This is the second post in a series which will explore the successes, failures, and teachings of Warren Buffett through his annual Berkshire Hathaway letters to shareholders. To start at the beginning, click here.
How Do You Build a Company With a Firm Foundation?
Warren Buffett’s propensity to large cash balances and acquisitions seems to have started early. We are already seeing the transformation of Berkshire Hathaway from a struggling textile business in New England to the thriving conglomerate it is today in these 1966-1968 reviews.
From 1960 to 1966, the net worth of Berkshire Hathaway’s decreased from $37,981,820 to $29,494,920 – a 22% decline! Mr. Buffett wryly referred to this outcome at the end of his 1967 letter, writing, “We feel it is essential that we not repeat the history of the 1956-1966 period, when over-all earnings on average invested capital of over $30 million were something less than zero” (emphasis mine). There are multiple reasons for this loss in value, including the cyclical nature of the textile industry itself, changing product demands, and increased international competition.
The Rainy Day Fund
On October 1, 1966, Berkshire had working capital of $23 million. In 2020 dollars that translates to well over $100 million! With this financial stability Berkshire was able to pay its only dividend in the 54 years of new management – $0.10/share. While this may seem paltry, I doubt long-term owners of Berkshire are complaining much about their 20% annually compounded (2,744,062% overall) returns.
Buffett highlights several reasons to maintain this large reserve of cash. Among these are the cyclical nature of the textile industry and the constant need to update machinery. Not content to sit on the cash, the company would invest “a major portion of these funds in marketable common stocks.” This leads to two benefits:
1) Improved return on cash
2) Benefit from earnings derived from outside of the textile business.
Pro Tip #1: Is the CEO planning for difficult financial times?
Pro Tip #2: Is the CEO seeking to maximise the owners’ (i.e., the shareholders’) investment, or his own short term metrics?
Diversification
The company’s other plan for this cash was acquisitions. In March of 1967 Berkshire acquired National Indemnity (NICO) and a smaller sister insurance company, both run by the co-founder Jack Ringwalt, also of Omaha.
“Our investment in the insurance companies reflects a first major step in our efforts to achieve a more diversified base of earning power.
Warren Buffett, Annual Report 1968
The purchase price for this company was $8.6 million. This investment began to pay off immediately. In the first year, the earnings of NICO “substantially exceeded” the earnings attributable to the textile business. This is not necessarily true, and it could be expected that business success would reverse.
However, we believe it is an added factor of strength to have these two unrelated sources of earnings rather than to be solely exposed to the conditions of one industry, as heretofore.
Warren Buffett, Annual Report 1968
According to the 2019 Berkshire letter, NICO is now the largest property and casualty company in the world measured by net worth, at $167 BILLION! Berkshire has bought several other insurance companies in the years since, and this is no coincidence. The insurance business model has intrinsic characteristics that make them particularly suited to Buffett’s strengths, a relationship we will explore more in the coming articles.
Final Thoughts
In hindsight we know this was a good decision, but was it necessarily so? Some might say that Berkshire has no expertise in the cutthroat insurance industry and is diverting their attention from their primary concern, textile manufacturing. If this is poorly managed, Berkshire runs the risk of now ruining two companies. What markers should we look for to judge for a successful merger?
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USA White House / Public domainLeave a comment with your thoughts below!
