After reading Warren Buffett's shareholder letter from 40 years ago, this is what I want to tell you

Author: BoringBiz_

Compiled by: Deep Tide TechFlow

Introduction: As Warren Buffett prepares to step down after nearly 60 years as CEO of Berkshire Hathaway, it is especially important to revisit the core ideas from his early thinking.

This article is a deep compilation of Buffett’s shareholder letters from 1981 to 1982. Even after more than 40 years, Buffett’s statements on “rejecting mediocre mergers,” “inflation as a parasite eroding companies,” and “real economic earnings outperform accounting profits” still serve as strong warnings for today’s Web3 investors, DAO governors, and business operators.

The full text is as follows:

As Warren Buffett has led Berkshire Hathaway as CEO for nearly six decades and is finally passing the baton, I have revisited and begun to study all of his annual shareholder letters.

If you want to read the lessons from the letters of 1977-1980, see here: 1977-1980 Letters

Below are some lessons that are considered classics for both investors and operators.

1981 Shareholder Letter

Standards for M&A Decisions

“Our acquisition decisions aim to maximize real economic benefits, not to expand management’s territory or to pursue accounting figures. (In the long run, managers who emphasize accounting appearances over economic substance usually get neither.)”

“Regardless of the impact on immediate financial results, we prefer to buy a 10% stake in excellent company T at a price of X per share, rather than acquiring 100% of T at 2X. However, most management teams prefer the latter and never lack reasons to justify their actions.”

Why CEOs are willing to pay premiums for M&A and LBOs

“We suspect that in most high-premium acquisitions, the following three (usually unwritten) motives are the main drivers, either acting alone or together:

1. Leaders in business or other fields rarely lack ‘animal spirits’; they tend to enjoy increasing activity and challenges. At Berkshire, whenever there’s an acquisition prospect, the company’s pulse beats more intensely than ever.
2. Most organizations, whether in business or other sectors, tend to measure themselves by size, and are also measured by others in the same way. Compensation for management is far more often based on ‘size’ than on other standards. (Ask a manager at a Fortune 500 company which rank his company holds on that famous list—his answer will likely be based on sales volume; he may not even know where his company ranks in profit margin on the same list.)
3. Many management teams are obviously deeply influenced during their formative years by the story of the Frog Prince—in which a handsome prince trapped inside a frog is reborn through a kiss from a beautiful princess. They are convinced that their ‘management kiss’ can work miracles for the target company T.

This optimism is essential. Without such a beautiful illusion, why would shareholders of company A support paying 2X for T’s equity instead of simply buying it on the secondary market at X?”

Investors should seek to buy the ‘prince’ at ‘frog prices’

“Investors can always buy frogs at market price. If investors fund those ‘princesses’ willing to pay double to kiss frogs, then these kisses should really pack some power.

We have observed many kisses, but miracles are rare. Still, many management ‘princesses’ remain confident in the effectiveness of their future kisses—even as their backyards are filled with unresponsive frogs.

Occasionally, we also try to buy frogs at low prices, as detailed in past reports. Clearly, our kisses have failed completely. We’ve done well with a few ‘princes’—but they were princes at the time of acquisition. At least our kisses didn’t turn them into frogs. Ultimately, we sometimes succeed very well in buying parts of easily recognizable ‘princes’ at ‘frog-like’ prices.”

What makes successful mergers work

“We must admit that some merger records are truly outstanding. They can be mainly categorized into two types:

The first involves companies that, through careful design or coincidence, only buy businesses that are particularly adaptable to inflation. These favored businesses must have two features:

1. The ability to raise prices easily (even when product demand is mediocre and capacity is underutilized), without worrying about significant loss of market share or sales;
2. The ability to handle huge dollar growth with minimal additional capital investment (such growth is usually driven by inflation rather than real expansion). Even management teams of average capability have achieved excellent results over the past decades by focusing on acquisitions that meet these standards. However, very few companies possess both features simultaneously, and competition for such acquisitions has become extremely fierce, even to the point of self-damage.

The second involves management geniuses—those rare princes who can identify disguised princes in frogs and have the management skills to tear off the disguise. We salute such managers.”

