[Week 20 - 1984] Discussing A Berkshire Hathaway Shareholder Letter (Almost) Every Week

Full Letter:

https://theoraclesclassroom.com/wp-content/uploads/2019/09/1984-Berkshire-AR.pdf

Letter Only

https://www.berkshirehathaway.com/letters/1984.html

This week we will go over two segments on two fully owned businesses that have had extraordinary years, Buffalo Evening News and Nebraska Furniture Mart. Also the acquisition of a large stake in ABC and Capital Cities in return for funding their merger. Along with their results for the year. In the comments there is a segment on Buffett’s clash with Efficient Market Hypothesis proponents.

Things covered in the letter but not this post are some special dividend-like buybacks from GEICO and General Foods, as well as buybacks generally. A discussion of See’s Candies and its growth in the last decade, and lack thereof this last year. A long segment on Insurance and its headwinds as well as Buffett taking responsibility for the poor performance. A full segment explaining their failures in Loss Reserving leading to grossly overstating last year’s underwriting earnings. The story of some junk bonds they own in Washington Public Power Supply Systems. An analysis of dividends as a capital allocation decision and why they oppose their own company paying a dividend. As well as the usual acquisition advertisement, discussion of the charitable contributions and an announcement of the annual meeting.

If you want to read or discuss anything in that second set feel free to read the letter yourselves and comment on it.

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Key Passage 1

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Buffalo Evening News

Profits at the News in 1984 were considerably greater than

we expected. As at See’s, excellent progress was made in

controlling costs. Excluding hours worked in the newsroom, total

hours worked decreased by about 2.8%. With this productivity

improvement, overall costs increased only 4.9%. This performance

by Stan Lipsey and his management team was one of the best in the

industry.

However, we now face an acceleration in costs. In mid-1984

we entered into new multi-year union contracts that provided for

a large “catch-up” wage increase. This catch-up is entirely

appropriate: the cooperative spirit of our unions during the

unprofitable 1977-1982 period was an important factor in our

success in remaining cost competitive with The Courier-Express.

Had we not kept costs down, the outcome of that struggle might

well have been different.

Because our new union contracts took effect at varying

dates, little of the catch-up increase was reflected in our 1984

costs. But the increase will be almost totally effective in 1985

and, therefore, our unit labor costs will rise this year at a

rate considerably greater than that of the industry. We expect

to mitigate this increase by continued small gains in

productivity, but we cannot avoid significantly higher wage costs

this year. Newsprint price trends also are less favorable now

than they were in 1984. Primarily because of these two factors,

we expect at least a minor contraction in margins at the News.

Working in our favor at the News are two factors of major

economic importance:

(1) Our circulation is concentrated to an unusual degree

in the area of maximum utility to our advertisers.

“Regional” newspapers with wide-ranging circulation, on

the other hand, have a significant portion of their

circulation in areas that are of negligible utility to

most advertisers. A subscriber several hundred miles

away is not much of a prospect for the puppy you are

offering to sell via a classified ad - nor for the

grocer with stores only in the metropolitan area.

“Wasted” circulation - as the advertisers call it -

hurts profitability: expenses of a newspaper are

determined largely by gross circulation while

advertising revenues (usually 70% - 80% of total

revenues) are responsive only to useful circulation;

(2) Our penetration of the Buffalo retail market is

exceptional; advertisers can reach almost all of their

potential customers using only the News.

Last year I told you about this unusual reader acceptance:

among the 100 largest newspapers in the country, we were then

number one, daily, and number three, Sunday, in penetration. The

most recent figures show us number one in penetration on weekdays

and number two on Sunday. (Even so, the number of households in

Buffalo has declined, so our current weekday circulation is down

slightly; on Sundays it is unchanged.)

I told you also that one of the major reasons for this

unusual acceptance by readers was the unusual quantity of news

that we delivered to them: a greater percentage of our paper is

devoted to news than is the case at any other dominant paper in

our size range. In 1984 our “news hole” ratio was 50.9%, (versus

50.4% in 1983), a level far above the typical 35% - 40%. We will

continue to maintain this ratio in the 50% area. Also, though we

last year reduced total hours worked in other departments, we

maintained the level of employment in the newsroom and, again,

will continue to do so. Newsroom costs advanced 9.1% in 1984, a

rise far exceeding our overall cost increase of 4.9%.

