Buffett's 1985-86 letters dispel cash flow, book value myths

Warren Buffett's 1985 and 1986 letters to Berkshire Hathaway shareholders are packed with timeless lessons—the kind that make you rethink how you look at businesses and investments. From commodity traps to flawed incentive plans and the myth of cash flow, Buffett's insights are as relevant today as they were back then. In continuation of our story series, we have laid out key takeaways from Buffett's 1985 and 1986 letters.

The commodity business curse

Commodity businesses are like that old car that swallows money but never runs quite right. These are companies in industries where products are undifferentiated and competition drives profits into the ground.

Take Burlington Industries, for example. In 1964, it was the largest textile company in the US and by 1985, it still had that title. Over two decades, Burlington poured a staggering $3 billion into capital expenditure. But the result? The stock price barely budged. Even with all that capital, inflation had tripled, and shareholders were left holding the bag.

Buffett explains that the issue isn't poor capital management. Rather, it's about being stuck in a business where, no matter how smart you are with capital, it won't work. You can run a textile mill efficiently, but you'll still end up with mediocre returns if you're in a commoditised industry. In essence, commodity businesses are often a losing game, where even brilliant capital management cannot generate lasting value for shareholders.

Don't trust shiny book values

If you think book value is a reliable indicator of a business's worth, Buffett's experience with Berkshire's textile machinery will change your mind. In the 1980s, Berkshire had invested around $13 million on equipment, some of which had been purchased just a few years prior. At the time, the machinery had a book value of $866,000 after depreciation. Yet when it was auctioned off in 1986, it fetched only $163,122. Even the relatively modern looms, bought in 1981 for $5,000 each, sold for a mere $26 per loom.

This example illustrates how book value merely tells you what has been spent on assets in the past, but it doesn't reflect their true value today. Buffett's lesson simply is: don't place too much weight on book value when evaluating a company. Instead, focus on the company's ability to generate earnings. Book value can be misleading, especially when dealing with industries where assets depreciate quickly or become obsolete.

Doing incentive compensation the right way

Now, let's talk about something that really grinds Buffett's gears—incentive compensation plans. Buffett has long been critical of incentive compensation plans that reward managers for doing little more than allowing wealth to grow passively. A common example is stock options, where managers benefit from increases in stock prices even if those gains come from market trends rather than their own efforts.

Buffett argues that managers should be compensated based on their ability to create real value for the company, not just for the passive accumulation of wealth. Stock options should be priced at the true intrinsic value of the company, not simply the market price. This ensures that managers are genuinely contributing to the company's growth rather than benefiting from growth they didn't actively drive. Rewarding managers for genuine performance is the key to aligning their interests with those of the shareholders.

Tax breaks are not always a gift to shareholders

Here's something that might surprise you: corporate tax cuts don't always put money in shareholders' pockets. When a business has a strong franchise, like an unregulated monopoly, it might keep most of the benefits. But if the franchise is weak, or if it's a price-competitive industry, the benefit might just end up trickling down to customers through lower prices.

In other words, not all tax breaks translate to higher profits. Some just keep the business afloat, and some don't stick around long enough to make a real difference. The bottom line? Don't assume every tax cut equals shareholder gain. It all depends on how strong the business is.

Don't buy the cash flow illusion

There's no doubt that cash flow is the holy grail of financial strength. However, Buffett warns that cash flow can be a misleading metric if it isn't properly understood. Investors often take cash flow numbers at face value, forgetting that companies need to reinvest in their businesses to maintain their competitive edge. This reinvestment comes in the form of capital expenditure—money spent to maintain and improve the business. But when calculating cash flow, most investors neglect to account for this crucial factor, instead focusing only on figures like depreciation and amortisation.

Buffett offers his own formula for owner earnings (free cash flow) as a far more accurate measure of a company's true earning power. It accounts for the need to reinvest in the business while factoring in depreciation and other non-cash charges. The formula is simple:

Owner earnings = Reported earnings + non-cash charges (depreciation, amortisation) - capital expenditure

By focusing on owner earnings, investors can ensure they don't fall for the trick where companies inflate their cash flow by ignoring the need for future capital investment. To Buffett, this is simply a way of masking the truth. Investors must dig deeper to get the real story and avoid falling for a rosy cash flow number that doesn't reflect the true costs of running the business.

The bigger picture: Think beyond the numbers

Buffett's letters remind us that numbers are just a starting point. Whether it's the illusion of cash flow or the misleading appeal of book value, the key is to think critically. Don't simply trust the numbers at face value; dig deeper and understand the business logic behind them. Metrics like cash flow and book value are important, but they are just pieces of the puzzle. The real value of a business lies in its capacity to generate earnings and its competitive position in the market.

Also read: Buffett's 1984 letter: A guide to capital allocation & more

This article was originally published on March 31, 2025.