Buffett Letter 1977: Return on Investment and Buffett’s Partnership Attitude Toward Disclosure

As an investor, I can think of no other “book” that is more deserving of religious study than Buffett’s letters.  Of the options out there, I think an annual review and study of Buffett’s early partnership and Berkshire letters remains one of the highest value activities. The return on investment is excellent.

My review, and I believe John’s also, is not intended as a magnum opus discussion of all salient points, but instead a snapshot of our thoughts as we read through them.  With no claims on complete examination, we hope to provide insights in nugget form.


Buffett’s letters provide the best business school education out there, especially on the cost-adjusted basis.  Many claim that he merely points out the obvious, but no one else is pointing these things out and in most cases people are specifically avoiding these principles, making them even more relevant.  

How to Judge Profit Growth?

Almost all business headlines assume higher profits compared to last year show a good or improving business.   For example, below is a recent press release from a public company, Chef’s Warehouse.  The press release went on to say: “2015 was a momentum building year for the Company as we continue to create the industry-leading, dynamic, food marketing and distribution company we envisioned when we went public four years ago.”

Financial highlights for the fourth quarter of 2015 compared to the fourth quarter of 2014:

  • Net sales increased 31.3% to $299.7 million for the fourth quarter of 2015 from $228.2 million for the fourth quarter of 2014.
  • Net income increased 28.0% to $6.7 million for the fourth quarter of 2015 compared to $5.2 million in the fourth quarter of 2014.
  • Earnings per diluted share increased 19.0% to $0.25 for the fourth quarter of 2015 compared to $0.21 for the fourth quarter of 2014.
  • Modified pro forma earnings per diluted share1 increased 30.0% to $0.26 for the fourth quarter of 2015 compared to $0.20 for the fourth quarter of 2014.
  • Adjusted EBITDA1 increased 70.5% to $20.8 million for the fourth quarter of 2015 compared to $12.2 million for the fourth quarter of 2014.


However, Buffett’s introductory paragraph provide a measuring stick to judge the performance of a business (and management’s stewardship of that business) over a multi-year period.  

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.

Chef’s Warehouse reported the following metrics since going public in 2011.


Chef’s Warehouse 2011 2015 Percentage Increase
Assets 108m 586m 442%
Debt 84m 398m 373%
Equity 24m 188m 683%
Share Count 18m 27m 50%
Operating Earnings 28m 40m 42%
Earnings Per Share .43 cents .63 cents 46%


If you focus on the increase in operating earnings and earnings per share, management can proclaim in their press releases that they have achieved a 42% and 46% increase in operating earnings and earnings per share, respectively.  But, as Buffett is quick to point out in his introductory lesson, what did it take you to get there?  

The change in assets, or the increase in capital inputs (in this case this increase came from both new debt, equity issuance and earnings) for this business was approximately $478m, and what did Chef get for this increase in assets, a measly $12m in additional operating earnings.

To simplify this picture, this business in 2011 was earnings $28m in operating income on $108m in assets, approximately 25%.

Imagine you have a savings account at your local bank.  You have a measly $108, but each year you are presented with a check from your local banker for $28.

The next year you get married and bring in your spouse.  She has been significantly more frugal than you leading up to your union and she is able to deposit $478.  At the end of your first year of marriage, you are presented with two checks from your banker, one of $28 (the interest from your account) and a second check of $12 (the new interest on your wife’s savings account).  As a couple, you are proudly able to report record savings of $40 on your tax return.  As the CEO of your financial planning, you might proudly proclaim, “We earned an additional 42% in interest compared with last year.”  Congratulations.

Your savings account is performing wonderfully, earning 25% return on capital, however, your wife’s new savings account is only earning approximately 3% return on capital.  Buffett’s insight is both basic and crucial to his success.

His business success has been based largely on “moving” money to its highest and best use.  The first $108 in savings is doing fine, but with the new $478, Buffett would find a higher use for this capital.  As a capital allocator, Buffett has been able to direct the flow of incoming cash (in his case, mainly from insurance premiums in the early years) to their highest “incremental return on capital.”

The beauty and genius of Buffett’s Berkshire Hathaway is two fold: 1) he was “allowed” to allocate incremental capital to its highest and best use and 2) he was able to correctly identify which areas would have low future return on capital and which areas would have higher incremental return on capital.

