(Image: Zen Buddha Silence by Marilyn Barbone.)
December 17, 2017
A chief purpose of this blog is to teach others about business and investing. (My other passion is artificial intelligence.) For those curious about these and related subjects, I hope this blog is useful.
The other main purpose of this blog is to create awareness for the Boole Microcap Fund, which I manage.
- Buffett correctly observes that a low-cost index fund is the best long-term investment for most investors: http://boolefund.com/warren-buffett-jack-bogle/
- A quantitative value strategy – properly implemented – has high odds of beating an index fund.
- Buffett, Munger, Lynch, and other top investors started in micro caps because there’s far less competition and far more inefficiency. An equal weighted microcap approach has outperformed every other size category historically: http://boolefund.com/best-performers-microcap-stocks/
- If you also screen for value and for improving fundamentals, then a microcap value approach is likely to do significantly better (net of all costs) than an S&P 500 index fund over time.
This week’s blog post covers The Essays of Warren Buffett: Lessons for Corporate America (4th edition, 2015), selected and arranged by Lawrence A. Cunningham. The book is based on 50 years of Buffett’s letters to shareholders, organized according to topic.
Not only is Warren Buffett arguably the greatest investor of all time; but Buffett wants to be remembered as a “Teacher.” Buffett and Munger have been outstanding “professors” for decades now, carrying on the value investing community’s tradition of generosity. Munger:
The best thing a human being can do is to help another human being know more.
Every section (but taxation) from The Essays of Warren Buffett is included here:
- Prologue: Owner-Related Business Principles
- Corporate Governance
- Finance and Investing
- Investment Alternatives
- Common Stock
- Mergers and Acquisitions
- Valuation and Accounting
- Accounting Shenanigans
- Berkshire at Fifty and Beyond
PROLOGUE: OWNER-RELATED BUSINESS PRINCIPLES
Buffett writes that Berkshire Hathaway shareholders are unusual because nearly all of them focus on long-term compounding of business value. At the end of a typical year, 98% of those who own shares in Berkshire owned the shares at the beginning of the year.
Buffett remarks that, to a large extent, companies end up with the shareholders they seek and deserve. Buffett sets forth Berkshire’s fifteen owner-related business principles:
- Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners… We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.
- In line with Berkshire’s owner-orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking.
- Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress…
- Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries…
- Because of our two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance. These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them.
- Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rate price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.
- We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care. (As one of the Indianapolis ‘500’ winners said: ‘To finish first, you must first finish.’)
- A managerial ‘wish list’ will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.
- We feel noble intentions should be checked periodically against results. We test the wisdom of retained earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis…
- We will issue common stock only when we receive as much in business value as we give…
- You should be fully aware of one attitude Charlie and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations…
- We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less… We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private.
- Despite our policy of candor we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation…
- To the extent possible, we would like each Berkshire shareholder to record a gain or loss in market value during his period of ownership that is proportional to the gain or loss in per-share intrinsic value recorded by the company during that holding period…
- We regularly compare the gain in Berkshire’s per-share book value to the performance of the S&P 500…
At Berkshire, full reporting means giving you the information that we would wish you to give to us if our positions were reversed. What Charlie and I would want under the circumstance would be all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business. We would expect both a lot of financial details and a discussion of any significant data we would need to interpret what was presented. (page 37)
Buffett comments that it is deceptive and dangerous – as he and Charlie see it – for CEOs to predict publicly growth rates for their companies. Though they are pushed to do so by analysts and their own investor relations departments, such predictions too often lead to trouble. Having internal targets is fine, of course. Buffett:
The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to ‘make the numbers.’ (page 39)
Buffett offers three suggestions for investors. He says:
- First, beware of companies displaying weak accounting… When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes.
- Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to…
- Finally, be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).
Buffett writes that when CEOs fall short, it’s quite difficult to remove them. Part of the problem is that there are no objective standards.