Stable price levels are like chastity

“We have explained how inflation makes our long-term performance, which appears satisfactory on the surface, illusory when measuring the true investment results for owners.

We appreciate the efforts of Fed Chairman Volcker and note that current price indices are moderating.

However, our view on the long-term inflation trend remains negative. Like chastity, stable price levels seem maintainable but cannot be fixed.”

On equity risk premiums

“The economic basis for justifying equity investments is that, overall, managing and entrepreneurial skills applied to equity capital will generate returns higher than passive investments (i.e., interest on fixed-income securities).

Furthermore, this basis assumes that because equity capital bears higher risk than passive investments, it ‘deserves’ higher returns. The ‘value-added’ bonus generated by equity capital seems logical and certain.

But is this really the case? Decades ago, a return on equity (ROE) as low as 10% could classify a company as a ‘good’ business—that is, in such a business, a $1 reinvestment could logically be valued by the market at over 100 cents.

Because when the long-term taxable bond yield is 5% and the tax-exempt bond yield is 3%, a business operating at a 10% efficiency with equity capital clearly commands a premium over the use of equity capital itself. Even if dividend and capital gains taxes reduce the 10% earnings to 6-8% in the hands of individual investors, the principle still holds.

At that time, the market recognized this fact. The average ROE of American companies was about 11%, and the overall stock prices were far above their book value, with an average price of over 150 cents per dollar of book value. Most businesses were ‘good’ because their earning power far exceeded their maintenance costs (long-term passive capital returns). The total appreciation from equity investments was enormous.

That era is gone. But the lessons from that time are hard to forget. While investors and managers must look to the future, their memories and neural systems often remain anchored in the past. For investors, using historical P/E ratios, or for managers, relying on historical valuation standards, is much easier than constantly rethinking assumptions.

When change is slow, constant re-evaluation is not advisable; it yields little and slows response. But when change is intense, clinging to yesterday’s assumptions can be costly. The pace of economic change has become breathtaking.”

Inflation as a parasite of companies

“In an inflationary environment, owners of ‘bad’ businesses face a particularly ironic penalty. To maintain operations, such low-return businesses often have to retain most of their profits—regardless of how much this punishes shareholders.

The rational approach is exactly the opposite. If someone holds a bond with a 5% rate that matures in many years, he wouldn’t use that bond’s interest to buy more bonds at 100 cents on the dollar, especially when similar bonds are available at around 40 cents. Instead, he would extract interest from that low-return bond and—if reinvestment is desired—seek opportunities with the highest current safe returns. Good money doesn’t follow bad money.

The same logic applies to creditors and shareholders. Rationally, a company with high historical and expected returns should retain most or all profits so that shareholders can earn premium returns through enhanced capital.

Conversely, low ROE suggests a high dividend payout policy, allowing owners to shift capital into more attractive areas. (The Bible shares this view: in the parable of the talents, the two high-yield servants received a 100% retention bonus and were encouraged to expand. But the third servant, who had no yield, was not only rebuked—‘wicked and lazy’—but also required to turn over all his capital to the best performer. Matthew 25:14-30)

But inflation is like a mirror-world in Alice in Wonderland, where everything is upside down. When prices keep rising, ‘bad’ businesses must retain every penny they can get. It’s not because they are attractive as repositories of equity capital; rather, it’s because they are unattractive, low-return businesses that must follow high retention policies. If they want to continue operating as they have in the past—most entities, including companies, want to do so—they have no choice.

Because inflation is like a giant ‘corporate parasite’ that preemptively consumes the investment dollars needed daily, regardless of the host’s health. No matter the reported profit level (even zero), to merely maintain last year’s business volume, companies continually need more dollars invested in receivables, inventories, and fixed assets. The worse the economy, the larger the proportion of nutrients consumed by this parasite.

Under current conditions, a company with an 8% or 10% equity return usually has no surplus funds for expansion, debt repayment, or ‘real’ dividends.

Inflation as this parasite simply clears the table. (The situation where low-return companies cannot pay dividends is often well concealed. US companies are increasingly turning to dividend reinvestment plans, sometimes with discounts that almost force shareholders to reinvest. Others are ‘robbing Peter to pay Paul,’ selling newly issued stock to fund dividends. Beware of ‘dividends’ paid only when someone promises to replace the distributed capital.)”

