[Week 21 - 1985] Discussing A Berkshire Hathaway Shareholder Letter (Almost) Every Week

Full Letter:

https://theoraclesclassroom.com/wp-content/uploads/2019/09/1985-Berkshire-AR.pdf

Letter Only

https://www.berkshirehathaway.com/letters/1985.html

This week we will go over two segments and an acquisition.

One is a really wonderful and insightful writeup on executive and managerial compensation, and the costs and benefits of compensating with cash vs stock vs options and Buffett’s reprimanding of some practices that have gotten out of hand as well as an explanation of their own compensation system.

The second is a eulogy and autopsy for the textile business which is being shut down. The acquisition is of Scott & Fetzer a conglomerate that makes vacuums, water heaters, air compressors, encyclopedias.

Things covered in the letter but not this post are a long breakdown of the insurance industry, its current state, Berkshire’s position, and predictions on where the insurance cycle is headed. A new insurance company run by a former character from these letters which Berkshire has entered into business with. A discussion of their marketable securities and their current positions and views on them. The acquisition of Capital Cities/ABC discussed in last week’s post. As well as the usual suspects, an advertisement for acquisition, planning the meeting, discussing the charitable contributions.

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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**Three Very Good Businesses (and a Few Thoughts About Incentive

Compensation)**

When I was 12, I lived with my grandfather for about four

months. A grocer by trade, he was also working on a book and

each night he dictated a few pages to me. The title - brace

yourself - was “How to Run a Grocery Store and a Few Things I

Have Learned About Fishing”. My grandfather was sure that

interest in these two subjects was universal and that the world

awaited his views. You may conclude from this section’s title

and contents that I was overexposed to Grandpa’s literary style

(and personality).

I am merging the discussion of Nebraska Furniture Mart,

See’s Candy Shops, and Buffalo Evening News here because the

economic strengths, weaknesses, and prospects of these businesses

have changed little since I reported to you a year ago. The

shortness of this discussion, however, is in no way meant to

minimize the importance of these businesses to us: in 1985 they

earned an aggregate of $72 million pre-tax. Fifteen years ago,

before we had acquired any of them, their aggregate earnings were

about $8 million pre-tax.

While an increase in earnings from $8 million to $72 million

sounds terrific - and usually is - you should not automatically

assume that to be the case. You must first make sure that

earnings were not severely depressed in the base year. If they

were instead substantial in relation to capital employed, an even

more important point must be examined: how much additional

capital was required to produce the additional earnings?

In both respects, our group of three scores well. First,

earnings 15 years ago were excellent compared to capital then

employed in the businesses. Second, although annual earnings are

now $64 million greater, the businesses require only about $40

million more in invested capital to operate than was the case

then.

The dramatic growth in earning power of these three

businesses, accompanied by their need for only minor amounts of

capital, illustrates very well the power of economic goodwill

during an inflationary period (a phenomenon explained in detail

in the 1983 annual report). The financial characteristics of

these businesses have allowed us to use a very large portion of

the earnings they generate elsewhere. Corporate America,

however, has had a different experience: in order to increase

earnings significantly, most companies have needed to increase

capital significantly also. The average American business has

required about $5 of additional capital to generate an additional

$1 of annual pre-tax earnings. That business, therefore, would

have required over $300 million in additional capital from its

owners in order to achieve an earnings performance equal to our

group of three.

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. You would hardly

expect hosannas for that particular accomplishment. Yet,

retirement announcements regularly sing the praises of CEOs who

have, say, quadrupled earnings of their widget company during

their reign - with no one examining whether this gain was

attributable simply to many years of retained earnings and the

workings of compound interest.

If the widget company consistently earned a superior return

on capital throughout the period, or if capital employed only

doubled during the CEO’s reign, the praise for him may be well

deserved. But if return on capital was lackluster and capital

employed increased in pace with earnings, applause should be

withheld. A savings account in which interest was reinvested

would achieve the same year-by-year increase in earnings - and,

at only 8% interest, would quadruple its annual earnings in 18

years.