At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands. (page 41)
A further problem is that the CEO has no immediate superior whose performance is itself being measured. Buffett describes this and related issues:
But the CEO’s boss is a board of directors that seldom measures itself and is infrequently held to account for substandard corporate performance. If the Board makes a mistake in hiring, and perpetuates that mistake, so what? Even if the company is taken over because of the mistake, the deal will probably bestow substantial benefits on the outgoing board members…
Finally, relations between the Board and the CEO are expected to be congenial. At board meetings, criticisms of the CEO’s performance is often viewed as the social equivalent of belching…
These points should not be interpreted as a blanket condemnation of CEOs or Boards of Directors: Most are able and hardworking, and a number are truly outstanding. But the management failings Charlie and I have seen make us thankful that we are linked with the managers of our permanent holdings. They love their businesses, they think like owners, and they exude integrity and ability. (pages 41-42)
Buffett wrote more about corporate governance on a different occasion. He points out that there are three basic manager/owner situations.
The first situation – by far the most common – is that there is no controlling shareholder. Buffett argues that directors in this case should act as if there is a single absentee owner, whose long-term interest they should try to further. If a board member sees management going wrong, he should try to convince other board members. Failing that, he should make his views known to absentee owners, says Buffett. Also, the board should set standards for CEO performance and regularly meet – without the CEO present – to measure that performance. Finally, board members should be chosen based on business savvy, interest in the job, and owner-orientation, holds Buffett.
The second situation is that the controlling owner is also the manager. In this case, if the owner/manager is failing, it’s difficult for board members to improve things. If the board members agree, they could as a unit convey their concerns. But this probably won’t achieve much. On an individual level, a board member who has serious concerns could resign.
The third governance situation is when there is a controlling owner who is not involved in management. In this case, unhappy directors can go directly to the owner, observes Buffett.
Buffett then remarks:
Logically, the third case should be the most effective in insuring first-class management. In the second case the owner is not going to fire himself, and in the first case, directors often find it very difficult to deal with mediocrity or mild over-reaching. Unless the unhappy directors can win over a majority of the board – an awkward social and logistical task, particularly if management’s behavior is merely odious, not egregious – their hands are effectively tied… (page 44)
Buffett also writes that most directors are decent folks who do a first-class job. But, nonetheless, being human, some directors will fail to be objective if their director fees are a large part of their annual income.
Buffett says that Berkshire’s policy is only to work with people they like and admire. Berkshire generally only buys a business when they like and admire the manager and when that manager is willing to stay in place.
…Berkshire’s ownership may make even the best of managers more effective. First, we eliminate all of the ritualistic and nonproductive activities that normally go with the job of CEO. Our managers are totally in charge of their personal schedules. Second, we give each a simple mission: Just run your business as if:
- you own 100% of it;
- it is the only asset in the world that you and your family have or will ever have; and
- you can’t sell or merge it for at least a century.
As a corollary, we tell them they should not let any of their decisions be affected even slightly by accounting considerations. We want our managers to think about what counts, not how it will be counted. (pages 50-51)
Buffett comments that very few CEOs of public companies can follow such mandates, chiefly because they have owners (shareholders) who focus on short-term prospects and reported earnings. It’s not that Berkshire ignores current results, says Buffett, but that they should never be achieved at the expense of building ever-greater long-term competitive strengths.
I believe the GEICO story demonstrates the benefits of Berkshire’s approach. Charlie and I haven’t taught Tony a thing – and never will – but we have created an environment that allows him to apply all of his talents to what’s important. He does not have to devote his time or energy to board meetings, press interviews, presentations by investment bankers or talks with financial analysts. Furthermore, he need never spend a minute thinking about financing, credit ratings or ‘Street’ expectations for earnings per share. Because of our ownership structure, he also knows that this operational framework will endure for decades to come. In this environment of freedom, both Tony and his company can convert their almost limitless potential into matching achievements. (page 51)
Buffett discusses the importance of building long-term competitive strengths:
Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.
When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as ‘widening the moat.’ And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence.
It’s interesting that Berkshire Hathaway itself, a textile operation, is one of Buffett’s biggest investment mistakes. Furthermore, Buffett owned the textile business from 1965 to 1985, despite generally bad results. Buffett explains that he held on to this business because management was straightforward and energetic, labor was cooperative and understanding, the company was a large employer, and the business was still earning modest cash returns.
