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1985 Shareholder Letter

Published on 4 March 1986

· Value Investing

The original 1985 Shareholder letter can be found here (https://www.berkshirehathaway.com/letters/1985.html)

High growth eventually slows down

This shareholder letter was interesting because it highlighted tremendous growth and returns for Berkshire Hathaway in 1985, leading WB to declare that 1985 was an exceptional year, as rare as Hailey's comet, and he's unlikely to see it again in his lifetime. This is a reality of life: as companies get bigger and bigger, it's going to get increasingly harder for them to maintain the same levels of growth.

An iron law of business is that growth eventually dampens exceptional economics

Markets and Companies' stock price are irrational

Again, WB shared his strong belief that most of the companies' stock price in the investment universe, are irrationally priced occasionally. This seems paradoxical to most beginner investors simply because big companies are typically well-covered by well-trained, experienced analysts, who run all kinds of mathematical models on them, and big companies have entire cohorts of staff available to run all kinds of presentations for the market and investors, so that the pricing of big companies should be relatively more stable and efficient, right? Unfortunately this is not true.

You might think that institutions, with their large staffs
of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not: stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued.

This is particularly pertinent for us to remember in 2020 and beyond, as we experience trillion-dollar companies that have not been broken up by anti-trust laws. Increasingly you will see indices like S&P500 being highly influenced by only a few big companies, leading to probably even more volatility. Indices, by design and by nature, are not supposed to fluctuate wildly, but with it being dominated by a couple of mega-companies, it's inevitable.

Value Investing is done better with an informational edge

As with most endeavors, whoever has more information will likely do better. That's why there's so many "data providers" that provides insights to funds, and funds subscribe to a whole bunch of platforms, trying to gain an edge over their competition. As individual investors, it's very difficult for us to gain any substantial informational edge over such funds, so we have to stick to what's available, and leverage strategies that plays best to our investment philosophy. But after the Financial Crisis of '08, there have been increased information being given out by the companies, and I personally believe that the playing field has been levelled more, and it's even easier now for individual investors to do better than the funds. A useful (but somehow sad) quote from WB:

The change in their behavior recalls an insight of Al Capone: “You can get much further with a kind word and a gun than you can with a kind word alone.”

Focus on Returns on Capital

Again, WB reminded everyone that most companies require a high level of capital expenditure (capex) in order to generate revenue/earnings/income. Is it actually a good company if you have to spend $5M extra capital to generate $1M extra earnings? We have to look and compare each company realistically and rationally as far as possible. An useful way to learn this is to create your own miniature company complete with financial statements, and play around with the numbers and decide for yourself what numbers are important, and what numbers are not so important?

When returns on capital are ordinary, an earn-more-by-
putting-up-more record is no great managerial achievement. You can get the same result personally while operating from your rocking chair. just quadruple the capital you commit to a savings account and you will quadruple your earnings.

It's very important to avoid looking at just the top-line revenue number, without any regards for how much debt, or retained earnings the management have "used-up". If every year, a huge bulk of the earnings are retained by management, then the next year's revenue number will have to be much higher so that the returns on capital are respectable. Retained earnings will, more or less, automatically build up the value for next year, but there's a cost to this retention: the money could have been put to better use (and at a higher return of capital) by savvy shareholders.

Stock Options

WB launched into quite a detailed exposition of what he feels is wrong with the stock option/incentive scheme, and useful to look at this as nowadays, it's to avoid these type of incentive schemes. This letter gives quite a detailed explanation of his thinking behind it, and how it doesn't really make sense.

Once Bitten, Twice Shy

As always, WB gave a long and detailed exposition of the insurance industry, and if you're looking to understand how insurers (and reinsurers) work, this is a master class. One of the quotes was also quite interesting. The reality for most of us when we first started investing, is that we inevitably let our emotions take-over, and we make mistakes. Unfortunately, for many, they automatically default to "let's stop invest" or "investing is too risky". The reality is that you may have made all the right moves, but you may have still lost. Correct investment results comes from two things: The quality of your decision-making and abit of luck. Having bad investment results doesn't necessarily mean that you made bad decisions. It could very well be the case that the 5% chance of bad-shit-happening, happened.

Mark Twain’s cat: having once sat on a hot stove, it never did so again - but it never again sat on a cold stove, either.

Count all mistakes, and all possible mistakes

WB, again in his explanation of the insurance business, explains that it's important to realise, upfront, all the "exceptions" first, instead of trying to explain away lousy business performance after the fact.

In any business, insurance or otherwise, "except for" should be exised from the lexicon. If you are going to play the game, you must count the runs scored against you in all nine innings. Any manager who consistently says “except for” and then reports on the lessons he has learned from his mistakes may be missing the only important lesson - namely, that the real mistake is not the act, but the actor.

This is why we encourage all investors, before committing to a purchase, to really "invert" your investment story, and think of all the possible things that could go wrong, and then try to find reasons to buy-in anyway.

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