1982 Shareholder Letter

Setting preset standards

“As long as results are good, yardsticks are rarely discarded. But when performance deteriorates, most managers tend to abandon the yardstick rather than the manager.

For managers facing declining performance, a more flexible measurement system often comes to mind: first, shoot arrows of business performance onto a blank canvas, then carefully draw the bullseye around where the arrows land. We tend to trust preset, long-term, and narrower standards more.”

Accounting is the starting point, not the endpoint, of business valuation

“We prefer the concept of ‘economic’ earnings, which include all undistributed profits, regardless of ownership percentage. In our view, the value of retained earnings to owners depends on how efficiently those earnings are used, not on your ownership stake. If you held 0.01% of Berkshire over the past ten years, regardless of how your accounting system records it, you have economically shared fully in our retained earnings. Proportionally, your benefit is the same as holding that attractive 20% stake. But if you held 100% of many capital-intensive businesses over the past decade, the retained earnings recorded under standard accounting—accurately and completely—may ultimately have little or no economic value.”

This is not a criticism of accounting procedures. We are not trying to design a better system. It’s simply to illustrate that managers and investors must understand that accounting figures are the starting point for business valuation, not the end.”

Retained earnings and market valuation

“Although total retained earnings over the years have been converted into at least an equivalent market value return to shareholders, this conversion is highly uneven across companies and irregular and unpredictable over time.

But it is precisely this unevenness and irregularity that creates opportunities for value-oriented buyers who purchase fractional portions of businesses.

Such investors can choose from nearly all large US companies, including many far superior to those that can be acquired through negotiated takeovers. Moreover, buying fractional shares can be done in auction markets, where prices are set by participants whose behavior sometimes resembles a herd of manic-depressive lemmings.

In this vast auction arena, our task is to select businesses with excellent economic characteristics so that each dollar of retained earnings ultimately translates into at least one dollar of market value. Despite many mistakes, we have achieved this goal so far. In this process, we have been greatly aided by the guardian of economics—St. Offset.

In some cases, the retained earnings attributable to our ownership stake have little or even negative impact on market value; in other major holdings, the dollar retained by the invested company has already been converted into two dollars or more of market value. So far, our best-performing companies have easily offset the laggards. If we can keep this record, it will prove that our strategy of maximizing ‘economic’ earnings is correct, regardless of its effect on ‘accounting’ profits.”

On M&A transactions

“When we look back at major acquisitions made by other companies in 1982, our reaction is not envy but relief that we did not participate.

Because in many such acquisitions, management’s rationality shrinks in competition with adrenaline; the thrill of pursuit blinds the pursuers to the consequences after the deal. Pascal’s observation seems apt: ‘I have found that all human misfortune comes from one simple cause: they cannot stay quietly in their own room.’”

What affects corporate profitability?

“If an industry features both ‘severe overcapacity’ and ‘commoditized’ products (with no differentiation in performance, appearance, or customer support), then it is a prime candidate for profitability problems. Of course, if prices or costs are managed by regulation—partially or wholly—these issues might be avoided.

Such management can be implemented in the following ways: (a) through government intervention (until recently, including regulated pricing for trucking and deposit costs for financial institutions); (b) through illegal collusion; or © through extralegal foreign cartels like OPEC (domestic non-cartel operators can also benefit).

However, if costs and prices are determined by full competition, and overcapacity exists, and buyers do not care who supplies the product or service, then the industry’s economic outlook is almost doomed to mediocrity or disaster.

Therefore, each supplier continually strives to establish and emphasize unique qualities of their products or services. This works well in candy bars (customers buy by brand, not by asking for ‘two ounces of candy’), but not in sugar (how often do you hear: ‘Please give me a coffee with cream and C & H sugar’?).

In many industries, differentiation cannot produce substantive value. If a few producers have broad and sustainable cost advantages, they may perform well. By definition, such exceptions are rare and often nonexistent in many industries. For most companies selling commoditized products, a depressing business equation prevails: persistent overcapacity + lack of regulated pricing (or cost management) = poor profitability.