Buffett was able to build today’s Berkshire Hathaway, one of the largest and most successful companies in the world, because he took cash out of the textile operation and reinvested in a series of highly successful businesses. Buffett did have to close the textile business in 1985 – twenty years after acquiring it – because, by then, the company was losing money each year, with no prospect for improvement.
Buffett tells the story of Burlington, the largest U.S. textile enterprise. From 1964 to 1985, Burlington spent about $3 billion on improvement and expansion. This amounted to more than $200-a-share on a $60 stock. However, after 20 years, the stock had gone nowhere, while the CPI had more than tripled. Buffett:
This devastating outcome for the shareholders demonstrates what can happen when much brain power and energy are applied to a faulty premise…
My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks. (pages 55-56)
Buffett also covers the topic of executive pay:
When returns on capital are ordinary, an earn-more-by-putting-up-more record is no great managerial achievement. You can get the same result personally by operating from your rocking chair. Just quadruple the capital you commit to a savings account and you will quadruple your earnings. You would hardly expect hosannas for that particular accomplishment. Yet, retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign – with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest.
If the widget company consistently earned a superior return on capital throughout the period, or if capital employed only doubled during the CEO’s reign, the praise for him may be well deserved. But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be withheld. A savings account in which interest was reinvested would achieve the same year-by-year increase in earnings – and, at only 8% interest, would quadruple its annual earnings in 18 years.
The power of this simple math is often ignored by companies to the detriment of their shareholders. Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in large part, by retained earnings – i.e., earnings withheld from owners… (page 67)
Buffett points out that ten-year, fixed-price options ignore the fact that earnings automatically build value, and that carrying capital has a cost. Managers in this situation profit just as they would if they had an option on the savings account that automatically was building value.
Buffett repeatedly emphasizes that excellent management performance should be rewarded. Indeed, says Buffett, exceptional managers nearly always get less than they should. But that means you have to measure return on capital versus cost of capital. Buffett does admit, however, that some managers he admires enormously disagree with him regarding fixed-price options.
Buffett designs Berkshire’s employment contracts with managers based on returns on capital employed versus the cost of that capital. If the return on capital is high, the manager is rewarded. If return on capital is sub-standard, then the manager is penalized. Fixed-price options, by contrast, besides not usually being adjustable for the cost of capital, also fall short in that they reward managers on the upside without penalizing them on the downside. (Buffett does adjust manager contracts based on the economic characteristics of the business, however. A regulated business will have lower but still acceptable returns, for instance.)
Regarding reputation, Buffett has written for over 30 years:
We can’t be perfect but we can try to be…
We can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.
Most auditors, observes Buffett, see that the CEO and CFO pay their fees. So the auditors are more worried about offending the CEO than they are about accurate reporting. Buffett suggests that audit committees ask the following four questions of auditors:
- If the auditor were solely responsible for the preparation of the company’s financial statements, would they in any way have been prepared differently from the manner selected by management? This question should cover both material and nonmaterial differences. If the auditor would have done something differently, both management’s argument and the auditor’s response should be disclosed. The audit committee should then evaluate the facts.
- If the auditor were an investor, would he have received – in plain English – the information essential to his understanding the company’s financial performance during the reporting period?
- Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?
- Is the auditor aware of any actions – either accounting or operational – that have had the purpose and effect of moving revenues or expenses from one reporting period to another? (page 79)
Buffett remarks that this procedure would save time and expense, in addition to focusing auditors on their duty.
FINANCE AND INVESTING
Buffett discusses his purchase of a farm in Nebraska in 1986, a few years after a bubble in Midwest farm prices had popped. First, he learned from his son how many bushels of corn and of soybeans would be produced, and what the operating expenses would be. Buffett determined that the normalized return from the farm would be 10%, and that productivity and prices were both likely to increase over time. Three decades later, the farm had tripled its earnings and Buffett’s investment had grown five times in value.
Buffett also mentions buying some real estate next to NYU shortly after a bubble in commercial real estate had popped. The unlevered current yield was 10%. Earnings subsequently tripled and annual distributions soon exceeded 35% of the original equity investment.
Buffett says these two investments illustrate certain fundamentals of investing, which he spells out as follows:
- You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick ‘no.’
- Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.
- If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so… And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
- With my two small investments, I thought only of what the property would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
- Forming macro opinions or listening to the macro or market opinions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important…
- My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.
Many long-term investors make the mistake of feeling good when stock prices rise. Buffett says that if you’re going to be a long-term investor and regularly add to your investments, you should prefer stock prices to fall rather than rise. Eventually, stock prices follow business results. And it’s safe to assume the U.S. economy will continue to grow over the long term. But between now and then, if you’re a net buyer of stocks, you’re better off if stock prices fall before they rise. Buffett:
So smile when you read a headline that says ‘Investors lose as market falls.’ Edit it in your mind to ‘Disinvestors lose as market falls – but investors gain.’ (page 89)
Buffett advises most investors to invest in index funds: http://boolefund.com/warren-buffett-jack-bogle/
But for a handful of investors who can understand some businesses, it’s better to patiently wait for the fattest pitches. Buffett gives an analogy:
If my universe of business opportunities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products? (page 102)
Buffett then quotes the economist and investor John Maynard Keynes:
‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.’ – J. M. Keynes
Here are details on Keynes as an investor: http://boolefund.com/greatest-economist-defied-convention-got-rich/
Buffett explains Berkshire’s equity investment strategy by quoting its 1977 annual report:
We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price. (page 106)
Buffett then notes that, due to Berkshire’s much larger size as well as market conditions, they would now substitute ‘an attractive price’ for ‘a very attractive price.’ How do you decide what’s ‘attractive’? Buffett quotes The Theory of Investment Value, by John Burr Williams:
‘The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.’
The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value…
Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find…
Though the mathematical calculations required to evaluate equities are not difficult, an analyst – even one who is experienced and intelligent – can easily go wrong in estimating future ‘coupons.’ At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows. Incidentally, that shortcoming doesn’t bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.
Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success. (pages 107-108)
At another point, Buffett explains concentrated, buy-and-hold investing:
Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses? The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.
When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio. This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate this portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team. (page 111)
Buffett reiterates that he and Charlie, when buying subsidiaries or common stocks, focus on businesses and industries unlikely to change much over time:
…The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.
I should emphasize that, as citizens, Charlie and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country’s standard of living to rise, and that’s clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride.
Obviously all businesses change to some extent. Today, See’s is different in many ways from what it was in 1972 when we bought it: It offers a different assortment of candy, employs different machinery and sells through different distribution channels. But the reasons why people today buy boxed chocolates, and why they buy them from us rather than from someone else, are virtually unchanged from what they were in the 1920s when the See family was building the business. Moreover, these motivations are not likely to change over the next 20 years, or even 50.
Buffett goes on to discuss Coca-Cola and Gillette, labeling companies like Coca-Cola ‘The Inevitables.’ Buffett points out that he’s not downplaying the important work these companies must continue to do in order to maximize their results over time. He’s merely saying that all sensible observers agree that Coke will dominate worldwide over an investment lifetime. This degree of brand strength – reflected in sustainably high returns on capital – is very rare. Buffett:
Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables. But I would rather be certain of a good result than hopeful of a great one. (page 112)
The main danger for a great company is getting sidetracked from its wonderful core business while acquiring other businesses that are mediocre or worse.
Unfortunately, that is exactly what transpired years ago at Coke. (Would you believe that a few decades back they were growing shrimp at Coke?) Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding. All too often, we’ve seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander. (page 113)
Buffett (again) recommends index funds for most investors:
Most investors, both individual and institutional, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.
For those investors seeking to pick individual stocks, the notion of circle of competence is crucial. Buffett and Munger are well aware of which companies they can evaluate and which they can’t. Buffett:
If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries – and seem to have their claims validated by the behavior of the stock market – we neither envy nor emulate them. Instead, we just stick with what we understand. (page 115)
Mistakes of the First 25 Years
Buffett first notes that the lessons of experience are not always helpful. But it’s still good to review past mistakes ‘before committing new ones.’ To that end, Buffett lists mistakes of the twenty-five years up until 1989:
** My first mistake, of course, was in buying control of Berkshire. Though I knew its business – textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.
