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Sahil Kapoor

@SahilKapoor

Oct 9

My notes from Berkshire Letters to shareholders.
Re-reading for the 2nd time. Will read 3rd time as well, as advised by @iramneek

Source: berkshirehathaway.com/letters/letter…

1977

1. On how ROE is a better measure of growth than earnings growth

Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.
Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital. In 1977 our operating earnings on beginning equity capital amounted to 19%, slightly better than last year and above both our own long-term average and that of American industry in aggregate. But, while our operating earnings per share were up 37% from the year before, our beginning capital was up 24%, making the gain in earnings per share considerably less impressive than it might appear at first glance.

2. Why businesses which have tailwinds are better than others

It is comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved. In a sense, this is the opposite case from our textile business where even very good management probably can average only modest results. One of the lessons your management has learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds.
Unusual managerial discipline will be required, as it runs counter to normal institutional behavior to let the other fellow take away business - even at foolish prices.

3. Why to avoid day to day or even annual changes in stock price

Most of our large stock positions are going to be held for many years and the scorecard on our investment decisions will be provided by business results over that period, and not by prices on any given day. Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by prospective near term earnings or recent trends in earnings when purchasing small pieces of a company; i.e., marketable common stocks.

4. How to select businesses
We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be
(1) one that we can understand,
(2) with favorable long-term prospects,
(3) operated by honest and competent people, and
(4) available at a very attractive price.
We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.

Our experience has been that pro-rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies. Consequently, bargains in business ownership, which simply are not available directly through corporate acquisition, can be obtained indirectly through stock ownership. When prices are appropriate, we are willing to take very large positions in selected companies, not with any intention of taking control and not foreseeing sell-out or merger, but with the expectation that excellent business results by corporations will translate over the long term into correspondingly excellent market value and dividend results for owners, minority as well as majority.

5. On sound management of a company

While control would give us the opportunity - and the responsibility - to manage operations and corporate resources, we would not be able to provide management in either of those respects equal to that now in place. In effect, we can obtain a better management result through non-control than control. This is an unorthodox view, but one we believe to be sound.

1978

1. Short term stock price moves are unpredictable.
We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do. In the longer run, however, we feel that many of our major equity holdings are going to be worth considerably more money than we paid, and that investment gains will add significantly to the operating returns of the insurance group.

2. The problem of a low margin and highly competitive industry
Earnings of $1.3 million in 1978, while much improved from 1977, still represent a low return on the $17 million of capital employed in this business. Textile plant and equipment are on the books for a very small fraction of what it would cost to replace such equipment today. And, despite the age of the equipment, much of it is functionally similar to new equipment being installed by the industry. But despite this “bargain cost” of fixed assets, capital turnover is relatively low reflecting required high investment levels in receivables and inventory compared to sales. Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital. Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management is diligent in pursuing such objectives. The problem, of course, is that our competitors are just as diligently doing the same thing. The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.

3. Competitor self-delusion & impact on all players in the market explained through the reinsurance business.
It is very easy to fool yourself regarding underwriting results in reinsurance (particularly in casualty lines involving long delays in settlement), and we believe this situation prevails with many of our competitors. Unfortunately, self- delusion in company reserving almost always leads to inadequate industry rate levels. If major factors in the market don’t know their true costs, the competitive “fall-out” hits all - even those with adequate cost knowledge.

4. Committing to equities only when these conditions are prevailing.
We get excited enough to commit a big percentage of insurance company net worth to equities only when we find
(1) businesses we can understand,
(2) with favorable long-term prospects,
(3) operated by honest and competent people, and
(4) priced very attractively.
We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire’s insurance subsidiaries amounted to only $10.7 million at cost, and $11.7 million at market. There were equities of identifiably excellent companies available - but very few at interesting prices. (An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities - at full prices they couldn’t buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.)

5. Preference to buy small fractions of businesses at bargain prices.
We continue to find for our insurance portfolios small portions of really outstanding businesses that are available, through the auction pricing mechanism of security markets, at prices dramatically cheaper than the valuations inferior businesses command on negotiated sales (such as corporate acquisitions and takeovers). This program of acquisition of small fractions of businesses (common stocks) at bargain prices, for which little enthusiasm exists, contrasts sharply with general corporate acquisition activity, for which much enthusiasm exists. It seems quite clear to us that either corporations are making very significant mistakes in purchasing entire businesses at prices prevailing in negotiated transactions and takeover bids, or that we eventually are going to make considerable sums of money buying small portions of such businesses at the greatly discounted valuations prevailing in the stock market.

