Lesson 4 of 8
Buffett's turn
The 1989 letter reviews twenty-five years of mistakes and names the change: from a fair company at a wonderful price to a wonderful company at a fair price.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The 1989 letter's review of twenty-five years of mistakes states the shift in his own accounting and credits Charlie Munger with reaching it first.
- The 1991 letter gives the test that replaced the balance sheet one: three conditions that together produce the ability to price aggressively and earn high returns on capital.
- The 1992 letter refuses the growth and value categories outright, treating growth as a variable inside the value calculation whose contribution can be negative.
Three Berkshire Hathaway letters, written over four years, record a change of method rather than a change of opinion. They are worth reading in order, because each one answers a question the last one opened.
Three letters, three steps in one argument
- 1989Mistakes of the first twenty-five yearsA purchase made only because the price was low leaves the buyer holding a business whose low return erodes the initial advantage. Time works against it.
- 1991An economic franchiseThree conditions define the businesses whose returns survive, and the evidence for all three is the ability to price aggressively and still earn well on capital.
- 1992Growth is not the opposite of valueGrowth is a variable inside the value calculation. Its contribution ranges from negligible to enormous, and it can be negative.
What the 1989 letter actually says
It is a condensed review of mistakes, written in the first person. The first mistake named is buying control of Berkshire itself in 1965, a textile business he already knew was unpromising, bought because the price looked cheap.
He calls that approach the cigar butt: a butt found on the street with one puff left in it offers a poor smoke, but the puff is free. The letter then gives two reasons the approach disappoints outside liquidation. The bargain price usually turns out not to have been one, because a difficult business produces a second problem as soon as the first is solved. And any advantage secured at purchase is eroded by the low return the business earns while you hold it.
The conclusion is the sentence people quote: buying a wonderful company at a fair price beats buying a fair company at a wonderful price. The letter credits Munger with understanding it early and describes himself as a slow learner.
The test that replaced the balance sheet one
If the question is no longer what the assets cover, it has to become something. The 1991 letter supplies it. An economic franchise arises from a product or service that is needed or desired, that its customers believe has no close substitute, and that is not subject to price regulation.
The letter is careful about evidence. The presence of all three conditions is demonstrated by an observable result: the company can price its product aggressively and earn high rates of return on capital by doing so. A franchise can also survive weak management, where an ordinary business can be killed by it.
Why growth stopped being a category
The 1992 letter treats the value and growth labels as a confusion. Growth is a component of the value calculation, a variable whose importance runs from negligible to enormous and whose impact can be negative as well as positive.
The letter's own example is an industry into which investors repeatedly poured money to finance growth that earned nothing, and it names the airline business. Growth benefits an owner only where the capital put in earns an attractive incremental return. Otherwise growth is a way of consuming capital on a schedule.
Check yourself
In the 1989 letter, why does a purchase made only for its low price disappoint outside liquidation?
- Because cheap companies are usually frauds
- Because a difficult business keeps producing problems, and the low return it earns erodes the advantage secured at purchase
- Because the market never re-rates a cheap company
Show the answer
Answer: B.
The letter gives both reasons: the bargain often is not one, and the return the business earns while held works against the buyer.Which three conditions does the 1991 letter give for an economic franchise?
- High margins, low debt and a long history
- The product is needed or desired, is thought to have no close substitute, and is not price regulated
- A famous brand, a patent and a network effect
Show the answer
Answer: B.
Those are the three, and the letter says their presence is demonstrated by the ability to price aggressively and earn high returns on capital.How does the 1992 letter treat the growth and value distinction?
- As two valid styles suited to different investors
- As a confusion: growth is a variable inside the value calculation and its impact can be negative
- As a rule that growth companies should be avoided
Show the answer
Answer: B.
The letter calls the two joined at the hip and says growth's contribution ranges from negligible to enormous and can be negative.Sources
- Berkshire Hathaway shareholder letter, 1989, the section reviewing the mistakes of the first twenty-five years: the cigar butt approach, and the move to buying a wonderful company at a fair price, credited to Charlie Munger.
- Berkshire Hathaway shareholder letter, 1991: the three conditions of an economic franchise, and the contrast with a business that earns exceptional profits only as the low-cost operator or while supply is tight.
- Berkshire Hathaway shareholder letter, 1992: growth as a component of the value calculation rather than an alternative to it, and the airline industry as the example of growth that did not benefit owners.
What this leaves out
- These are three letters out of a run of decades. They are cited for the arguments named here and for nothing else.
- The worked example uses invented round numbers and is labelled illustrative.
- The franchise conditions are a description, not a screen. Nothing in a filing reports whether customers believe a substitute exists.
- Nothing here is advice about any security.