace and his team to maximize Berkshire’s strengths in textiles.

Insurance underwriting

The various insurance subsidiaries suffered in 1975 due to the fact that inflation in payouts increased rapidly, more than general inflation, in part because “social” inflation caused “the liability concept to be expanded continuously, far beyond limits contemplated when rates were established.” This meant jury awards for events not previously considered “statistically significant” were paid but not factored into insurance rates. Buffett noted Berkshire may “remain positioned in the more difficult part of the insurance spectrum during the inflationary years ahead.”

The Home and Automobile Insurance Company continued to see poor performance, which resulted in a management change. John Seward was made president and we are told he “energetically and imaginatively implemented a completely revamped underwriting approach.” Buffett can tolerate some underperformance in the short term, as he seems to always look at the bigger picture, but in cases where management is not up to scratch over a period of time, they will not be given a second chance.

Buffett noted that 1976 should see insurance premium gains, but cautioned this would be due to increased rates, rather than increased policies.

Insurance investments

Here we see the link between investment income and underwriting. Gains in investment income were moderate during 1975 because premium volume remained flat and underwriting losses reduced funds available for investment.

Buffett wrote:

"Our equity investments are heavily concentrated in a few companies which are selected based on favourable economic characteristics, competent and honest management, and a purchase price attractive when measured against the yardstick of value to a private owner. When such criteria are maintained, our intention is to hold for a long time; indeed, our largest equity investment is 467,150 shares of Washington Post “B” stock with a cost of $10.6 million, which we expect to hold permanently. With this approach, stock market fluctuations are of little importance to us – except as they may provide buying opportunities – but business performance is of major importance."

On bonds, Buffett continued on from last year’s explanation of interest sensitivity, saying:

"We consider such market fluctuation of minor importance as our liquidity and general financial strength make it highly improbable that bonds will have to be sold at times other than those of our choice."

Banking

Once again, Buffett praised Gene Abegg for the performance and management of Illinois National Bank and Trust, writing:

"Despite the maintenance of premier liquidity and the avoidance of ‘stretching’ for high yield loans, the Illinois National continues as about the most profitable bank of its size."

Buffett also noted that under the “present interest rate structure, it is expected that earnings of the Bank will be off somewhat during 1976 but will remain at a highly satisfactory level.”

Conclusion

The final paragraph of the 1975 letter, under the title of General Review, is a perfect summary of what Buffett is trying to achieve:

"While 1975 was a major disappointment, efforts will continue to develop growing and diversified sources of earnings. Our objective is a conservatively financed and highly liquid business – possessing extra margins of balance sheet strength consistent with the fiduciary obligations inherent in the banking and insurance industries – which will produce a long term rate of return on equity capital exceeding that of American industry as a whole."