Buffets shareholder letter 1985 – Esops

Warren Buffets shareholder letter 1985.

Buffet speaks in this letter in great length the economics of Employee stock options.

Share prices rise relatively higher when companies do not give Dividend as the net worth of the company increases. However, the return, which shareholders might get, is relatively low as managements with ESOPs are more concerned about the stock price then shareholder value. While a shareholder may get less returns when no dividend is rolled out, as the money retained may not give enough returns (if money is retained). Therefore, ESOPs may induce behavior (which has been witnessed) to increase share price and not shareholder value.

Reinsurance business – Buffet comments on the dynamics.

In this case the seller knows most about the risk and is selling a part (most of it) of risk to you at a Price. Such deals had earlier seen long losses for the insurance industry where Reinsures where not able to appraise the risk/ return profile and have gradually moved away from it. Risks in this case are very long drawn and this made some of the competition very skeptical of such deals. This is when Berkshire Hathaway (Insurance business) actually ran an Ad in a newspaper that they are willing to reinsure and looking for big contracts. (Buffet also runs an ad in his shareholder letter, inviting friendly business acquisitions).  

Argument: The behavior of reinsurers finally becomes like that of Mark Twain’s cat: having once sat on a hot stove, it never did so again – but it never again sat on a cold stove, either. I think anything can be bought, provided it is at the right price.

It is interesting to note that most of Buffets investments in earlier days were commodity business against his regularly applauding the Brand value (Coke, Gillette).
His earlier investments – Textile (shut), Insurance, Furniture (Nebraska- Cheapest seller) etc.  Candy and newspaper business could be off some brand value…

What could be the most rational things for individuals to do, when the same decision looked collectively may appear poor. Just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes.
This is what buffet was talking about Insurance companies decision to raise capital (increase capacity). “Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational. “

I think this is happening with the Textile industry ( Textile quota, global demand expectations- Increase capacity) and the Banking sector in India(Credit growth expectations – Raise Capital).

Some good quotes from the 1985 Letter:

Chairman, Charlie Munger, has always emphasized the study of mistakes rather than successes, both in business and other aspects of life.  He does so in the spirit of the man who said: “All I want to know is where I’m going to die so I’ll never go there.”

Shutting down the textile business:

Comte’s advice – “the intellect should be the servant of the heart, but not its slave”

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.

“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.”

An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news.  “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed.  There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants.  That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions.  Impressed, St. Peter invited the prospector to move in and make himself comfortable.  The prospector paused.  “No,” he said, “I think I’ll go along with the rest of the boys.  There might be some truth to that rumor after all.”

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