6. Not looking for quick repricing (upwards) but of a prolonged period of lower prices for businesses that they wish to buy
(A second footnote: in 1978 pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities - breaking the record low figure set in 1974 and tied in 1977.) We are not concerned with whether the market quickly revalues upward securities that we believe are selling at bargain prices. In fact, we prefer just the opposite since, in most years, we expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up in stock prices to levels at which we are unwilling to continue buying.

7. Buying worthwhile amounts are not nibbling.
Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts.

8. Let great managements do their work and you participate.
While there may be less excitement and prestige in sitting back and letting others do the work, we think that is all one loses by accepting a passive participation in excellent management.

9. If retained earnings are deployed at attractive rates, don’t disturb the process
We are not at all unhappy when our wholly owned businesses retain all of their earnings if they can utilize internally those funds at attractive rates. Why should we feel differently about retention of earnings by companies in which we hold small equity interests, but where the record indicates even better prospects for profitable employment of capital? (This proposition cuts the other way, of course, in industries with low capital requirements, or if management has a record of plowing capital into projects of low profitability; then earnings should be paid out or used to repurchase shares - often by far the most attractive option for capital utilization.) The aggregate level of such retained earnings attributable to our equity interests in fine companies is becoming quite substantial. It does not enter into our reported operating earnings, but we feel it well may have equal long-term significance to our shareholders. Our hope is that conditions continue to prevail in securities markets which allow our insurance companies to buy large amounts of underlying earning power for relatively modest outlays. At some point market conditions undoubtedly will again preclude such bargain buying but, in the meantime, we will try to make the most of opportunities.

10. Low-cost operators find more ways to cut costs.
Our experience has been that the manager of an already high-cost operation frequently is uncommonly resourceful in finding new ways to add to overhead, while the manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors.

1979

1. ROCE is a superior performance evaluation criterion
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.

2. Investor’s misery index – How inflation impacts equity investments
But before we drown in a sea of self-congratulation, a further - and crucial - observation must be made. A few years ago, a business whose per-share net worth compounded at 20% annually would have guaranteed its owners a highly successful real investment return. Now such an outcome seems less certain. For the inflation rate, coupled with individual tax rates, will be the ultimate determinant as to whether our internal operating performance produces successful investment results - i.e., a reasonable gain in purchasing power from funds committed - for you as shareholders.
Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives, a business earning 20% on capital can produce a negative real return for its owners under inflationary conditions not much more severe than presently prevail.
If we should continue to achieve a 20% compounded gain - not an easy or certain result by any means - and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.
That combination - the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) - can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.

3. How Gold preserves value when money printing is going crazy
One friendly but sharp-eyed commentator on Berkshire has pointed out that our book value at the end of 1964 would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce. A similar comparison could be drawn with Middle Eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil

4. Turnarounds seldom turn
Our textile business also continues to produce some cash, but at a low rate compared to capital employed. This is not a reflection on the managers, but rather on the industry in which they operate. In some businesses - a network TV station, for example - it is virtually impossible to avoid earning extraordinary returns on tangible capital employed in the business. And assets in such businesses sell at equally extraordinary prices, one thousand cents or more on the dollar, a valuation reflecting the splendid, almost unavoidable, economic results obtainable. Despite a fancy price tag, the “easy” business may be the better route to go. We can speak from experience, having tried the other route. Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment. By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing. But the purchase was a mistake. While we labored mightily, new problems arose as fast as old problems were tamed. Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price. Although a mistake, the Waumbec acquisition has not been a disaster. Certain portions of the operation are proving to be valuable additions to our decorator line (our strongest franchise) at New Bedford, and it’s possible that we may be able to run profitably on a considerably reduced scale at Manchester. However, our original rationale did not prove out.