If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the ‘cigar butt’ approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.
Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original ‘bargain’ price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns…
** That leads right into a related lesson: Good jockeys will do well on good horses, but not on broken-down nags…
I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact…
** A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.
The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult. On occasion, tough problems must be tackled. In other instances, a great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO…
** My most surprising discovery: the overwhelming importance in business of an unseen force that we might call ‘the institutional imperative.’ In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.
For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.
** After some mistakes, I learned to go into business only with people I like, trust, and admire… We’ve never succeeded in making a good deal with a bad person.
** Some of my worst mistakes were not publicly visible. These were stock and business purchases whose virtues I understood and yet didn’t make… For Berkshire’s shareholders, myself included, the cost of this thumb-sucking has been huge.
** Our consistently-conservative financial policies may appear to have been a mistake, but in my view were not. In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.
We wouldn’t have liked those 99:1 odds – and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds – though we have learned to live with those also. (pages 117-120)
Buffett in 2011:
Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.
Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as ‘safe.’ In truth they are among the most dangerous of assets. Their beta may be zero but their risk is huge.
Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.
Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as income. (pages 123-124)
Buffett then notes that it’s even worse for tax-paying investors, who would have needed 5.7% annually to hold their ground. In other words, an invisible ‘inflation tax’ has consumed 4.3% per year. Given that interest rates today (mid-2017) are very low, currency-based investments are not attractive for the long term (decades).
The second major category of investments involves assets that will never produce anything, but that are purchased in the hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.
This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.
The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce of gold at its end.
Today, the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it sitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus sixteen Exxon Mobiles (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobile will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.
Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse drives investors to sterile assets such as gold. We heard ‘cash is king’ in late 2008, just when cash should have been deployed rather than held…
My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM, and our own See’s Candy meet that double-barreled test. Certain other companies – think of our regulated utilities for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.
Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.
Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens… I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest. (pages 125-127)
Pessimism creates low prices. But you cannot be a contrarian blindly:
The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.
None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: ‘Most men would rather die than think. Many do.’ (page 130)
Transaction costs eat up an astonishing degree of corporate earnings every year. Buffett writes at length – in the 2005 letter – about how this works:
The explanation of how this is happening begins with a fundamental truth: …the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.
Indeed, owners must earn less than their businesses earn because of ‘frictional’ costs. And that’s my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.
To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.
But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth dimishes, equalling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.
After a while, most of the family members realize that they are not doing so well at this new ‘beat-my-brother’ game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: ‘Hire a manager – yes, us – and get the job done professionally.’ These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.
The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course.
It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.
The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions…
The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.
The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important… Calmed by this explanation, the family decides to pay up.
And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).
A sufficient number of the arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’ If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases. (pages 169-172)
For more details, see: http://berkshirehathaway.com/letters/2005ltr.pdf
MERGERS AND ACQUISITIONS
The Oracle of Omaha says:
Of all our activities at Berkshire, the most exhilarating for Charlie and me is the acquisition of a business with excellent economic characteristics and a management that we like, trust, and admire. Such acquisitions are not easy to make, but we look for them constantly…
In the past, I’ve observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess. Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations. Initially, disappointing results only deepen their desire to round up new toads… Ultimately, even the most optimistic manager must face reality. Standing knee-deep in unresponsive toads, he then announces an enormous ‘restructuring’ charge. In this corporate equivalent of a Head Start program, the CEO receives the education but the stockholders pay the tuition. (page 199)
Not only do most acquisitions fail to create value for the acquirer; many actually destroy value. However, a few do create value. Buffett writes:
…many managerial princesses remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads. In fairness, we should acknowledge that some acquisition records have been dazzling. Two major categories stand out.
The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accomodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing only on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition for those that do has now become fierce to the point of being self-defeating.
The second category involves the managerial superstars – who can recognize the rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise. (page 201)
Capital allocation decisions, including value-destroying acquisitions, add up over the long term. Buffett:
Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value. Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally. The company could, of course, distribute the money to shareholders by way of dividends or share repurchases. But often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense. That’s like asking your interior decorator whether you need a $50,000 rug.
