▶ Full Post Text
\*\*Full Letter:\*\*
https://theoraclesclassroom.com/wp-content/uploads/2019/09/1973-Berkshire-AR.pdf
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This week we will be starting with the…
\*\*\~\~Acquisition\~\~ Merger of the Week\*\*
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\*\*Merger With Diversified Retailing Company, Inc.\*\*
\>Your Directors have approved the merger of Diversified Retailing Company, Inc. into Berkshire Hathaway Inc. on terms involving issuance of 195,000 shares of Berkshire stock for the 1,000,000 shares of Diversified stock outstanding. Because Diversified and its subsidiaries own 109,551 shares of Berkshire, the net increase in the number of shares of Berkshire outstanding after giving effect to this transaction will not exceed 85,449. Various regulatory approvals must be obtained before this merger can be completed, and proxy material will be submitted to you later this year so that you may vote upon it.
\>Diversified Retailing Company, Inc., through subsidiaries, operates a chain of popular-priced women's apparel stores and also conducts a reinsurance business. In the opinion of your management, its most important asset is 16% of the stock of Blue Chip Stamps.
\*\*Blue Chip Stamps\*\*
\>Our holdings of stock in Blue Chip Stamps at year-end amounted to approximately 19% of that company's outstanding shares. Since year-end, we have increased our holdings so that they now represent approximately 22½%; implementation of the proposed merger with Diversified Retailing Company, Inc. would increase this figure to about 38½%.
\>Our equity in earnings of Blue Chip Stamps became significant for the first time in 1973, and posed an accounting question as to just what period's earnings should be recognized by Berkshire Hathaway Inc. as applicable to the financial statements covered by this annual report.
\>Blue Chip's fiscal year ends on the Saturday closest to February 28, or two months after the fiscal year-end of Berkshire Hathaway Inc. Or, viewed, alternatively, their year ends ten months prior to Berkshire Hathaway's. An acceptable accounting choice for us, and one which, if made, would not have required an auditor's disclaimer as to scope, was to recognize in our 1973 income an equity of $632,000 in Blue Chip's earnings for their year ended March 3, 1973 with regard to the fewer shares of Blue Chip we owned during this earlier period. But such an approach seemed at odds with reality, and would have meant a ten month lag each year in the future. Therefore, we chose to reflect as 1973 income our equity of $1,008,000 in Blue Chip's earnings based upon unaudited interim earnings through November as publicly reported by Blue Chip Stamps and with regard to our shareholdings during 1973. Because we made this choice of unaudited but current figures, as opposed to the alternative of audited but far from current figures, Peat, Marwick, Mitchell & Co. were unable to express an opinion on our 1973 earnings attributable to Blue Chip Stamps.
\>The annual report of Blue Chip Stamps, which will contain financial statements for the year ending March 2, 1974 audited by Price, Waterhouse and Company, will be available in early May. Any shareholder of Berkshire Hathaway Inc. who desires an annual report of Blue Chip Stamps may obtain it at that time by writing Mr. Robert H. Bird, Secretary, Blue Chip Stamps, 5801 South Eastern Avenue, Los Angeles, California 90040.
\>Blue Chip's trading stamp business has declined drastically over the past year or so, but it has important sources of earning power in its See's Candy Shops subsidiary as well as Wesco Financial Corporation, a 54% owned subsidiary engaged in the savings and loan business. We expect Blue Chip Stamps to achieve satisfactory earnings in future years related to capital employed, although certainly at a much lower level than would have been achieved if the trading stamp business had been maintained at anything close to former levels.
\>Your Chairman is on the Board of Directors of Blue Chip Stamps, as well as Wesco Financial Corporation, and is Chairman of the Board of See's Candy Shops Incorporated. Operating management of all three entities is in the hands of first-class, able, experienced executives.
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Here we see the intertangling of the many holding companies rearing its head for possibly the first time. Buying and owning companies that are all buying and owning each other. Recommending shareholders reach out to Blue Chip Stamps for reports as Berkshire now owns 39% of the company. Buying Blue Chip, while buying Diversified Retail, which was also buying Blue Chip and owned a ton of it and also owns some of Berkshire so Berkshire is buying its own shares back somewhere in here… A big mess that will soon bring the eyes of the SEC onto Buffett.
Diversified Retail hasn’t really been touched on too much in my posts yet, it was Buffett’s first collaboration with Charlie Munger back in 1966. It was basically them investing in retail cigar butt turnaround plays. They ended up in a lot of value traps they were often lucky to break even from. He came out of this with a new appreciation for value traps along with how uniquely bad the retail sector could be. Possibly the chapter of their careers that made him begin to lose his appetite for cigar butts in my opinion. As mentioned in the letter, Diversified Retail somehow ended up in the reinsurance business (Going back to the same bag of tricks when the original business sucks I suppose) so this is likely just the final step in tapping out on the concept and just wrapping it into a bigger insurance company.