The power of this simple math is often ignored by companies

to the detriment of their shareholders. Many corporate

compensation plans reward managers handsomely for earnings

increases produced solely, or in large part, by retained earnings

• i.e., earnings withheld from owners. For example, ten-year,

fixed-price stock options are granted routinely, often by

companies whose dividends are only a small percentage of

earnings.

An example will illustrate the inequities possible under

such circumstances. Let’s suppose that you had a $100,000

savings account earning 8% interest and “managed” by a trustee

who could decide each year what portion of the interest you were

to be paid in cash. Interest not paid out would be “retained

earnings” added to the savings account to compound. And let’s

suppose that your trustee, in his superior wisdom, set the “pay-

out ratio” at one-quarter of the annual earnings.

Under these assumptions, your account would be worth

$179,084 at the end of ten years. Additionally, your annual

earnings would have increased about 70% from $8,000 to $13,515

under this inspired management. And, finally, your “dividends”

would have increased commensurately, rising regularly from $2,000

in the first year to $3,378 in the tenth year. Each year, when

your manager’s public relations firm prepared his annual report

to you, all of the charts would have had lines marching skyward.

Now, just for fun, let’s push our scenario one notch further

and give your trustee-manager a ten-year fixed-price option on

part of your “business” (i.e., your savings account) based on its

fair value in the first year. With such an option, your manager

would reap a substantial profit at your expense - just from

having held on to most of your earnings. If he were both

Machiavellian and a bit of a mathematician, your manager might

also have cut the pay-out ratio once he was firmly entrenched.

This scenario is not as farfetched as you might think. Many

stock options in the corporate world have worked in exactly that

fashion: they have gained in value simply because management

retained earnings, not because it did well with the capital in

its hands.

Managers actually apply a double standard to options.

Leaving aside warrants (which deliver the issuing corporation

immediate and substantial compensation), I believe it is fair to

say that nowhere in the business world are ten-year fixed-price

options on all or a portion of a business granted to outsiders.

Ten months, in fact, would be regarded as extreme. It would be

particularly unthinkable for managers to grant a long-term option

on a business that was regularly adding to its capital. Any

outsider wanting to secure such an option would be required to

pay fully for capital added during the option period.

The unwillingness of managers to do-unto-outsiders, however,

is not matched by an unwillingness to do-unto-themselves.

(Negotiating with one’s self seldom produces a barroom brawl.)

Managers regularly engineer ten-year, fixed-price options for

themselves and associates that, first, totally ignore the fact

that retained earnings automatically build value and, second,

ignore the carrying cost of capital. As a result, these managers

end up profiting much as they would have had they had an option

on that savings account that was automatically building up in

value.

Of course, stock options often go to talented, value-adding

managers and sometimes deliver them rewards that are perfectly

appropriate. (Indeed, managers who are really exceptional almost

always get far less than they should.) But when the result is

equitable, it is accidental. Once granted, the option is blind

to individual performance. Because it is irrevocable and

unconditional (so long as a manager stays in the company), the

sluggard receives rewards from his options precisely as does the

star. A managerial Rip Van Winkle, ready to doze for ten years,

could not wish for a better “incentive” system.

(I can’t resist commenting on one long-term option given an

“outsider”: that granted the U.S. Government on Chrysler shares

as partial consideration for the government’s guarantee of some

lifesaving loans. When these options worked out well for the

government, Chrysler sought to modify the payoff, arguing that

the rewards to the government were both far greater than intended

and outsize in relation to its contribution to Chrysler’s

recovery. The company’s anguish over what it saw as an imbalance

between payoff and performance made national news. That anguish

may well be unique: to my knowledge, no managers - anywhere -

have been similarly offended by unwarranted payoffs arising from

options granted to themselves or their colleagues.)

Ironically, the rhetoric about options frequently describes

them as desirable because they put managers and owners in the

same financial boat. In reality, the boats are far different.

No owner has ever escaped the burden of capital costs, whereas a

holder of a fixed-price option bears no capital costs at all. An

owner must weigh upside potential against downside risk; an

option holder has no downside. In fact, the business project in

which you would wish to have an option frequently is a project in

which you would reject ownership. (I’ll be happy to accept a

lottery ticket as a gift - but I’ll never buy one.)

