6 insights from Buffett's 1987 letter you shouldn't miss

In our previous stories, we've unpacked several of Warren Buffett's key investing principles, and this time, we dive into his 1987 letter to Berkshire Hathaway shareholders, which is a treasure trove of insights that remain incredibly relevant. As always, Buffett's sharp observations on business strategy, capital allocation, and investment discipline provide valuable lessons that transcend decades. Let's break down the six critical themes that stood out in this letter.

Consistency and returns: The case for stability

In the investing world, change is often equated with excitement. But Buffett argues that the best returns usually come from companies that have been doing the same thing for decades. Businesses that constantly encounter significant changes are prone to mistakes and failures. On the flip side, those that have remained steadfast in their operations, consistently delivering value to customers, tend to build robust franchises and deliver higher returns.

Investors tend to get swept up by the allure of rapid transformation, assigning lofty valuations to flashy, high-growth ventures. Yet, it's the unassuming, stable businesses that often outperform over the long haul. The lesson? Look for consistency rather than the excitement of change.

Two tests of economic excellence: Filtering the best from the rest

How do you identify a truly exceptional business? Buffett sets two simple but powerful tests:

• An average return on equity (ROE) of over 20 per cent over a decade
  
• No single year with a ROE below 15 per cent

Out of 1,000 companies he analysed in a Fortune study, only 25 made the cut. Surprisingly, most of these firms weren't in high-tech or flashy sectors but were in relatively mundane industries. Their secret? They stuck to what they did best and avoided excessive leverage, demonstrating that economic excellence simply needs consistency and prudence.

The illusion of a flexible operating budget

Buffett takes a jab at flexible operating budgets, which allow companies to inflate expenses when revenues are high and cut them when revenues dip. He and Charlie Munger don't buy into that mindset. They prefer rigid cost control, not linking spending to revenue fluctuations. Why? Because it keeps management disciplined and prevents complacency during good times.

Why insurance businesses are uniquely flexible

Buffett highlights three reasons why insurance businesses are uniquely flexible:

• Market share isn't crucial: Unlike most industries, bigger isn't necessarily better in insurance. Profitability is more important than volume.
  
• Low barriers to entry: You can ramp up volume quickly without being hamstrung by distribution challenges.
  
• Idle capacity isn't costly: Since idle capacity mostly means unused people rather than heavy machinery, it doesn't crush profitability.

This flexibility allows Berkshire's insurance operations to operate prudently without chasing growth at any cost.

Capital allocation: The critical skill most CEOs lack

According to Buffett, most CEOs rise through the ranks by excelling in operations, sales, or production, but few have a natural aptitude for capital allocation. Yet, it's one of the most critical skills for a leader, as poorly allocated capital can sink even the most promising businesses.

He further highlights the importance of capital management by pointing how CEOs generally end up managing a substantial amount of capital in their businesses. A CEO whose company annually retains earnings equal to 10 per cent of net worth will have deployed more than 60 per cent of all the capital in the business in 10 years. Misallocating such a large amount of money can destroy shareholder value on an enormous scale.

Rather than relying on investment bankers and consultants, whose advice often compounds problems, CEOs must think like owners and deploy capital with a long-term perspective. Companies that master capital allocation build enduring wealth, while those that fail are often the ones "restructured" out of existence.

A blueprint for intelligent investing

Buffett's message is clear: focus on consistency, find economic excellence, reject gimmicky budgeting, understand your industry's unique dynamics, think like a business owner, and most importantly, master capital allocation.

In a world obsessed with novelty and disruption, Buffett's wisdom stands out: be consistent, stay grounded, and think long-term. In the end, that's what builds sustainable wealth.

Also read: The five laws of stupid investing

This article was originally published on April 01, 2025.