The year Warren Buffett explained, in plain words, how to tell a good business from a merely busy one.
This is where it all begins: the first of Warren Buffett's now-famous annual letters to the shareholders of Berkshire Hathaway. A new one has followed every year since. In early 1978, he sat down to tell the people who owned a piece of his company how the year had gone.
He was not just reporting numbers. Without quite announcing it, he laid out a way of thinking about business and money that would run through every letter he wrote afterward. We will read it as five simple lessons, each tied to the real 1977 business that proves it.
- 01"We made more money" doesn't mean muchThe real scoreboard
- 02Some businesses are hard no matter how good you areHeadwinds
- 03And some businesses give you a free pushTailwinds
- 04Buy a slice the way you'd buy the whole shopOwnership
- 05The best businesses grow without needing cashQuiet winners
"We made more money" doesn't mean much
In 1977 Berkshire made about $22 million in profit from running its businesses, and the profit for each slice of the company jumped 37% over the year before. That sounds great. Buffett's first job is to explain why, on its own, it isn't.
A company making more money than last year is not automatically doing a good job. What counts is how much profit it earns for every dollar the owners have put in.
Yes, profit per slice rose 37%. But the pile of the owners' money in the business had grown 24% bigger too (profits kept from earlier years, not new cash put in), so most of that jump was simply a bigger pile making more money, not the company getting smarter. The figure Buffett actually cared about was this: for every $100 of the owners' money the company began the year with, it earned about $19 of profit. A 19% return, better than most companies manage, and far better than leaving cash in a bank.
Finance people call that 19% the return on equity. It just means profit measured against the owners' money. It is the one number that cannot be faked by a business simply getting bigger.
Money in a savings account grows every single year while you do nothing at all, because the interest earns interest. Sitting on the sofa, sadly, is not a business strategy. So "we earned more than last year" proves nothing by itself. The real question is always: more, compared to what you put in?
Some businesses are hard no matter how good you are
Berkshire's original business was making cloth. In 1977 it had another bad year, and Buffett had wrongly promised it would improve two years running. That, he admitted, might say something about the textile business, his own forecasting, or both. He uses it to make an honest point about effort.
In some industries, even excellent and hard-working managers can only ever do okay, because the whole industry is brutally tough.
The cloth business kept struggling with both making and selling its product. Buffett kept it going anyway, and he is honest about why: the factories were among the biggest employers in their towns, the workers were loyal and skilled, and years earlier this same business had quietly supplied the cash that built Berkshire's far better insurance arm. But he does not pretend. In cloth-making, he says, even very good management can earn only modest results.
It is like sprinting straight into a strong headwind. You can be the fittest runner alive and still barely move forward. The wind, not your fitness, is deciding the race.
And some businesses give you a free push
Insurance was the opposite story, and Berkshire's big winner. An insurer collects money from many customers up front and pays out only to the few who later suffer a loss. Done well, it is a wonderful business. Done badly, it is a wonderful business for the customers.
In other businesses the wind is at your back. You can do very well in them even when you make some mistakes.
In the decade since Berkshire entered insurance, the money its insurers collect each year had grown roughly sevenfold, and it never had to sell new slices of itself to pay for the growth. Why was 1977 so strong? Insurers had pushed through big price rises in 1976 after some dreadful years, and those higher prices only fully landed in 1977. Even a few honest mistakes could not spoil a year like that.
Buffett adds a warning. The good times were already fading. The cost of paying claims was creeping up about 1% every month (things get pricier over time, and juries keep deciding insurers owe more). Unless prices kept climbing too, profits would shrink, and he expected them to start shrinking later in the year.
For every $1 an insurer collects, count how many cents it pays back out in claims and costs. Under $1, it keeps the difference as profit. Over $1, it is losing money on the insurance itself. (The trade calls this the combined ratio.)
When every company sells the exact same thing, the only thing that sets them apart is the people running them.
Insurance, Buffett points out, is almost identical from one company to the next. Everyone sells the same thing: a promise to pay if something goes wrong. Anyone can get a license, and the prices are public. Nothing makes one insurer special except how well it is run, which is why he praises his managers by name, like a coach naming star players.
A row of stalls all selling identical bottles of water at the same price. The water is the same everywhere. The only thing that decides which stall wins is the person behind the counter.
Buy a slice the way you'd buy the whole shop
Berkshire's insurers held a big pile of cash, and Buffett invested it by buying shares of other companies. The trick: he buys a few shares thinking exactly like someone buying the entire business.
Do I understand how it makes money? Will it still do well in ten years? Are the people honest and good at their jobs? And is the price a bargain?