In dividend policy also, the option holders’ interests are

best served by a policy that may ill serve the owner. Think back

to the savings account example. The trustee, holding his option,

would benefit from a no-dividend policy. Conversely, the owner

of the account should lean to a total payout so that he can

prevent the option-holding manager from sharing in the account’s

retained earnings.

Despite their shortcomings, options can be appropriate under

some circumstances. My criticism relates to their indiscriminate

use and, in that connection, I would like to emphasize three

points:

First, stock options are inevitably tied to the overall

performance of a corporation. Logically, therefore, they should

be awarded only to those managers with overall responsibility.

Managers with limited areas of responsibility should have

incentives that pay off in relation to results under their

control. The .350 hitter expects, and also deserves, a big

payoff for his performance - even if he plays for a cellar-

dwelling team. And the .150 hitter should get no reward - even

if he plays for a pennant winner. Only those with overall

responsibility for the team should have their rewards tied to its

results.

Second, options should be structured carefully. Absent

special factors, they should have built into them a retained-

earnings or carrying-cost factor. Equally important, they should

be priced realistically. When managers are faced with offers for

their companies, they unfailingly point out how unrealistic

market prices can be as an index of real value. But why, then,

should these same depressed prices be the valuations at which

managers sell portions of their businesses to themselves? (They

may go further: officers and directors sometimes consult the Tax

Code to determine the lowest prices at which they can, in effect,

sell part of the business to insiders. While they’re at it, they

often elect plans that produce the worst tax result for the

company.) Except in highly unusual cases, owners are not well

served by the sale of part of their business at a bargain price -

whether the sale is to outsiders or to insiders. The obvious

conclusion: options should be priced at true business value.

Third, I want to emphasize that some managers whom I admire

enormously - and whose operating records are far better than mine

• disagree with me regarding fixed-price options. They have

built corporate cultures that work, and fixed-price options have

been a tool that helped them. By their leadership and example,

and by the use of options as incentives, these managers have

taught their colleagues to think like owners. Such a Culture is

rare and when it exists should perhaps be left intact - despite

inefficiencies and inequities that may infest the option program.

“If it ain’t broke, don’t fix it” is preferable to “purity at any

price”.

At Berkshire, however, we use an incentive-compensation

system that rewards key managers for meeting targets in their own

bailiwicks. If See’s does well, that does not produce incentive

compensation at the News - nor vice versa. Neither do we look at

the price of Berkshire stock when we write bonus checks. We

believe good unit performance should be rewarded whether

Berkshire stock rises, falls, or stays even. Similarly, we think

average performance should earn no special rewards even if our

stock should soar. “Performance”, furthermore, is defined in

different ways depending upon the underlying economics of the

business: in some our managers enjoy tailwinds not of their own

making, in others they fight unavoidable headwinds.

The rewards that go with this system can be large. At our

various business units, top managers sometimes receive incentive

bonuses of five times their base salary, or more, and it would

appear possible that one manager’s bonus could top $2 million in

1. (I hope so.) We do not put a cap on bonuses, and the

potential for rewards is not hierarchical. The manager of a

relatively small unit can earn far more than the manager of a

larger unit if results indicate he should. We believe, further,

that such factors as seniority and age should not affect

incentive compensation (though they sometimes influence basic

compensation). A 20-year-old who can hit .300 is as valuable to

us as a 40-year-old performing as well.

Obviously, all Berkshire managers can use their bonus money

(or other funds, including borrowed money) to buy our stock in

the market. Many have done just that - and some now have large

holdings. By accepting both the risks and the carrying costs

that go with outright purchases, these managers truly walk in the

shoes of owners.