This may sound obvious, but part (1) of this process is not even “allowed” at most modern-day corporations.

Chef’s business model is a food service distributor to high-end restaurants.  Prior to 2011, Chef’s had a long and profitable history catering to high-end restaurants in large cities, New York, Washington D.C., San Francisco and Los Angeles.  This density and focus on these markets allowed for high returns on capital, most likely due to the number of high-end customers within these geographic areas and the fact that these cities support true “high-end” dining establishments, where the average food costs per meal is sometimes over $100.  However, as Chef embarked on a plan to grow into secondary cities throughout the country, its ability to earn high returns on capital invested was impaired due to less restaurant density per city and the fact that even the “high-end” restaurants in these secondary cities might not be as high-end.

However, if we look at the choice facing Chef in 2011, we can see that “growth” or expansion of their business was basically their only choice. It would have been exceedingly rare for the CEO of Chef to take the $28m in operating earnings in 2011 and direct that capital to any of the following: insurance company (GEICO), furniture retailer (Nebraska Furniture Mart), chocolate maker (See’s Candies), bank (Illinois National Bank or Wells Fargo), credit card company (American Express) or a newspaper (Washington Post).  These actions would be unheard of, however, this is precisely what Buffett did.

The internal memo to Chef CEO might have been as follows:

Chef [CEO]:

You have a great business, but your business will earn poor incremental returns on capital if you expand to smaller cities.  Stay small (and only in big cities) and stay great, I will take your excess cash flow and re-invest that capital at higher incremental returns.  



Although Buffett’s principle of incremental return on capital to measure and judge “record” earnings is basic, there are countless instances where the principle is ignored purposefully or through organizational inertia.

Using Buffett’s simple savings account description provides an excellent roadmap for evaluating the capital allocator in companies we will discuss here.

Buffett’s Partnership Attitude Towards Disclosure:

“We expect difficulty in matching our 1977 rate of return during the forthcoming year.”

“The textile business again had a very poor year in 1977.”

“The textile business again had a very poor year in 1977.  We have mistakenly predicted better results in each of the last two years.  This may say something about our forecasting abilities, the nature of the textile industry, or both.  Despite strenuous efforts, problems in marketing and manufacturing have persisted.  Many difficulties experienced in the marketing area are due primarily to industry conditions, but some of the problems have been of our own making.”

“In aggregate, the insurance business has worked out very well.  But it hasn’t been a one-way street.  Some major mistakes have been made during the decade, both in products and personnel.  We experienced significant problems from (1) a surety operation initiated in 1969, (2) the 1973 expansion of Home and Automobile’s urban auto marketing into the Miami, Florida area, (3) a still unresolved aviation “fronting” arrangement, and (4) our Worker’s Compensation operation in California, which we believe retains an interesting potential upon completion of a reorganization now in progress.”

“Recently the pace of rate increases has slowed dramatically, and it is our expectation that underwriting margins generally will be declining by the second half of the year.”

This is only a brief preview of the consistent no fluff language that is present throughout Buffett’s letters.  It may sound overly simplistic to say that when things are not great, Buffett tells you so directly.  This, however, is not par for the course among public companies.  Typical CEOs live with the idea that their job security is premised on near-term results.  Buffett’s large stake in Berkshire Hathaway allowed him to never have to worry about his position, which allowed him to talk frankly about the challenges Berkshire faced.  I also believe he saw his fellow shareholders as partners and wanted them to have accurate knowledge of their ownership in the “partnership.”

To contrast Buffett’s comments, I have included excerpts from transcripts of companies who filed for bankruptcy within 9 months of the comments below.  You will read the following comments, “adequate liquidity”, “validated our technology”, “our strong market position….will allow us to increase shareholder value.”  The fourth company, Valeant, I present as an example of Valeant’s former CEO discussing the “wonderful” Walgreen’s deal, and contrast that with a new CEO (Joseph Papa) only three months later who describes this same Walgreen’s deal in almost the exact opposite terms.

Buffett’s approach to honesty is not radical when taken out of context. His approach seems ordinary or run of the mill. But, when contrasted with others, his approach provides a stark difference that helps set a standard we should require when evaluating other CEOs.