The acquisition problem is often compounded by a biological bias: Many CEOs obtain their positions in part because they possess an abundance of animal spirits and ego. If an executive is heavily endowed with these qualities – which, it should be acknowledged, sometimes have their advantages – they won’t disappear when he reaches the top…
At Berkshire, our managers will continue to earn extraordinary returns from what appear to be ordinary businesses. As a first step, these managers will look for ways to deploy their earnings advantageously in their businesses. What’s left, they will send to Charlie and me. We then will try to use those funds in ways that build per-share intrinsic value. Our goal will be to acquire either part or all of businesses that we believe we understand, that have good, sustainable underlying economics, and that are run by managers whom we like, admire and trust. (pages 209-210)
Over the years, Berkshire Hathaway has become the buyer of choice for many private business owners. Buffett remarks:
Our long-avowed goal is to be the ‘buyer of choice’ for businesses – particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises; avoid leveraging up acquired businesses; grant unusual autonomy to our managers; and hold the purchased companies through think and thin (though we prefer thick and thicker).
Our record matches our rhetoric. Most buyers competing against us, however, follow a different path. For them, acquisitions are ‘merchandise.’ Before the ink dries on their purchase contracts, these operators are contemplating ‘exit strategies.’ We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses. (pages 221-222)
VALUATION AND ACCOUNTING
Buffett writes about Aesop and the Inefficient Bush Theory:
The formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).
The oracle was Aesop, and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’ To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota – nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years…
Alas, though Aesop’s proposition and the third variable – that is, interest rates – are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.
Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startingly low in relation to value. (Let’s call this phenomenon the IBT – Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.
At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. (pages 223-224)
Here Buffett is talking about the bubble in internet stocks in 1999. He acknowledges that, overall, much value had been created and there was much more to come. However, many individual internet companies destroyed value rather than creating it.
As noted earlier, Buffett and Munger love technological progress. But they generally don’t invest in tech companies because it doesn’t fit their buy-and-hold approach. It’s just not their game. Some venture capitalists have excelled at it, but it usually takes a statistical investment approach whereby a few big winners eventually outweigh a large number of losses.
At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to ‘A girl in the convertible is worth five in the phone book.’) Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores. (page 226)
Buffett writes about how to evaluate management:
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure. (page 237)
This leads to a discussion of economic Goodwill:
…businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.
In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.
Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation… and an enduring position as the low cost producer in an industry. (page 239)
Buffett compares economic Goodwill with accounting Goodwill. As mentioned, economic Goodwill is when the net tangible assets produce earnings in excess of market rates of return. By contrast, accounting Goodwill is when company A buys company B, and the price paid is above the fair market value of net tangible assets. The difference between price paid and net tangible asset value is accounting Goodwill.
In the past, companies would amortize accounting Goodwill, typically over a 40-year period. But the current rule is that companies periodically test the value of the assets acquired. If it is determined that the acquired assets have less value than when acquired, then the accounting Goodwill is written down based on an impairment charge. This new way of measuring accounting Goodwill is what Buffett and Munger suggested (see page 247).
Earlier we saw that the net present value of any business is the discounted value of its future cash flows. However, when we estimate future cash flows, it’s important to distinguish between earnings and free cash flow. Buffett uses the the term owner earnings instead of free cash flow. Buffett on owner earnings:
…These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.
Buffett then observes that item (c), capital expenditures, usually requires a guess. So owner earnings, or free cash flow, must also be an estimate. Nonetheless, free cash flow is what matters when estimating the intrinsic value of a business.
If a business requires heavy capital expenditures to maintain its competitive position, that’s worth less to an owner. By the same logic, if a business requires very little capital investment to maintain its competitive position, that’s clearly worth much more. The capital-light business will generally earn much higher returns on capital.
So, generally speaking, as Buffett points out, when capital expenditure requirements exceed depreciation, GAAP earnings overstate owner earnings. When capital expenditure requirements are less than depreciation, GAAP earnings understate owner earnings.
Moreover, Buffett offers a warning. Often marketers of businesses and securities present ‘cash flow’ as simply (a) plus (b), without subtracting (c). However, looking at cash flows without subtracting capital expenditures can give you a very misleading notion of what the business is worth. Every business must make some capital expenditures over time to maintain its competitive position.