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\*\*Key Passage\*\*
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\*\*Insurance Operations\*\*
\>During 1973, Jack Ringwalt retired as President of National Indemnity Company after an absolutely brilliant record since founding the business in 1940. He was succeeded by Phil Liesche who, fortunately for us, possesses the same underwriting and managerial philosophy that worked so well for Jack.
\>Our traditional business, specialized auto and general liability lines conducted through National Indemnity Company and National Fire and Marine Insurance Company, had an exceptionally fine underwriting year during 1973. We again experienced a decline in volume. Competition was intense, and we passed up the chance to match rate-cutting by more optimistic underwriters. There currently are faint indications that some of these competitors are learning of the inadequacy of their rates (and also of their loss reserves) which may result in easing of market pressures as the year develops. If so, we may again experience volume increases.
\>Our reinsurance operation had a somewhat similar year - good underwriting experience, but difficulty in maintaining previous volume levels. This operation, guided by the tireless and welldirected efforts of George Young, has been a major profit producer since its inception in 1969.
\>Our "home state" insurance companies made excellent progress in Nebraska and Minnesota, with both good growth in volume and acceptable loss ratios. We began operations late in the year in Iowa. To date, our big problem has been Texas. In that state we virtually had to start over during 1973 as the initial management we selected proved incapable of underwriting successfully. The Texas experience has been expensive, and we still have our work cut out for us. Overall, however, the home state operation appears to have a promising potential.
\>Our specialized urban auto operation, Home and Automobile Insurance Company, experienced very poor underwriting in Chicago during 1973. It would appear that rates are inadequate in our primary Cook County marketing area, although the current energy situation confuses the picture. The question is whether possible lowered accident frequency because of reduced driving will more than offset continuing inflation in medical and repair costs, as well as jury awards. We believe that inflation will hurt us more than reduced driving will help us, but some of our competitors appear to believe otherwise.
\>Home and Auto expanded into Florida and California during the year, but it is too early to know how these moves will prove out financially.
\>A contributing factor in our unsatisfactory earnings at Home and Auto during 1973 was an accounting system which was not bringing information to management on a sufficiently timely basis. This situation now is being corrected.
\>On the investment side of our insurance operation, we made substantial additional commitments in common stocks during 1973. We had significant unrealized depreciation - over $12 million- in our common stock holdings at year-end, as indicated in our financial statements. \*\*Nevertheless, we believe that our common stock portfolio at cost represents good value in terms of intrinsic business worth. In spite of the large unrealized loss at year-end, we would expect satisfactory results from the portfolio over the longer term.\*\*
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I added the bolding to that last bit because it is relevant to us all this week but also because it is referencing a market crash going on in the background. The Nifty Fifty crash happened this year and into the beginning of next year. I will be doing an expanded writeup on that in the comments.
Otherwise we are once again seeing the first of these insurance cycles continuing on. The last couple years were extremely profitable, now there is more competition, while others are cutting into their underwriting profit to combat this, Berkshire is instead cutting into its volume, or at least that is the intent, who knows how any of this will look in hindsight when the claims have been paid. But he mentions here other insurance companies are already running into issues with unprofitable underwriting and insufficient cash reserves. When the tide goes out and those caught with their pants down are gone the good times ought to return.
The core businesses did great, some of the new experimental insurance operations not so much, the newly acquired Home and Auto is having instant issues and the home state operations are having mixed results state to state.
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|\*\*Segment\*\*|\*\*1972 Earnings\*\*|\*\*1973 Earnings\*\*|\*\*% Change\*\*|
|:-|:-|:-|:-|
|\*\*Insurance\*\*|$8.98M|$9.87M|+9.9%|
|\*\*Banking\*\*|$2.70M|$2.78M|+3.0%|
|\*\*Textiles\*\*|$0.44M\*|$0.21M\*|-52.3%|
|\*\*Net Total\*\*|\*\*$12.13M\*\*|\*\*$12.86M\*\*|\*\*+6.0%\*\*|
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|\*\*Metric\*\*|\*\*1972\*\*|\*\*1973\*\*|\*\*% Change\*\*|
|:-|:-|:-|:-|
|\*\*Net Earnings\*\*|$12.13M|$12.86M|+6.0%|
|\*\*Return on Equity (RoE)\*\*|19.8%|17.4%|-12.1%|
|\*\*Shareholders' Equity\*\*|$68.30M|$81.16M|+18.8%|
\* Textile net income calculated by hand, using operating income for textile business minus non-bank/insurance taxes. Need to change how I calculate this every time they change the reporting sorry
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The textile earnings reduction is actually almost entirely due to changing from a FIFO inventory system (when inventory sells, profit was calculated on the cost of the oldest item in inventory) to a LIFO system (profit is calculated at price of newest item to enter inventory when it sells) which reduced earnings almost $300k compared to last years accounting methods.
Otherwise this is a story of solid but suppressed growth from the company due to poor stock performance. He has been saying for years the market is overpriced and they were minimizing their exposure but they still took some hit. But there will likely be buying opportunities aplenty
RoE is down, Earnings growth was only 6% this year, but in a market where all the big blue chip stocks are down 50-90%, years like these are the ones that lead to Berkshire’s long term outperformance.