Now let’s get back - at long last - to our three businesses:

At Nebraska Furniture Mart our basic strength is an

exceptionally low-cost operation that allows the business to

regularly offer customers the best values available in home

furnishings. NFM is the largest store of its kind in the

country. Although the already-depressed farm economy worsened

considerably in 1985, the store easily set a new sales record. I

also am happy to report that NFM’s Chairman, Rose Blumkin (the

legendary “Mrs. B”), continues at age 92 to set a pace at the

store that none of us can keep up with. She’s there wheeling and

dealing seven days a week, and I hope that any of you who visit

Omaha will go out to the Mart and see her in action. It will

inspire you, as it does me.

At See’s we continue to get store volumes that are far

beyond those achieved by any competitor we know of. Despite the

unmatched consumer acceptance we enjoy, industry trends are not

good, and we continue to experience slippage in poundage sales on

a same-store basis. This puts pressure on per-pound costs. We

now are willing to increase prices only modestly and, unless we

can stabilize per-shop poundage, profit margins will narrow.

At the News volume gains are also difficult to achieve.

Though linage increased during 1985, the gain was more than

accounted for by preprints. ROP linage (advertising printed on

our own pages) declined. Preprints are far less profitable than

ROP ads, and also more vulnerable to competition. In 1985, the

News again controlled costs well and our household penetration

continues to be exceptional.

One problem these three operations do not have is

management. At See’s we have Chuck Huggins, the man we put in

charge the day we bought the business. Selecting him remains one

of our best business decisions. At the News we have Stan Lipsey,

a manager of equal caliber. Stan has been with us 17 years, and

his unusual business talents have become more evident with every

additional level of responsibility he has tackled. And, at the

Mart, we have the amazing Blumkins - Mrs. B, Louie, Ron, Irv, and

Steve - a three-generation miracle of management.

I consider myself extraordinarily lucky to be able to work

with managers such as these. I like them personally as much as I

admire them professionally.

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A really great (if long) section from Buffett who clearly has some thoughts to get out about stock based compensation, even more particularly about options based compensation or earnings goals. He mainly does this through the analogy of instead of a manager running a business, say a trustee managing a savings account with an 8% interest rate. That savings account if interest(earnings) is retained will double in 9 years, if you simply deposit some extra money and double the size of the account its earnings will double. Thus doubling earnings does not inherently imply that the account has become a better place for your money.

Now imagine that the trustee is given a share of the account or its payouts if some are chosen, in that case the interests of the two parties are roughly aligned and he will be running the math on paying out if there are better opportunities.

Now imagine he has some long term option to say 5% of the account in 10 years. Well in this case interests are not aligned, and by retaining the earnings he is basically robbing you and by paying out earnings he would be robbing himself. You have actually put your interests in direct opposition to one another.

After this he talks about how he views compensation packages at Berkshire. He doesn’t want to reward a manager of one of their dozen businesses for how the stock does. The managers of See’s candies shouldn’t get a bigger bonus because the conglomerate’s GEICO investment doubled again. He says a .350 batter on a losing team should be rewarded but a .150 batter on a winning team should not be.

So instead at Berkshire he chooses to give cash bonuses for specific performance of the things that particular manager manages. If See’s exceeds expectations the managers at See’s get a big cash bonus. Many of them he says then choose to use that bonus to load up on Berkshire stock, but this means they are much more aligned with the owners anyways than one who was paid in stock and simply decided not to sell it all right away. The ones who are choosing to load up on Berkshire shares with their bonus are planning to use it as a longer term wealth vehicle and aren’t just looking for a better time to cash out.

One thing he doesn’t say here but that I think is worth considering, is that stock compensation that is usually flipped for cash would cause dilution and create selling pressure. While cash bonuses that sometimes get converted into shares on the open market cause no dilution and create buying pressure on the stock, a weaker version of buybacks done by employees who believe the shares are at a good price at that moment and want to be owners of the business they work for.

He wraps up with a quick rundown of NFM, See’s and The News as he doesn’t have much to say about them but praise for their managers.

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Key Passage 2

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Shutdown of Textile Business

In July we decided to close our textile operation, and by

yearend this unpleasant job was largely completed. The history

of this business is instructive.

