Client Letter January 2001
This letter is a continuation of The November 2000 letter “Build It and They Will Come”.
The flip side of the problems created by cheap money, is the benefit that comes from tight money. It teaches respect for capital. The managers of Berkshire Hathaway’s various wholly owned businesses can get all the money that they want, but they have to pay. On the other hand if CEO returns money from earnings to the parent, Berkshire Hathaway pays them a nice return (2 to 3 percent above the respective interest charged).
At the 1995 Berkshire Hathaway Annual meeting a shareholder asked Warren Buffett to describe the capital allocation process that he and Munger followed. Warren Buffett replied that there is “no better way to make managers understand how valuable capital is than to charge them for it.” The rates varied from company to company depending upon the industry, Company history, and typical capital requirements for its sector. The amount charged to the individual manager “varied from 14 to 20 percent at times.” The important thing Warren Buffett emphasized it that “we don’t want managers to think of other peoples money as ‘free’ money.”
Berkshire Hathaway managers can have all the money they want but in most cases they are going be to better off giving the money to Warren Buffett to manage. The real cost of money within the Berkshire Hathaway system is not the interest rate. (The amount that they paid Berkshire to use the money) but the opportunity cost. (The profit they lose by not turning the money over to Warren Buffett). This makes money at Berkshire Hathaway very expensive all of the time.
It is my opinion that this capital allocation policy is one of the essential elements of Warren Buffett’s genius, and is a product of his ability to see things very differently from most people. The Idea that expensive capital could be his vehicle to build a giant conglomerate flies in the face of common sense. Screams erupted in December when the FED left interest rates unchanged. Larry Kudlow accused the Fed of attempting to destroy American prosperity. They are denying the flow of capital necessary to fuel the tech revolution. On the surface this argument seems to make sense.
Business needs capital to expand and popular wisdom says, the easier that capital is to get the faster the economy will grow. But the history of the last two years surely destroys this theory. Never have so many CEO’s pissed away so much money so fast with so little benefit to anyone. At the same time we have the example of the Nebraska Furniture Mart and Borshiem’s two retail operations that have lived with Warren Buffett’s tight money for quite a few years. When you walk in to either of these stores there is no sense of capital deprivation, just the opposite. The stores are modern and beautiful, merchandising is top of the line, and the depth of inventories is awesome. Respect for capital has not restricted growth but persevered and enhanced it.
This is a logical paradox. Easy money should produce growth but if it gets too easy what it produces is waste. Expensive capital should produce stagnation, but at Berkshire Hathaway it teaches respect for other people’s money, and promotes growth. Common Sense tells us that tight money is bad for Profits. The cost of money is an expense, and it limits the amount of capital available for expansion. Yet NFM and Borshiems have operated in a system that arguably has the highest cost of capital anywhere, since their acquisition by Berkshire Hathaway. Now they are two of the most impressive retail operations I have ever seen.
If you want further evidence of beneficial long-term effect of tight money, look at history. Many Causes have been proposed for our 18-year bull market that began in 1982, and the economic boom that inspired it. The stage for this expansion was set many years ago by the rigid monetary discipline in the late 1970’s and early 1980’s. The cost money has an important role through its influence on the behavior of corporations. When interest rates are high, as they were during the above period, Businesses are forced to find the most productive use for their money. If money is cheap capital gets pissed away. The long period of tight money caused a massive change in the behavior of American business, and the effect was profound precisely because rates were so high.
The problem is in the limits human intelligence, and our failure to recognize those limits. Predicting the future is difficult to impossible, yet it is always easy to find managers are sure they know how to spend their shareholders money. Capital allocation is essentially an exercise in crystal ball gazing. Inevitably it degenerates into an exercise in the endless extrapolation of past trends into the future. This process works the best in boring businesses and long economic cycles. It works very poorly in high tech businesses were with rapid change makes the past a very poor guide to anything. The point is to invest in those areas where capital allocation is easy and avoid those where it is difficult.
As you can see from your statements, December was a good month, this helped to make 2000 good year. Any year that you out perform the averages is a good year. But the best of all possible worlds is to be up when the market is going down. Our Accounts managed to beat the S&P by anywhere 7% to 38% or the year 2000. For the Conservative investor 2000 was a very easy year to beat the averages, whereas in 1999 it was impossible.
At the end of the year 2000 all of our managed accounts have beaten the S&P since their inception. The account that has been managed for the longest period is up 1258.57% over thirteen years, Versus 434.35 % for the S&P during that period. The accounts that have been managed for shorter periods are not yet showing this kind of gain, but the worst five year account has an annual appreciation of 122% versus 101% for the Wilshire 5000 index.
More important is the fact that there are many good companies available at prices that more attractive now than they have been since the early 1990s. This in turn is allowing us to take positions that is setting the stage for good performance over the next ten years.