Buffett sums up the discussion of owner earnings – or free cash flow – with a note on accounting:
Accounting numbers of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress. Charlie and I would be lost without these numbers: they invariably are the starting point for us in evaluating our own businesses and those of others. Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it. (page 254)
Buffett observes that managers should try to report the essential information that investors need:
What needs to be reported is data – whether GAAP, non-GAAP, or extra-GAAP – that helps financially literate readers answer three key questions: (1) Approximately how much is this company worth? (2) What is the likelihood that it can meet its future obligations? and (3) How good a job are its managers doing, given the hand they have been dealt? (page 259)
In 1998, Buffett observed that it had become common to manipulate accounting statements:
In recent years, probity has eroded. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers – CEOs you would be happy to have as spouses for your children or as trustees under your will – have come to the view that it’s OK to manipulate earnings to satisfy what they believe are Wall Street’s desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.
These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don’t produce the result hoped for, these CEOs result to unadmirable accounting strategems. These either manufacture the desired ‘earnings’ or set the stage for them in the future.
Rationalizing this behavior, these managers often say that their shareholders will be hurt if their currency for doing deals – that is, their stock – is not fully-priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does. Once such an everybody’s-doing-it attitude takes hold, ethical misgivings vanish. Call this behavior Son of Gresham: Bad accounting drives out good.
The distortion du jour is the ‘restructuring charge,’ an accounting entry that can, of course, be legitimate but that too often is a device for manipulating earnings. In this bit of legerdemain, a large chunk of costs that should properly be attributed to a number of years is dumped into a single quarter, typically one already fated to disappoint investors. In some case, the purpose of the charge is to clean up earnings misrepresentations of the past, and in others it is to prepare the ground for future misrepresentations. In either case, the size and timing of these charges is dictated by the cynical proposition that Wall Street will not mind if earnings fall short by $5 per share in a given quarter, just as long as this deficiency ensures that quarterly earnings in the future will consistently exceed expectations by five cents per share.
This dump-everything-into-one-quarter behavior suggests a corresponding ‘bold, imaginative’ approach to – golf scores. In his first round of the season, a golfer should ignore his actual performance and simply fill his card with atrocious numbers – double, triple, quadruple bogeys – and then turn in a score of, say, 140. Having established this ‘reserve,’ he should go to the golf shop and tell his pro that he wishes to ‘restructure’ his imperfect swing. Next, as he takes his new swing onto the course, he should count his good holes, but not his bad ones. These remnants from his old swing should be charged instead to the reserve established earlier. At the end of five rounds, then, his record will be 140, 80, 80, 80, 80 rather than 91, 94, 89, 94, 92. On Wall Street, they will ignore the 140 – which, after all, came from a ‘discontinued’ swing – and will classify our hero as an 80 shooter (and one who never disappoints).
For those who prefer to cheat up front, there would be a variant of this strategy. The golfer, playing alone with a cooperative caddy-auditor, should defer the recording of bad holes, take four 80s, accept the plaudits he gets for such athleticism and consistency, and then turn in a fifth card carrying a 140 score. After rectifying his earlier scorekeeping sins with this ‘big bath,’ he may mumble a few apologies but will refrain from returning the sums he has previously collected from comparing scorecards in the clubhouse. (The caddy, need we add, will have acquired a loyal patron.)
Unfortunately, CEOs who use variations of these scoring schemes in real life tend to become addicted to the games they’re playing – after all, it’s easier to fiddle with the scorecard than to spend hours on the practice tee – and never muster the will to give them up. (pages 272-273)
In discussing pension estimates, Buffett explains why index fund investors will do better – net of all costs – than active investors:
Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: (1) Investors, overall, will necessarily earn an average return, minus costs they incur; (2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; (3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the ‘know-nothings’ – must win. (page 276)
BERKSHIRE AT FIFTY AND BEYOND
Remarks by Buffett (in early 2015) on Berkshire’s fiftieth anniversary:
At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That’s important: If horses had controlled investment decisions, there would have been no auto industry.