When Buffett Partnership, Ltd., an investment partnership of

which I was general partner, bought control of Berkshire Hathaway

21 years ago, it had an accounting net worth of $22 million, all

devoted to the textile business. The company’s intrinsic

business value, however, was considerably less because the

textile assets were unable to earn returns commensurate with

their accounting value. Indeed, during the previous nine years

(the period in which Berkshire and Hathaway operated as a merged

company) aggregate sales of $530 million had produced an

aggregate loss of $10 million. Profits had been reported from

time to time but the net effect was always one step forward, two

steps back.

At the time we made our purchase, southern textile plants -

largely non-union - were believed to have an important

competitive advantage. Most northern textile operations had

closed and many people thought we would liquidate our business as

well.

We felt, however, that the business would be run much better

by a long-time employee whom we immediately selected to be

president, Ken Chace. In this respect we were 100% correct: Ken

and his recent successor, Garry Morrison, have been excellent

managers, every bit the equal of managers at our more profitable

businesses.

In early 1967 cash generated by the textile operation was

used to fund our entry into insurance via the purchase of

National Indemnity Company. Some of the money came from earnings

and some from reduced investment in textile inventories,

receivables, and fixed assets. This pullback proved wise:

although much improved by Ken’s management, the textile business

never became a good earner, not even in cyclical upturns.

Further diversification for Berkshire followed, and

gradually the textile operation’s depressing effect on our

overall return diminished as the business became a progressively

smaller portion of the corporation. We remained in the business

for reasons that I stated in the 1978 annual report (and

summarized at other times also): “(1) our textile businesses are

very important employers in their communities, (2) management has

been straightforward in reporting on problems and energetic in

attacking them, (3) labor has been cooperative and understanding

in facing our common problems, and (4) the business should

average modest cash returns relative to investment.” I further

said, “As long as these conditions prevail - and we expect that

they will - we intend to continue to support our textile business

despite more attractive alternative uses for capital.”

It turned out that I was very wrong about (4). Though 1979

was moderately profitable, the business thereafter consumed major

amounts of cash. By mid-1985 it became clear, even to me, that

this condition was almost sure to continue. Could we have found

a buyer who would continue operations, I would have certainly

preferred to sell the business rather than liquidate it, even if

that meant somewhat lower proceeds for us. But the economics

that were finally obvious to me were also obvious to others, and

interest was nil.

I won’t close down businesses of sub-normal profitability

merely to add a fraction of a point to our corporate rate of

return. However, I also feel it inappropriate for even an

exceptionally profitable company to fund an operation once it

appears to have unending losses in prospect. Adam Smith would

disagree with my first proposition, and Karl Marx would disagree

with my second; the middle ground is the only position that

leaves me comfortable.

I should reemphasize that Ken and Garry have been

resourceful, energetic and imaginative in attempting to make our

textile operation a success. Trying to achieve sustainable

profitability, they reworked product lines, machinery

configurations and distribution arrangements. We also made a

major acquisition, Waumbec Mills, with the expectation of

important synergy (a term widely used in business to explain an

acquisition that otherwise makes no sense). But in the end

nothing worked and I should be faulted for not quitting sooner.

A recent Business Week article stated that 250 textile mills have

closed since 1980. Their owners were not privy to any

information that was unknown to me; they simply processed it more

objectively. I ignored Comte’s advice - “the intellect should be

the servant of the heart, but not its slave” - and believed what

I preferred to believe.

The domestic textile industry operates in a commodity

business, competing in a world market in which substantial excess

capacity exists. Much of the trouble we experienced was

attributable, both directly and indirectly, to competition from

foreign countries whose workers are paid a small fraction of the

U.S. minimum wage. But that in no way means that our labor force

deserves any blame for our closing. In fact, in comparison with

employees of American industry generally, our workers were poorly

paid, as has been the case throughout the textile business. In

contract negotiations, union leaders and members were sensitive

to our disadvantageous cost position and did not push for

unrealistic wage increases or unproductive work practices. To

the contrary, they tried just as hard as we did to keep us

competitive. Even during our liquidation period they performed

superbly. (Ironically, we would have been better off financially

if our union had behaved unreasonably some years ago; we then

would have recognized the impossible future that we faced,

promptly closed down, and avoided significant future losses.)

