In 1977, the US economy was in the second year of economic recovery following the deep economic recession of 1973-1975:
“The longest and deepest economic recession since the end of World War II began in the late fall of 1973 and hit bottom in midwinter 1975.”
– Federal Reserve Bank of Minneapolis, Winter 1978
The economy was experiencing both high inflation and high unemployment, which economists had rarely seen occur simultaneously. Most economists expect high inflation to occur because of an overheating economy, where unemployment is very low leading to wage pressures that in turn puts upward pressure on price levels in the economy.
In addition to the high inflation of 1977, Jimmy Carter was inaugurated as President, Saturday Night Fever had captivated young Americans, and New York City arrested 4000+ looters in the largest mass arrest in its history during the 1977 blackout. Amidst all this, Warren Buffett was laying the foundation for what would eventually become one of the largest companies in the world, Berkshire Hathaway.
Let’s look back at what Mr. Buffett was up to in 1977:
Berkshire Struggles with the Textile Business
“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.”
– Warren Buffett, 1977
Lesson 1: Even Warren Buffett makes mistakes. Buffett entered the textile business based on an investment thesis that failed to play out according to his expectations, and Buffett recognizes that the textile business is unlikely to earn returns comparable to Berkshire’s other divisions.
Lesson 2: Forecasting is extremely difficult and inherently uncertain. When you hear financial commentators and analysts make confident prognostications about the market or specific companies, take these predictions with a grain of salt.
The Insurance Business is Growing
“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,”
– Warren Buffett, 1977
In 1976, the insurance industry instituted large rate increases to offset poor underwriting results in 1974 and 1975, and the full effect of these rate increases was felt in 1977. However, Buffett commented that he expects margins in insurance to decrease going forward as it is becoming difficult to institute premium increases that are keeping up with the high inflation rates (which increase the cost of Berkshire’s claims).
Lesson 3: Buffett looks to invest in industries with long-term growth. As Buffett states directly, company specific mistakes will often resolve themselves over the long-term when that company operates in an industry with strong underlying growth dynamics.
Investing in Stocks is Similar to Buying Whole Companies
“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.”
– Warren Buffett, 1977
Buffett finishes his letter by providing his views on purchasing stocks (small stakes in public companies). An investor would never purchase an entire company with the goal of flipping it for a short-term profit. Similarly, Buffett views the purchase of a small piece of a company in the same manner. The ownership of that company is based on a long-term view of its prospects and underlying value.
Lesson 4: If a company’s fundamentals remain the same and the stock becomes cheaper (goes down), Buffett welcomes the opportunity to purchase stock at a cheaper valuation.