Our news hole policy costs us significant extra money for

newsprint. As a result, our news costs (newsprint for the news

hole plus payroll and expenses of the newsroom) as a percentage

of revenue run higher than those of most dominant papers of our

size. There is adequate room, however, for our paper or any

other dominant paper to sustain these costs: the difference

between “high” and “low” news costs at papers of comparable size

runs perhaps three percentage points while pre-tax profit margins

are often ten times that amount.

The economics of a dominant newspaper are excellent, among

the very best in the business world. Owners, naturally, would

like to believe that their wonderful profitability is achieved

only because they unfailingly turn out a wonderful product. That

comfortable theory wilts before an uncomfortable fact. While

first-class newspapers make excellent profits, the profits of

third-rate papers are as good or better - as long as either class

of paper is dominant within its community. Of course, product

quality may have been crucial to the paper in achieving

dominance. We believe this was the case at the News, in very

large part because of people such as Alfred Kirchhofer who

preceded us.

Once dominant, the newspaper itself, not the marketplace,

determines just how good or how bad the paper will be. Good or

bad, it will prosper. That is not true of most businesses:

inferior quality generally produces inferior economics. But even

a poor newspaper is a bargain to most citizens simply because of

its “bulletin board” value. Other things being equal, a poor

product will not achieve quite the level of readership achieved

by a first-class product. A poor product, however, will still

remain essential to most citizens, and what commands their

attention will command the attention of advertisers.

Since high standards are not imposed by the marketplace,

management must impose its own. Our commitment to an above-

average expenditure for news represents an important quantitative

standard. We have confidence that Stan Lipsey and Murray Light

will continue to apply the far-more important qualitative

standards. Charlie and I believe that newspapers are very

special institutions in society. We are proud of the News, and

intend an even greater pride to be justified in the years ahead.

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Buffalo Evening News was unprofitable just two years ago, burning money for market share essentially, trying to turn Buffalo News from a duopoly into a monopoly. They have won the war for this city’s newspaper market, although how long the newspaper market will be a desirable one to be in remains to be seen.

They have finally succeeded and are now raising their prices and giving their workers a long deferred raise. There is a famous story of when Buffett first bought the news and had them change their footing to go to war in Buffett’s vision of a winner takes all newspaper industry. The Union was demanding a raise and going on strike. Buffett told them "If you're smart enough to figure out exactly how far you can push us where we still have a business and you still have a job, you're smarter than I am, so you go home and figure it out." He also told them: "If you come back in a day, we're competitive. If you come back in a year, we're out of business." and after 10 days the strike ended that day.

This raise is him fulfilling his end of that promise, The Courier Express collapsed in September 1982 and now they are the only paper left standing, Buffett owns his toll road, prices will raise, costs will be cut, and he is paying the writers their due for sacrificing their desired wages for the last 5 years for the good of the business.

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Key Passage 2

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Nebraska Furniture Mart

Last year I introduced you to Mrs. B (Rose Blumkin) and her

family. I told you they were terrific, and I understated the

case. After another year of observing their remarkable talents

and character, I can honestly say that I never have seen a

managerial group that either functions or behaves better than the

Blumkin family.

Mrs. B, Chairman of the Board, is now 91, and recently was

quoted in the local newspaper as saying, “I come home to eat and

sleep, and that’s about it. I can’t wait until it gets daylight

so I can get back to the business”. Mrs. B is at the store seven

days a week, from opening to close, and probably makes more

decisions in a day than most CEOs do in a year (better ones,

too).

In May Mrs. B was granted an Honorary Doctorate in

Commercial Science by New York University. (She’s a “fast track”

student: not one day in her life was spent in a school room prior

to her receipt of the doctorate.) Previous recipients of honorary

degrees in business from NYU include Clifton Garvin, Jr., CEO of

Exxon Corp.; Walter Wriston, then CEO of Citicorp; Frank Cary,

then CEO of IBM; Tom Murphy, then CEO of General Motors; and,

most recently, Paul Volcker. (They are in good company.)

The Blumkin blood did not run thin. Louie, Mrs. B’s son,

and his three boys, Ron, Irv, and Steve, all contribute in full

measure to NFM’s amazing success. The younger generation has

attended the best business school of them all - that conducted by

Mrs. B and Louie - and their training is evident in their

performance.