Another major advantage we possess is an ability to buy pieces of wonderful business – a.k.a. common stocks. That’s not a course of action open to most managements. Over our history, this strategic alternative has proved to be very helpful; a broad range of options sharpens decision-making. The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety. Additionally, the gains we’ve realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities.
In effect, the world is Berkshire’s oyster – a world offering us a range of opportunities far beyond those realistically open to most companies. We are limited, of course, to businesses whose economic prospects we can evaluate. And that’s a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now. But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry. On top of that, we can profitably scale to a far larger size than many businesses that are constrained by the limited potential of the single industry in which they operate.
Berkshire has one further advantage that has become increasingly important over the years: We are now the home of choice for the owners and managers of many outstanding businesses. Families that own successful businesses have multiple options when they contemplate sale. Frequently, the best decision is to do nothing. There are worse things in life than having a prosperous business that one understands well. But sitting tight is seldom recommended by Wall Street. (Don’t ask the barber whether you need a haircut.)
When one part of a family wishes to sell while others wish to continue, a public offering often makes sense. But, when owners wish to cash out entirely, they usually consider one of two paths. The first is sale to a competitor who is salivating at the possibility of wringing ‘synergies’ from the combining of the two companies. The buyer invariably contemplates getting rid of large numbers of the seller’s associates, the very people who have helped the owner build his business. A caring owner, however – and there are plenty of them – usually does not want to leave his long-time associates sadly singing the old country song: ‘She got the goldmine, I got the shaft.’
The second choice for sellers is the Wall Street buyer. For some years, these purchasers accurately called themselves ‘leveraged buyout firms.’ When that term got a bad name in the early 1990s – remember RJR and Barbarians at the Gate? – these buyers hastily relabeled themselves ‘private-equity.’ The name may have changed but that was all: Equity is dramatically reduced and debt is piled on in virtually all private-equity purchases. Indeed, the amount that a private-equity purchaser offers to the seller is in part determined by the buyer assessing the maximum amount of debt that can be placed on the acquired company.
Later, if things go well and equity begins to build, leveraged buy-out shops will often seek to re-leverage with new borrowings. They then typically use part of the proceeds to pay a huge dividend that drives equity sharply downward, sometimes even to a negative figure. In truth, ‘equity’ is a dirty word for many private-equity buyers; what they love is debt. And, these buyers can frequently pay top dollar. Later the business will be resold, often to another leveraged buyer. In effect, the business becomes a piece of merchandise.
Berkshire offers a third choice to the business owner who wishes to sell: a permanent home, in which the company’s people and culture will be retained (though, occasionally, management changes will be needed). Beyond that, any business we acquire dramatically increases its financial strength and ability to grow. Its days of dealing with banks and Wall Street analysts are also forever ended. Some sellers don’t care about these matters. But, when sellers do, Berkshire does not have a lot of competition. (pages 289-291)
Buffett also observes that companies are worth more as a part of Berkshire than they would be separately. Berkshire can move funds between businesses or to new ventures instantly and without tax. Also, some costs would be duplicated if the businesses were independent entities. This includes regulatory and administrative expenses. Moreover, there are tax efficiencies, says Buffett: Certain tax credits available to Berkshire’s utilities are realizable because Berkshire generates large taxable income in other operations.
Buffett sums it up:
Today Berkshire possesses (1) an unmatched collection of businesses, most of them now enjoying favorable economic prospects; (2) a cadre of outstanding managers who, with few exceptions, are unusually devoted to both the subsidiary they operate and to Berkshire; (3) an extraordinary diversity of earnings, premier financial strength and oceans of liquidity that we will maintain under all circumstances; (4) a first-choice ranking among many owners and managers who are contemplating sale of their businesses; and (5) in a point related to the preceding item, a culture, distinctive in many ways from that of most large companies, that we have worked 50 years to develop and that is now rock-solid. These strengths provide us a wonderful foundation on which to build. (page 292)
For the rest of Buffett’s comments, as well as observations by Charles T. Munger on the history and evolution of Berkshire Hathaway, see pages 34-43 of the 2014 letter: http://berkshirehathaway.com/letters/2014ltr.pdf
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: http://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees. The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
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Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.