5. How running a slack is ok when business volumes decline, than to do unprofitable business
We hear a great many insurance managers talk about being willing to reduce volume in order to underwrite profitably, but we find that very few actually do so. Phil Liesche is an exception: if business makes sense, he writes it; if it doesn’t, he rejects it. It is our policy not to lay off people because of the large fluctuations in work load produced by such voluntary volume changes. We would rather have some slack in the organization from time to time than keep everyone terribly busy writing business on which we are going to lose money. Jack Ringwalt, the founder of National Indemnity Company, instilled this underwriting discipline at the inception of the company, and Phil Liesche never has wavered in maintaining it. We believe such strong-mindedness is as rare as it is sound - and absolutely essential to the running of a first-class casualty insurance operation

6. Bond philosophy (summarized for brevity)
The insurance industry has faced significant losses in bond investments, partly due to accounting conventions that obscure market value declines. While insurers have adjusted to inflation by shortening policy terms, they paradoxically lock in long-term bond contracts, which have been ill-suited to inflationary pressures.

Berkshire Hathaway avoided purchasing straight long-term bonds but made some errors by holding 15-year bonds too long. The company prefers convertible bonds, which offer flexibility and potential profit, unlike fixed-interest long-term bonds. Berkshire remains cautious about long bonds, doubting their viability in an inflationary world, though it acknowledges the possibility of missing out on potential bond market gains.

7. Attracting aligned shareholders and investors
In large part, companies obtain the shareholder constituency that they seek and deserve. If they focus their thinking and communications on short-term results or short-term stock market consequences they will, in large part, attract shareholders who focus on the same factors. And if they are cynical in their treatment of investors, eventually that cynicism is highly likely to be returned by the investment community.
Phil Fisher, a respected investor and author, once likened the policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A restaurant could seek a given clientele - patrons of fast foods, elegant dining, Oriental food, etc. - and eventually obtain an appropriate group of devotees. If the job were expertly done, that clientele, pleased with the service, menu, and price level offered, would return consistently. But the restaurant could not change its character constantly and end up with a happy and stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revolving door of confused and dissatisfied customers.
So it is with corporations and the shareholder constituency they seek. You can’t be all things to all men, simultaneously seeking different owners whose primary interests run from high current yield to long-term capital growth to stock market pyrotechnics, etc.

The reasoning of managements that seek large trading activity in their shares puzzles us. In effect, such managements are saying that they want a good many of the existing clientele continually to desert them in favor of new ones - because you can’t add lots of new owners (with new expectations) without losing lots of former owners.
We much prefer owners who like our service and menu and who return year after year. It would be hard to find a better group to sit in the Berkshire Hathaway shareholder “seats” than those already occupying them. So we hope to continue to have a very low turnover among our owners, reflecting a constituency that understands our operation, approves of our policies, and shares our expectations. And we hope to deliver on those expectations.

Read 33 tweets

Sahil Kapoor

@SahilKapoor

Apr 5

Over the past few editions #DSPNetra has highlighted a number of indicators which depict an 'unsettling calm' in stock markets.

Here is a thread 🧵putting all the indicators together.
Read on:

1. Eight Years of Calm Rivals 1980s Low Volatility Era

BSE Sensex Index has now gone for almost 8 years without a bear market.

Defining a bear market:
One of the ways to define a bear markets is a decline of more than 20% and a time period of more than one year to regain previous highs. COVID decline was much deeper but the markets recovered in about 9 months to reclaim all time highs. This made sure that participants avoided the long-drawn periods of pain when stocks don’t deliver returns.

The previous period of such a stable and smooth market was way back in 1980s. Volatility moves in clusters and current cluster of low volatility would likely give way to higher volatility. We don’t know when or why, though. But history tends to rhyme more often.

2. Recent Readings In SMID Indicate Unsettling Calm
The number of days the Small & Midcap indices have risen by 1% or more neared previous best years in 2023. Such broad, ‘all boats sailing’ uptrend years are rare. In the past, such years have been followed by more than average drawdowns in the following year.

On average, calendar year drawdowns for largecap, midcap and smallcap are 19%, 23% & 26%, respectively. But the year following a bullish ‘unsettling calm’ year, the average drawdowns for top 5 of such years are 27%, 32% & 37% for largecap, midcap and smallcap indices respectively. This indicates that these calm years are followed by heightened volatility and drawdowns. Means, expect markets to become volatile in 2024.

Read 10 tweets

Sahil Kapoor

@SahilKapoor

Jan 1

Starting a new thread🧵 for 2024 on my reading stack.

Book 1

"Why We Sleep: The New Science of Sleep and Dreams" by Matthew Walker.

Book 2

"The Rare Metals War: the dark side of clean energy and digital technologies" by Guillaume Pitron, Bianca Jacobsohn.

Book 3

"The Vital Question: Why is life the way it is?" by Nick Lane.