Last year NFM’s net sales increased by $14.3 million,

bringing the total to $115 million, all from the one store in

Omaha. That is by far the largest volume produced by a single

home furnishings store in the United States. In fact, the gain

in sales last year was itself greater than the annual volume of

many good-sized successful stores. The business achieves this

success because it deserves this success. A few figures will

tell you why.

In its fiscal 1984 10-K, the largest independent specialty

retailer of home furnishings in the country, Levitz Furniture,

described its prices as “generally lower than the prices charged

by conventional furniture stores in its trading area”. Levitz,

in that year, operated at a gross margin of 44.4% (that is, on

average, customers paid it $100 for merchandise that had cost it

$55.60 to buy). The gross margin at NFM is not much more than

half of that. NFM’s low mark-ups are possible because of its

exceptional efficiency: operating expenses (payroll, occupancy,

advertising, etc.) are about 16.5% of sales versus 35.6% at

Levitz.

None of this is in criticism of Levitz, which has a well-

managed operation. But the NFM operation is simply extraordinary

(and, remember, it all comes from a $500 investment by Mrs. B in

1937). By unparalleled efficiency and astute volume purchasing,

NFM is able to earn excellent returns on capital while saving its

customers at least $30 million annually from what, on average, it

would cost them to buy the same merchandise at stores maintaining

typical mark-ups. Such savings enable NFM to constantly widen

its geographical reach and thus to enjoy growth well beyond the

natural growth of the Omaha market.

I have been asked by a number of people just what secrets

the Blumkins bring to their business. These are not very

esoteric. All members of the family: (1) apply themselves with

an enthusiasm and energy that would make Ben Franklin and Horatio

Alger look like dropouts; (2) define with extraordinary realism

their area of special competence and act decisively on all

matters within it; (3) ignore even the most enticing propositions

failing outside of that area of special competence; and, (4)

unfailingly behave in a high-grade manner with everyone they deal

with. (Mrs. B boils it down to “sell cheap and tell the truth”.)

Our evaluation of the integrity of Mrs. B and her family was

demonstrated when we purchased 90% of the business: NFM had never

had an audit and we did not request one; we did not take an

inventory nor verify the receivables; we did not check property

titles. We gave Mrs. B a check for $55 million and she gave us

her word. That made for an even exchange.

You and I are fortunate to be in partnership with the

Blumkin family.

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As you will see in the segment by segment breakdown, NFM increased its net income by 281% this year, from $3.8M to $14.5M. All from one single location. So I think this segment giving them their flowers and explaining the work ethic of Mrs Blumkin and the competitive advantage of the business merited inclusion. I once again compare the NFM model to Costco, massive volume from single locations, passing along the savings to customers, drawing people from further and further away. The only difference being the lack of membership fees which make sense as people go furniture shopping probably less than once a year.

Not endorsing Costco and certainly not saying Costco’s earnings will go up 281% next year, the same problem that plagues Berkshire making past earnings growth seem unachievable for the future more so plagues Costco, their size weighs them down compared to a single store. The point is Munger and Buffett threw money into Costco during the dotcom bubble when finding deals was hard and tech was trendy and their shares went up 10x over the 20 years they held them and paid them out ~70% of their initial investment as dividends. Meanwhile the S&P 500 was just under a 4x in the same time I wouldn’t be surprised if their experience with NFM let them see what Costco had going for it while everyone else was chasing internet startups.

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Minority Acquisition of the Week

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Subsequent Event: On March 18, a week after copy for this

report went to the typographer but shortly before production, we

agreed to purchase three million shares of Capital Cities

Communications, Inc. at $172.50 per share. Our purchase is

contingent upon the acquisition of American Broadcasting

Companies, Inc. by Capital Cities, and will close when that

transaction closes. At the earliest, that will be very late in

1. Our admiration for the management of Capital Cities, led

by Tom Murphy and Dan Burke, has been expressed several times in

previous annual reports. Quite simply, they are tops in both

ability and integrity. We will have more to say about this

investment in next year’s report.

