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In a previous article, we summarised the key takeaways from Warren Buffett's letters to his partners at Buffett Partnership Limited. Now, let's delve into the lessons from the letters he penned to Berkshire Hathaway shareholders between 1966 and 1976.
Insights from running a capital-intensive business
During the time of writing these letters, Berkshire Hathaway was not the conglomerate that it is today. It was primarily a struggling textile business. After purchasing its shares, Buffett could immediately see the woes of running a capital-intensive, commodity business.
In his 1966 letter, he wrote, "The threat of technological change is ever present in the textile field. An important change at any level of our manufacturing process could require major capital expenditures at tomorrow's replacement prices. Sufficient working capital would be particularly necessary if the advent of important cost-cutting equipment coincided with a period of depressed textile earnings."
Buffett emphasised the potential need for significant capital expenditures to keep pace with technological advancements, a challenge that could be exacerbated by periods of depressed textile earnings. The constant need to upgrade facilities and the inability to set prices make commodity businesses difficult to manage.
Tryst with insurance business
By 1968, Buffett's focus moved towards the insurance sector. According to him, the only benchmark for a successful insurance company was disciplined underwriting. Insurance underwriting means assessing risk and setting premiums accordingly.
Buffett was of the view that it is crucial for insurance businesses to underwrite at a profit than the size. This means the premiums collected should exceed the costs of claims and expenses, even if it means rejecting a large volume of business.
In his own words, "The emphasis continues, however, to be on underwriting at a profit rather than volume simply for the sake of size (1968)".
...."Underwriting profitability is the yardstick of success and that operations can only be expanded significantly when it is clear that we are doing the right job in the underwriting area (1972)".
Suggested reads: Buffett's commandments
Cyclicality woes in insurance business
When companies hit a purple patch, they attract competition. This is particularly potent in insurance. This leads to lenient underwriting standards. Short-term profitability and size are prioritised over long-term success. Moreover, in their eagerness to grow, companies don't set aside enough money for future claims.
Buffett witnessed this firsthand in 1974: "We consistently have commented on the unusual profitability in insurance underwriting. This seemed certain eventually to attract unintelligent competition with consequent inadequate rates. It has also been apparent that many insurance organisations, major as well as minor, have been guilty of significant under-reserving of losses, which inevitably produces faulty information as to the true cost of the product being sold. In 1974, these factors, along with a high rate of inflation, combined to produce a rapid erosion in underwriting results".
The building blocks of stock investing
Buffett had also shared an investing framework in his letters. The principles he laid out are easy to understand, yet most investors find them difficult to implement. However, these parameters have stood the test of time and can help you ace stock market investing.
Buffett wrote, "We select investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100 per cent of an operating business:
- Favourable long-term economic characteristics
- Competent and honest management
- Purchase price attractive when measured against the yardstick of value to a private owner
- An industry with which we are familiar and whose long-term business characteristics we feel competent to judge
...It is difficult to find investments meeting such a test, and that is one reason for our concentration of holdings. We simply can't find one hundred different securities that conform to our investment requirements. However, we feel quite comfortable concentrating our holdings in the much smaller number that we do identify as attractive."
Not many companies pass the Buffett test. So, when you find the ones that do, you should bet big the Buffett way.
Also read: Seven investing sins
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