Uber investor Warren Buffet is justly famous for his folksy shareholder letters. Last year I made a vague resolution to go back and read them all, but I never really made the commitment. So this year I’m going to read one per week and blog about any nuggets I find. I’ve even create a category just for Warren Buffet.
In other words, I 
Warren Buffet.
First up, 1977 (written in 1978). Here’s the high-level summary:
Gross operating earnings: $21,904,000
Per share earnings: $22.54
As we know in hindsight, Berkshire Hathaway, Buffet’s holding company, is one of the most successful enterprises in the history of industry. It has delivered a sustained compounded growth rate of 20% every year over the past 30 years. That’s astounding. He took some hits during the late 90s bull run in tech and internet stocks, and he took a tremendouse hit after 9/11 because Berkshire subsidiaries were some of the most exposed insurers that had to pay for the rebuilding of New York. Nonetheless, here we are years later, thousands of companies having collapsed, New York rebuilt and Berkshire Hathaway still thriving. (It will be interesting to learn the effects of Hurricane Katrina on his businesses in this year’s letter.)
With such an incredible growth rate, it’s obvious that Buffet has delivered record earnings pretty much every year, which any manager would crow about. But back in 1978, Buffet actually downplayed the significance of record earnings:
Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share.After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.
Buffet prefers a different metric, one that’s more fitting for bankers and insurers rather than go-go tech jockies:
Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.
After setting expectations, it’s time to brag a little:
In 1977 our operating earnings on beginning equity capital amounted to 19%, slightly better than last year and above both our own long-term average and that of American industry in aggregate.
Or is it?
But, while our operating earnings per share were up 37% from the year before, our beginning capital was up 24%, making the gain in earnings per share considerably less impressive than it might appear at first glance… We expect difficulty in matching our 1977 rate of return during the forthcoming year. Beginning equity capital is up 23% from a year ago, and we expect the trend of insurance underwriting profit margins to turn down well before the end of the year.
Buffet practices a great management principal, one that seems especially important today given all the CEOs on trial and in jail (not to mention Sarbanes-Oxley): underpromise and overdeliver.
Here’s another good principle: candor. When you make a mistake, admit it.
The textile business again had a very poor year in 1977. We have mistakenly predicted better results in each of the last two years. This may say something about our forecasting abilities, the nature of the textile industry, or both. Despite strenuous efforts, problems in marketing and manufacturing have persisted. Many difficulties experienced in the marketing area are due primarily to industry conditions, but some of the problems have been of our own making.
(It’s no coincidence that candor is also one of the 22 Immutable Laws of Marketing.)
Insurance has always been a rather opaque business to me. I understand the basic model – be smart enough to invest current premiums well enough to pay future claims – but all the legal gobbledygook makes my eyes glaze over, and the actuarial stuff is way over my head. And competitively speaking, it seems like a nightmare to someone like me who’s used to technology businesses and their proprietary advantages. Buffet is forthright about this:
Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition.
And think about the common perception of insurance. For me, at least, it conjures up the image of a slightly cloying sales guy working the room at chamber of commerce events, followed much later by arguing about a claim with some agent at a call center in who-knows-where. I suspect I’m not alone. Buffet concludes that in such an undifferentiated market, and particularly one which includes a lot of human contact, the only sustainable advantage you can create is through hiring good people:
[Th]ere is no question that the nature of the insurance business magnifies the effect which individual managers have on company performance. We are very fortunate to have the group of managers that are associated with us.
(Although, now that I think about it, Geico – a Buffet company – does about as good a job as anyone when it comes to brand advertising. I suppose you could argue AFLAC is pretty good at basic brand identity, but I have no idea what their unique selling proposition is. I just know they have a goose or a duck or something as a mascot. Conversely, I now solely from hearing their commercials a jillion times that Geico is all about direct sales, and particularly saving 15% or more over other insurers. How’s that for staying on message? Oh yeah, they have a cute lizard or chameleon or something as a mascot.)
My lessons learned
Summing it up, here’s what I learned from this letter:
- Focus on the right metric for measuring operational success (in his case, return on equity), not just the popular one
- The only way to succeed in very competitive markets is to have the right people
- Underpromise, overdeliver
- Practice candor