Aeropostale (ARO) Transcript: August 2015; Bankruptcy Filing: May 2016:
Consistent with the improvement we have made in our Aéropostale stores, we are also making progress in our other businesses. Our P.S. business and our e-commerce channel are currently showing sequential improvement as well. I believe that these positive results are a combination of not only our revised merchandise assortment and renewed marketing effort, but also are benefits being driven by our new vertical, organizational structure. In addition, our GoJane.com business, which is by design far more contemporary than Aéropostale, is building upon the significant growth it showed during the second quarter with continued positive comps month-to-date in August.

Before I turn the call over to David, I would like to address the closing of our amended credit facility. As you may have seen in our press release, we recently closed on an amended credit facility that would deliver increased availability and whose term will now extend to February 2019. We believe that this new revolver, coupled with our current cash balance of $87 million, gives us ample liquidity and time to execute our strategies and forge a path back to profitability.

We believe that the continued sequential progress we are making for Q3 will position us well for the future. David will elaborate more fully on both the credit facility and on our guidance for third quarter, but to make sure there is no ambiguity, I feel that we have done a very good job, consistent with our initial goals, to be prepared for the back-to-school selling season.

Horsehead Holdings (ZINC) Transcript October 2015; Bankruptcy Filing: February 2016:
During the past few months, we have enhanced our Mooresboro organization and have expanded the use of external engineering assistance. These resources, which include engineering, technical support, and operations management, have validated the feasibility of the technology, developed improvements to many of the known issues, and confirmed the nature and general extent of the operational and financial benefits we expect from this facility. We are focused on implementing the various improvements, a number of which were completed during the recent outage.

In summary, before we open the call for questions, I would like to say that while the third quarter continued to present challenges, our confidence in our plans to address the issues in Mooresboro has increased as we have strengthened the team of internal and external resources needed to develop and implement those plans.

Sun Edison (SUNE) Transcript November 2015, Bankruptcy Filing April 2016:
Our long-term outlook for renewable energy continues to be quite positive as solar and wind become increasingly competitive, governments focus on climate change and as investors see attractive returns. This, combined with our strong market position and cost reduction initiative, will enable SunEdison to continue to grow faster than the market and increase shareholder value.

Valeant (VRX) Pearson Comments: March 2016, Papa Comments June 2016:

Pearson’s Comments on Walgreens Deal:

We have launched our branded access program with Walgreens and this is a piece of the good news, in mid-January, with our dermatology portfolio, followed in mid-February with Ophthalmology Rx and [Indiscernible]. Negotiations are underway to add networks of independent pharmacies.

The program itself is off to a terrific start. Within two months of launch in dermatology, approximately 30% of our dermatology scripts are flowing through Walgreens. This is approximately two times the volume flowing through Walgreens from when we started. More importantly, well over 90% of our doctors who are using Philidor are now using Walgreens, and many new doctors are also using this channel.

Walgreens senior management, whom we met with last week, is equally excited about the program, and we continue to fine tune it to better serve our physicians and patients and improve the economics. Our Brand for Generic program is on track to launch sometime this summer.

3 months later, Papa’s Comments on Walgreens Deal:

With respect to dermatology, I want to make sure that you’re aware. A significant portion of our Walgreens prescriptions have profitability significantly below our internal projections and meaningfully below non-Walgreen prescriptions. In some instances, these prescriptions actually have a negative average selling price. The vast majority of the revenue shortfall in dermatology in our revised guidance relates to this average selling price shortfall.

The good news is that we believe this problem is fixable and we’re working collaboratively with our partners to address these issues. It is in Walgreens and Valeant’s interest to fix this problem. If we are successful in improving the Walgreens ASP, there will be an additional upside to our current derm latest estimate. We will continue to advance our rich pipeline and demonstrate our commitment to the field of dermatology also in terms of the action plans for dermatology.

Clearly, we have some challenges, I mentioned the challenge with the dermatology program and what we’re doing with Walgreens and some of the negative ASPs, the average selling prices we’re dealing with in dermatology. But I think all those things are fixable.

Matt Brice is the portfolio manager of The Sova Group, LLC, an investment firm that manages separate accounts for clients.

I can be reached at matt@thesovagroup.com 

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