- 1Do I understand how it makes money?
- 2Will it still do well in ten years?
- 3Are the people honest and good at their jobs?
- 4Is the price a bargain?
Here is what Berkshire paid for its biggest shareholdings, beside what those shares were worth at the end of 1977. The first thing worth noticing is not the gains, but when Buffett bought.
| Company | What it is | Bought | Paid | Worth '77 | Compounded/yr |
|---|---|---|---|---|---|
| Kaiser Industries | Metals | mid-70s | $0.8M | $6.0M | ≈174% |
| GEICO | Car insurance · common | 1976 | $4.1M | $10.5M | ≈156% |
| GEICO | Car insurance · preferred | 1976 | $19.4M | $33.0M | ≈70% |
| Interpublic | Advertising | ~1973 | $4.5M | $17.2M | ≈40% |
| The Washington Post | Newspapers | 1973 | $10.6M | $33.4M | ≈33% |
| Ogilvy & Mather | Advertising | ~1973 | $2.8M | $7.0M | ≈26% |
| Kaiser Aluminum | Metals | mid-70s | $11.2M | $10.0M | ≈-5% |
| Knight-Ridder | Newspapers | mid-70s | $7.5M | $8.7M | n/a |
| Capital Cities | TV & newspapers | 1977 | $10.9M | $13.2M | new |
| All other holdings | $35.0M | $42.0M | |||
| All holdings | $106.9M | $181.1M |
Several holdings date to the market slump of 1973 and 1974, when fine companies were on sale. The big GEICO stake came in 1976, the year that insurer nearly went bankrupt and its price collapsed. Capital Cities was brand new in 1977. The pattern fits what Buffett says elsewhere in this very letter: when prices fall, he is glad to buy more, not less.
The Washington Post stands out, worth about three times what he paid. Yet Buffett warns against getting carried away by a number like that. Any single date's figure is unreliable: Berkshire's year-end holdings showed a painful paper loss at the end of 1974 and a $74 million gain three years later. He judges his choices by how the businesses perform over many years, not by the price on any single day.
Berkshire put about $10.9 million into Capital Cities, a company with excellent managers. Buying it outright would have cost about twice as much, and Buffett admits he could not have run it as well as the people already there. So owning a piece, and leaving the right people in charge, beat taking over and running it himself.
Never judge a business by a single moment. A snapshot can fool you. Watch the whole story unfold over years.
Buffett tells an embarrassing story about his own company. Back in 1948, Berkshire's cloth mills were a powerhouse: about $18 million in profit, 10,000 workers, profits in the league of giants like IBM. A snapshot from 1948 would have screamed "blue-chip winner."
A single photo versus the whole movie. A big smile in one frame can hide a sad film, and a dull frame can hide a wonderful one. Always ask to see the whole movie.
The best businesses grow without needing cash
Buffett's favorite kind of business makes plenty of profit without needing much new money to keep growing. These rarely have a flashy year, which is exactly why people overlook them.
A dream business earns lots of profit but barely needs new cash to grow, so the profit is yours to keep or to put to work elsewhere.
Berkshire owned a small bank in Illinois. For its size it earned about three times as much on its assets as most big banks, while staying very safe. Started in 1931 with a quarter-million dollars, it never asked its owner for another dime. It just kept mailing money out, year after year, a bank that gives back rather than asking for more.
The clearest sign of a great business: it can charge more each year, and earn more, without having to sell more.
Berkshire also owned a slice of a candy company, See's Candies. In just five years its yearly profit, before tax, roughly tripled on very little new money, in a candy market that was barely growing at all. People simply loved it enough to pay more.
A beloved local bakery. Everyone adores it, so it can nudge prices up a little every year and customers happily pay, without baking a single extra loaf. More profit, no extra work, no extra cost. That is the quiet magic Buffett hunts for.
The whole chapter, at a glance
In his own words
"[W]e believe a more appropriate measure of managerial economic performance to be return on equity capital."
"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."
"It is comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved."
"Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises."
"We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety."
"[W]e welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price."
"So much for single year snapshots as adequate portrayals of a business."
"[W]e can obtain a better management result through non-control than control. This is an unorthodox view, but one we believe to be sound."
The whole first letter, in one breath.
"[T]he scorecard on our investment decisions will be provided by business results over that period, and not by prices on any given day."
Don't be fooled by bigger numbers: check the profit against the money it took to earn. Know whether your business has the wind with it or against it. Where everyone sells the same thing, bet on the people. Buy a slice like a careful owner. And never trust a single snapshot when you could watch the whole story. These same ideas, tested and retold, will return in every chapter ahead.