Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio) have recommended that to learn about investing, investors should read Berkshire Hathaway Inc.'s (BRK.A, Financial) (BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, I cover the 2006 letter.
Understanding industry dynamics
In the 2006 shareholder letter, Buffett discusses what happens when an industry’s underlying economics are crumbling. Buffett notes that not all Berkshire Hathaway's businesses are destined to increase profits. However, with good management in place, the rate of decline for an eroding business can be slowed. By 2006, the fundamentals were definitely eroding in the newspaper industry, a trend that has caused the profits of Buffalo News to decline and Buffett predicted that the “skid will almost certainly continue.”
The rise and fall of newspapers
The newspaper business was once “as easy a way to make huge returns as existed in America.” In a one-paper city, that paper would typically gush profits, regardless of the product itself. As Buffett explained, for most of the 20th Century, newspapers were the primary source of information for the American public. This led to a situation where most cities ended up having just one paper as a the stand-alone winner for market share. As Buffett said, “After competition disappeared, the paper’s pricing power in both advertising and circulation was unleashed.”
Peering into the future
As typically rates for both advertisers and readers would be raised annually, the profits would roll in. This meant newspapers back then has a strong moat. But nothing lasts forever. Fast forward to 2006, and all newspapers were constantly losing ground in the battle for eyeballs thanks to cable and satellite broadcasting, as well as the internet, which people simply prefer over newspapers.
Unrelenting pressure
Buffett praised Buffalo News’ leadership for outperforming peers, but recognised the business “faces unrelenting pressures that will cause profit margins to slide.” He noted that some people may still wish to own newspapers for other reasons, but due to the terrible economics, “We are likely therefore to see non-economic individual buyers of newspapers emerge, just as we have seen such buyers acquire major sports franchises.”
Adapting to change
However, Buffett predicted that unless Berkshire Hathaway faced an irreversible cash drain, it would stick with Buffalo News as Charlie Munger (Trades, Portfolio) and Buffett both love newspapers (Buffett has said they both read five a day). Buffett hoped some combination of print and online will ward off economic doomsday for newspapers, promising Berkshire Hathaway would work hard in Buffalo to develop a sustainable business model. While he thought that would happen, he recognized, in a very rational way, the days of big profit margins were well and truly gone.
Measuring progress
Buffett noted that he and Munger “measure Berkshire Hathaway's progress and evaluate its intrinsic value in a number of ways.” No single criterion is effective in measing progress, and “even an avalanche of statistics will not capture some factors that are important.” He said there are two statistics, however, that are of real importance. The first is the amount of investments (including cash and cash equivalents) that Berkshire Hathaway owns on a per-share basis. Arriving at this figure, Buffett excluded investments held in Berkshire Hathaway's finance operation because they were largely offset by borrowings.
Buyer of choice and going international
Buffett noted that large gains from non-insurance businesses “will come only if we are able to make major, and sensible, acquisitions. That will not be easy.” But he emphasized that Berkshire had one advantage: it had become “the buyer of choice” for business owners and managers. That was the case in the United States, and Buffett wants that to be the case internationally too. The point Buffett is making is you should make investments that move the needle, and if that means extending your horizons, then so be it.