Over the years, we had the option of making large capital

expenditures in the textile operation that would have allowed us

to somewhat reduce variable costs. Each proposal to do so looked

like an immediate winner. Measured by standard return-on-

investment tests, in fact, these proposals usually promised

greater economic benefits than would have resulted from

comparable expenditures in our highly-profitable candy and

newspaper businesses.

But the promised benefits from these textile investments

were illusory. Many of our competitors, both domestic and

foreign, were stepping up to the same kind of expenditures and,

once enough companies did so, their reduced costs became the

baseline for reduced prices industrywide. Viewed individually,

each company’s capital investment decision appeared cost-

effective and rational; viewed collectively, the decisions

neutralized each other and were irrational (just as happens when

each person watching a parade decides he can see a little better

if he stands on tiptoes). After each round of investment, all

the players had more money in the game and returns remained

anemic.

Thus, we faced a miserable choice: huge capital investment

would have helped to keep our textile business alive, but would

have left us with terrible returns on ever-growing amounts of

capital. After the investment, moreover, the foreign competition

would still have retained a major, continuing advantage in labor

costs. A refusal to invest, however, would make us increasingly

non-competitive, even measured against domestic textile

manufacturers. I always thought myself in the position described

by Woody Allen in one of his movies: “More than any other time in

history, mankind faces a crossroads. One path leads to despair

and utter hopelessness, the other to total extinction. Let us

pray we have the wisdom to choose correctly.”

For an understanding of how the to-invest-or-not-to-invest

dilemma plays out in a commodity business, it is instructive to

look at Burlington Industries, by far the largest U.S. textile

company both 21 years ago and now. In 1964 Burlington had sales

of $1.2 billion against our $50 million. It had strengths in

both distribution and production that we could never hope to

match and also, of course, had an earnings record far superior to

ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business,

and in 1985 had sales of about $2.8 billion. During the 1964-85

period, the company made capital expenditures of about $3

billion, far more than any other U.S. textile company and more

than $200-per-share on that $60 stock. A very large part of the

expenditures, I am sure, was devoted to cost improvement and

expansion. Given Burlington’s basic commitment to stay in

textiles, I would also surmise that the company’s capital

decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real

dollars and has far lower returns on sales and equity now than 20

years ago. Split 2-for-1 in 1965, the stock now sells at 34 --

on an adjusted basis, just a little over its $60 price in 1964.

Meanwhile, the CPI has more than tripled. Therefore, each share

commands about one-third the purchasing power it did at the end

of 1964. Regular dividends have been paid but they, too, have

shrunk significantly in purchasing power.

This devastating outcome for the shareholders indicates what

can happen when much brain power and energy are applied to a

faulty premise. The situation is suggestive of Samuel Johnson’s

horse: “A horse that can count to ten is a remarkable horse - not

a remarkable mathematician.” Likewise, a textile company that

allocates capital brilliantly within its industry is a remarkable

textile company - but not a remarkable business.

My conclusion from my own experiences and from much

observation of other businesses is that a good managerial record

(measured by economic returns) is far more a function of what

business boat you get into than it is of how effectively you row

(though intelligence and effort help considerably, of course, in

any business, good or bad). Some years ago I wrote: “When a

management with a reputation for brilliance tackles a business

with a reputation for poor fundamental economics, it is the

reputation of the business that remains intact.” Nothing has

since changed my point of view on that matter. Should you find

yourself in a chronically-leaking boat, energy devoted to

changing vessels is likely to be more productive than energy

devoted to patching leaks.

*

There is an investment postscript in our textile saga. Some

investors weight book value heavily in their stock-buying

decisions (as I, in my early years, did myself). And some

economists and academicians believe replacement values are of

considerable importance in calculating an appropriate price level

for the stock market as a whole. Those of both persuasions would

have received an education at the auction we held in early 1986

to dispose of our textile machinery.