Of course, overcapacity may eventually self-correct—either through capacity shrinkage or demand expansion. Unfortunately, for participants, such corrections are often delayed long-term. When they finally occur, the widespread enthusiasm for re-expansion often re-creates overcapacity within a few years, leading to a new environment of unprofitability. In other words, nothing breeds failure like success.

The long-term profitability of such industries is ultimately determined by the ratio of ‘tight supply years’ to ‘ample supply years.’ This ratio is usually abysmally low. (It seems our textile business’s last period of tight supply—several years ago—lasted only half a morning.)

In some industries, tight capacity can last a long time. Sometimes, actual demand growth exceeds forecasts for extended periods. Other times, expanding capacity requires lengthy preparations, as complex manufacturing facilities must be planned and built.”

Using equity as a payment method in M&A

“Our stock issuance follows a simple fundamental rule: we do not issue stock unless the intrinsic business value we receive equals what we give. This policy seems obvious. You might ask, why would anyone exchange $1 for 50 cents in coins? Unfortunately, many managers have been willing to do so.

These managers’ first choice in acquisitions is often cash or debt. But CEOs’ desires often outstrip their cash and credit resources (of course, mine always do). Moreover, these desires often occur when their own stock is trading well below its intrinsic value. This creates a moment of truth. As Yogi Berra said: ‘You can observe a lot just by watching.’ Because shareholders will then see which target management truly prefers—expansion or wealth preservation.

The reason for choosing between these goals is simple. A company’s market price often falls below its intrinsic value. But when a company seeks to sell its entire business through negotiated sale, it inevitably wants—and usually can—obtain full value in any form of currency.

If paid in cash, the seller’s valuation of the received value is straightforward. If paid in the buyer’s stock, the seller’s calculation remains relatively simple: just determine the market cash value of the assets received via stock.

Meanwhile, a buyer who hopes to use its own stock as currency, if its stock price reflects full intrinsic value, faces no problem.

But if its stock price is only half of intrinsic value, then the buyer faces the painful prospect of purchasing with significantly undervalued currency.

Ironically, if the buyer becomes the seller of its entire business, it can also negotiate to obtain full intrinsic value. But when the buyer conducts a partial sale—issuing stock to acquire—it’s essentially doing this. Usually, it cannot set its stock’s value higher than the market assigns.

Even so, aggressive acquirers end up paying with undervalued (market value) currency for assets that are worth full (negotiated) value. In effect, they must give up $2 of value to get back $1. In such cases, even a well-priced business turns into a poor deal. Because gold priced as gold cannot be smartly bought with gold—or even with silver priced as lead.”

How CEOs justify value-destroying mergers

“If the desire for scale and action is strong enough, acquisition managers can always find plenty of reasons to justify such value-destroying stock issuance. Friendly investment bankers will assure him of its rationality. (Never ask a barber if you need a haircut.)

Here are some common excuses used by management when issuing stock:

1. ‘The company we acquire will be more valuable in the future.’ (Presumably, the existing business interests being traded away are also valued accordingly; future prospects are already embedded in the business valuation. If you issue at 2X to buy at X, when both parts double in value, the imbalance persists.)
2. ‘We must grow.’ (One might ask, who is ‘we’? For existing shareholders, the reality is that issuing stock causes all current businesses to shrink. If Berkshire issues stock tomorrow to acquire, Berkshire will own everything it owns now plus new businesses, but your interests in See’s Candy, National Indemnity, and other unmatched businesses will automatically decrease. If (1) your family owns a 120-acre farm, (2) and you invite a neighbor with 60 acres to merge into an equal partnership—where you are the managing partner—then (3) your management footprint grows to 180 acres, but your ownership in land and crops shrinks by 25% forever. Managers seeking to expand at the expense of owners’ interests should consider working for the government.)
3. ‘Our stock is undervalued, and we’ve minimized its use in transactions—yet we need to give sellers 51% of stock and 49% cash so some shareholders can get their tax-free exchange.’ (This argument admits that reducing stock issuance benefits the acquirer, which we like. But if using 100% stock damages existing shareholders, then using 51% likely does too. After all, if a poodle dirties someone’s lawn, he won’t care if it’s a poodle or a St. Bernard. Seller’s willingness should not determine the buyer’s best interests—God knows what happens if the seller insists on replacing the acquirer’s CEO as a merger condition.)”