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Closest I could find to an acquisition this week, Capital Cities is merging with ABC and Buffet is helping to finance the deal in exchange for just under 20% ownership of the merged company. Capital Cities is a relatively lean collection of Radio, TV, Newspaper stations/publishers. It was seen as a smaller but incredibly efficient operation. ABC on the other hand was a giant that had a lot of fat to be trimmed. They own cable networks like ESPN, tons of local news stations, they had rights to Football, Good Morning America, the Academy Awards, a massive radio empire, etc…

The idea was that ABC used to be one of the Big Three when there were fewer options but they were being out-operated and out-competed and just falling behind in the attention economy from a time when there were maybe 10 or 20 TV channels. ABC’s stock was depressed and they knew they needed new management to turn the company around but were afraid of selling out by a bigger conglomerate and having the company raided for assets. Instead they wanted to sell to a smaller operation that had a great reputation and would treat ABC as it’s priority. The issue was ABC was still 4x the size of Capital Cities, so outside capital was needed. Buffett had a big pile of cash, wanted to get into news wherever possible, Capital Cities seems like exactly the kind of operation he loves with the kind of management he loves. He also already owned a chunk of ABC as you can see in the below chart, which meant he already knew the business inside and out and his 3/4 million shares would be on their side already and after this deal. Buffett will end up having those converted to cash and stock warrants for the new company and re-invested all that in the company and threw another $518M cash into the deal for a final ownership of 3 million shares, 18% of the new company.

Next year’s letter will include more about this but I suspect a different acquisition will be taking this slot next week.

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Common Stock Ownership

| No. of Shares | Company | Cost (000s) | Market (000s) |

|:---|:---|---:|---:|

| 690,975 | Affiliated Publications, Inc. | $3,516 | $32,908 |

| 740,400 | American Broadcasting Companies, Inc. | $44,416 | $46,738 |

| 3,895,710 | Exxon Corporation | $173,401 | $175,307 |

| 4,047,191 | General Foods Corporation | $149,870 | $226,137 |

| 6,850,000 | GEICO Corporation | $45,713 | $397,300 |

| 2,379,200 | Handy & Harman | $27,318 | $38,662 |

| 818,872 | Interpublic Group of Companies, Inc. | $2,570 | $28,149 |

| 555,949 | Northwest Industries | $26,581 | $27,242 |

| 2,553,488 | Time, Inc. | $89,327 | $109,162 |

| 1,868,600 | The Washington Post Company | $10,628 | $149,955 |

| - | All Other Common Stockholdings | $11,634 | $37,326 |

| - | Total Common Stocks | $584,974 | $1,268,886 |

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Segment by Segment Breakdown

|Segment|1983 EBIT Earnings|1984 EBIT Earnings|% Change|

|:-|:-|:-|:-|

|Insurance|$9.94M|$20.84M|+109.66%|

|Textiles|(-$0.10M)|$0.42M|+520.00%|

|Associated Retail|$0.70M|(-$1.07M)|-252.86%|

|See’s Candies|$27.41M|$26.64M|-2.81%|

|Buffalo Evening News|$19.35M|$27.33M|+41.24%|

|Wesco Financial|$7.49M|$9.78M|+30.57%|

|Mutual Savings and Loan|(-$0.80M)|$1.46M|+282.50%|

|Precision Steel|$3.24M|$4.09M|+26.23%|

|Nebraska Furniture Mart|$3.81M|$14.51M|+280.84%|

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|Metric|1983|1984|% Change|

|:---|:---|:---|:---|

|Cash|$6.16M|$3.68M|-40.26%|

|Marketable Securities|$1,232.15M|$1,235.90M|+0.30%|

|Return on Equity (RoE)|23.25%|14.23%|-38.79%|

|Shareholders' Equity|$1,119.19M|$1,271.76M|+13.63%|

|Berkshire Net Earnings|$112.17M|$148.90M|+32.75%|

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The insurance segment looks good this year, but this is quite misleading. Last year’s number got revised down from $31M to $10M, so this year's $21M number is lower than last year’s contemporary number and has a chance of being revised down itself in next year’s report. So the estimate for this year’s earnings is actually a 33% decline from last year’s number. But it is double last year's finalized number after the dust has settled. The insurance segment of the letter is actually Buffett taking responsibility for the poor results and trying to talk about the silver linings to their operation, its reputation and financial position and lack of quota chasing.

Textiles is actually profitable again, but still pretty pathetic results for the longest holding of the company and its original business. Once again highlighting how much better off they were pivoting away. The S&P 500 was only up 6% this year, Berkshire’s stock holdings were basically flat in comparison, their equity gain was basically all earnings from their businesses and next to none from investments.

Those earnings are fortunately up about ⅓, partially due to the great performance of the Furniture Mart and Evening News which increased their EBIT earnings almost $20M this year, more than half of the increase in net earnings for the whole conglomerate.