The equipment sold (including some disposed of in the few

months prior to the auction) took up about 750,000 square feet of

factory space in New Bedford and was eminently usable. It

originally cost us about $13 million, including $2 million spent

in 1980-84, and had a current book value of $866,000 (after

accelerated depreciation). Though no sane management would have

made the investment, the equipment could have been replaced new

for perhaps $30-$50 million.

Gross proceeds from our sale of this equipment came to

$163,122. Allowing for necessary pre- and post-sale costs, our

net was less than zero. Relatively modern looms that we bought

for $5,000 apiece in 1981 found no takers at $50. We finally

sold them for scrap at $26 each, a sum less than removal costs.

Ponder this: the economic goodwill attributable to two paper

routes in Buffalo - or a single See’s candy store - considerably

exceeds the proceeds we received from this massive collection of

tangible assets that not too many years ago, under different

competitive conditions, was able to employ over 1,000 people.

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This is basically a eulogy and autopsy for the textile business that Berkshire Hathaway was founded on. The profits simply aren’t coming, the competition is getting more vicious, their equipment is getting more outdated, and the costs to upgrade it are getting higher. So they are finally liquidating it and laying off all the workers and getting out of the industry.

Buffett’s first focus is basically why it took him so long to see the truth that much of the rest of the industry saw over the last decade. He mentions that he would have happily taken a bigger loss on the exit if he could have found a willing buyer for just about any price to avoid the mass layoffs. But not a single buyer was interested. Most textile mills in the country have already shut down.

He puts this up to stubbornness, belief that good management in a bad industry could work a miracle even though he has said many times in the past that it can’t. “A horse that can count to ten is a remarkable horse - not a remarkable mathematician.”. Berkshire Textiles was a remarkable business with remarkable managers, but a horrible investment and a horrible place to sink more money.

I think there are also some unstated things that are pointed to more in The Snowball. Buffett is a compulsive collector and Berkshire was an important part of his story and he had a lot of sentimental value attached to it and wanted to keep it in his collection. There is also the PR of it all, he has had bad experiences in the past of buying and liquidating businesses for their book value pre-Berkshire and having whole towns hate him was a very uncomfortable experience. He is now much more visible and he owns media agencies that will be in an uncomfortable situation if he makes a habit of this. Finally it hurts the reputation of Berkshire as a serial acquirer which hurts its future growth potential. In his advertisements for acquisitions he is generally searching for family businesses on the promise he will take care of their baby for them for an indefinite future… The idea he was holding onto Berkshire against his better business sense out of respect for the business, the founders, the managers, the workers was a very good look for that promise. Him firing hundreds of people and selling all their equipment because he was having a hard time making the math work and thinks he can unlock a few percentage points of shareholder value will paint the exact opposite picture and perhaps harm their ability to convince these businesses to enter the fold. So he held out until the writing was on the wall for all to see, he was one of the last people out of the burning theater so nobody could blame him and he got burned a bit while waiting and watching it burn.

He then talks a lot about why they didn’t and will not do any capex spending to upgrade their now very old equipment. That many of these upgrades looked good on paper in the moment, we are producing this much product for this much time and effort and materials right now, for this one time spend we will be able to improve all those numbers and make more money. But he says that every other manufacturer runs the same math and makes the same decision and that changes the math and the margin increases never actually appear. He likens this to everyone at a parade standing on their tip-toes to see better but all getting in each other's view.

Finally he runs some math on Burlington who is a bigger producer and they did do all this capex spending Berkshire didn’t. Their sales doubled but their margins shrank, their shares are worth the same they were 20 years ago and their buying power has gone down by two thirds. On top of that while it was trading for ~60 per share 20 years ago, they have done ~100 per share of capex spending in that time. Berkshire on the other hand used their equivalent to that capex money to get into the insurance business which has had wonderful returns, Burlington used it to be worth less and have lower margins than they began with.

He finally runs the math on the alleged book value of the textile mills vs what was actually received in liquidation. That the liquidation of just under $1M in equipment actually cost them more money than it generated. Highlighting the illusion book value can sometimes create for value investors.

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Acquisition of the Week

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Acquisition of the Week & Performance Tables in comments due to character limit