Read 53 tweets

Sahil Kapoor

@SahilKapoor

Dec 27, 2023

I read a bunch of books in 2023.
Here is a thread 🧵 on 'Book Bundles.

Book Bundles?
These collections, if read together, can help build a broader view on the topic.

This is my current understanding and there is a vast ocean that I would have definitely missed.

Take a read

The workings of the brain

A few key lessons:
1. Your brain does not react—it predicts. Contrary to how we think about the brain as a reactive machine, it is actually a prediction machine. Our world view is because we make our own reality, literally, in our own brain.

2. It takes more than one human brain to create a human mind. Our brains are incomplete for a reason. Infants come with an incomplete brain and complete it by learning from the society. The age bracket of 5 to 8 years is the best time for brain plasticity ( debatable, but broaderly accepted).

3. Words can have a powerful effect on your body. Many species, including humans, regulate one other’s nervous systems. Ants, bees, and other insects do this using chemicals such as pheromones. Humans are unique in the animal kingdom, however, because we also regulate each other with words. A kind word may calm you, as when a friend gives you a compliment at the end of a hard day.

These books can help you learn a great deal about the 3 pound magic called the 'Brain'.

Book list

1. "Seven and a Half Lessons About the Brain" by Lisa Feldman Barrett.

2. SELF COMES TO MIND: Constructing the conscious Brain by Antonio Damasio

3. "Livewired: The Inside Story of the Ever-Changing Brain" by David Eagleman

4. "How Emotions Are Made: The Secret Life of the Brain" by Lisa Feldman Barrett.

Understanding Our Mind by Thich Nhat Hahn is another great read which I read years ago and presents a different angle.

Evolution: How did humans and other species evolve.

It was a mistake not reading Charles Darwin and other authors on evolution early in my life. It is absolutely important to learn evolution. It opens ones mind to the biological equivalent of compouding.

One lesson that most peoeple (including me) has it wrong is the true meaning of 'the survival of the fittest'.

Most of us interpret it as the strongest or the fittest surviving versus those who aren’t. It’s not.

Darwin was saying something very different. He said those who adapt, survive. They may not be the fittest at the time, in the sense of agility, size, or reproductivity. They may also not be the strongest in terms of strength, both physical and mental. So, what does adaptability mean?

Charles Darwin showed that each organism and species undergo random, natural variations. These variations may or may not be influenced by factors such as climate, human interference in selection, or availability of food, among others. But the biggest overriding factor for adaptability is randomness.

Randomly occuring kinks, which seem meaningless at the time, may hold key to survival. Some of them can be generated (artificial selection). Some of these variations allow you to thrive when unfavourable conditions emerge. Those who get/evolve these kinks survive. This lesson is an absolute crunch for me.

My takeaway: How do you ensure your own survivial (financial, professional, in relationships ...)? These books may hold some important insights that you may like.

1. "The Origin of Species" by Charles Darwin

2.. "The Greatest Show on Earth: The Evidence for Evolution" by Richard Dawkins.

3&4. Sapiens: A Brief History of Humankind; Homo Deus: A Brief History of Tomorrow
by Yuval Noah Harari

To link these lessons to investing, Pulak Prasad's book is a good start.
5. "What I Learned About Investing from Darwin" by Pulak Prasad.

Read 8 tweets

Sahil Kapoor

@SahilKapoor

Apr 26, 2023

I have used the ICE BofAML Move Index across various publications. It has been one of the most important indicators, especailly in 2023.

Here is short thread 🧵on what it is:

MOVE is widely used as a benchmark for measuring the level of risk in the US Treasury market. Higher MOVE readings generally indicate higher levels of market uncertainty or volatility, while lower readings indicate lower levels of market volatility.

How is it calculated? Read on

MOVE (Merrill Lynch Option Volatility Estimate) is a measure of the implied volatility of US Treasuries. It is calculated using the prices of OTC options on US Treasuries.

It is expressed in basis points (bps), which represent hundredths of a percentage point.

Read 9 tweets

Sahil Kapoor

@SahilKapoor

Mar 30, 2023

"I believe that learning how to think about how to eat, learning to understand what makes us fat and diabetic, means implicitly learning what to cook, how to order in a restaurant, and how to shop at the supermarket."

"The Case for Keto" by Gary Taubes

Protein consumption stimulates secretion of two other hormones, glucagon and growth hormone, the former of which will work to limit fat storage, while the latter will help promote growth and repair.

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