How to avoid value-destroying mergers

“There are three ways to prevent destroying old shareholders’ value when issuing stock for acquisitions:

The first is a true ‘business-for-business’ merger, aiming to be fair to both sets of shareholders, with each paying and receiving in intrinsic business value equally. Such a deal is not sought by the acquirer, but it is very difficult to achieve.

The second occurs when the acquirer’s stock price equals or exceeds its intrinsic business value. In this case, using stock as currency can actually increase the acquirer’s wealth. Many mergers from 1965-1969 were based on this principle. The result is quite different from most activity since 1970: the shareholders of the acquired company received highly inflated currency (often driven by dubious accounting and promotional hype), and they were the ones who lost wealth in these deals.

In recent years, the second approach has been effective for only a few large companies. Exceptions mainly include those in attractive or promotional industries, where the market temporarily assigns valuations equal to or above intrinsic business value.

The third approach involves the acquirer continuing to buy, but then repurchasing an amount of stock equivalent to what was issued in the merger. This effectively transforms a ‘stock-for-stock’ merger into a ‘cash-for-stock’ acquisition. Such repurchases are ‘damage repair’ measures. Regular readers of my letters will correctly guess that we prefer repurchases that directly increase owner wealth rather than merely repairing previous damage. Scoring a touchdown is more exciting than recovering your fumble. But when a fumble occurs, regaining possession is crucial, and we sincerely recommend this damage-repair repurchase that turns a bad stock deal into a fair cash transaction.”

Pitfalls to watch for in M&A language

“The language used in mergers often confuses issues and encourages managers to take irrational actions. For example, ‘dilution’ is usually based on pro forma calculations using book value and current EPS, with particular emphasis on the latter.

When this calculation looks negative (dilutive) from the acquirer’s perspective, management will offer an explanation (internally, if not externally) that these curves will cross favorably at some future point. (Although deals often fail in practice, they never fail in forecasts—if the CEO is obviously eager for a potential acquisition, subordinates and consultants will provide the necessary forecasts to justify any price.) If the resulting number looks immediately positive (anti-dilutive) for the acquirer, no explanation is needed.

Overemphasizing this form of dilution is a mistake: current EPS (or even future EPS) is an important but not decisive variable in most business valuations.

Many mergers are ‘non-dilutive’ in this limited sense but can instantly destroy value for the acquirer. Conversely, some mergers that dilute current and short-term EPS actually increase value. The real issue is whether a merger dilutes or enhances ‘intrinsic business value’ (a judgment involving many variables). We believe that calculating dilution from this perspective is crucial (but rarely done).

The second language issue relates to the exchange ratio. If Company A announces it will issue stock to merge with B, this is often described as ‘A acquiring B’ or ‘B being sold to A.’ A more precise, albeit clumsy, description might be: ‘Part of A is sold to exchange for B,’ or ‘B’s owners receive part of A in exchange for their assets.’ In trading, what you give and what you get are equally important. Even if the payment is deferred, this remains true.

Subsequently, to finance the deal or restore balance sheet strength, common stock or convertible bonds are issued, which must be fully accounted for in the basic mathematical model of the original acquisition. (If the result of the merger is a ‘pregnant’ company, the moment to face this fact is before the climax.)

Managers and directors can sharpen their thinking by asking: Would I be willing to sell 100% of my business if asked to sell a part? If selling part of the business isn’t smart, then why is selling all of it? A pile of tiny managerial foolishness adds up to a huge stupidity—rather than a great victory. (Las Vegas is built on wealth transfers that occur when people engage in seemingly minor unfavorable capital transactions.)”

The ‘double whammy’ of value dilution in M&A

“Finally, it’s important to mention the ‘double whammy’ effect when value-dilutive stock issuance occurs. The first blow is the intrinsic business value loss caused by the merger itself.

The second blow is the downward revision of market valuation, which is quite rationally assigned to the now-diluted business value. Because current and potential owners naturally do not want to pay high prices for assets managed by a record of ‘destroying wealth through mergers’…”