The Essays of Warren Buffett by Lawrence A. Cunningham
A must read for all serious investors. Can be a little tough read if you are just starting out your journey into value investing but is one of the best books to read on Buffett and investing in general. Lawrence accumulates a lot Warren's wisdom and teachings from his annual letters as CEO and Chairman of Berkshire Hathaway. This book discusses a lot of business and investing related topics such as GAAP earnings, intrinsic value, owner's earnings, investing folly, management, executive compensation, Mr. Market, margin of safety, some of his own mistakes, and many other topics.
It is important that managers be forward and right about their statements to the shareholders.
Contrary to textbook rules on organizational behavior, mapping an abstract chain of command on to a particular business situation, according to Buffett, does little good. What matters is selecting people who are able, honest, and hard working. Having first rate people on the team is more important than designing hierarchies and clarifying who reports to whom about what and at what times.
Special attention must be paid to selecting a CE because three major differences Buffett Identifies between CEO’s and other employees. First, standards for measuring a CEO’s performance are inadequate or easy to manipulate, so a CEO’s performance is harder to measure than that of most workers. Second, no one is senior to the CEO, so no senior person’s performance can be measured either. Third a board of directors cannot serve that senior role since relations between CEOs and boards are conventionally congenial.
Buffett does things differently than other business corporations regarding charities. He lets the shareholders choose what charities to donate to and this may because Buffett’s job is safer than other CEOs.
Buffett therefore cautions shareholders who are reading proxy statements about approving option plans to be aware of the asymmetry in this kid of alignment. Many shareholders rationally ignore proxy statements, but this subject should really be on the front-burner of shareholders, particularly shareholder institutions that periodically engage in promoting corporate governance improvements.
Buffett emphasizes that performance should be the basis for executive pay decisions. Executive performance should be measured by profitability, after profits are reduced by a charge for the capital employed in the relevant business or earnings retained by it. If stock options are used, they should be related to individual performance, rather than corporate performance, and price based on business value.
After all, exceptional managers who earn cash bonuses based on the performance of their own business can simply buy stock if they want to; if they do, they “truly walk in the shoes of owners” Buffett says.
Buffett thinks most markets are not purely efficient and that equating volatility with risk is a gross distortion.
“Stick to investment knitting and ignore modern finance theory and other quasi-sophisticated views of the market” says Buffett. For some people the best way to invest is in a long-term index fund. It can also be done by conducting hard headed analyses of businesses within an investor’s competence to evaluate. In that kind of thinking, the risk that matters is not beta or volatility, but the possibility of loss or injury from an investment.
Assessing that kind of investment risk described in the note below requires thinking about a company’s management, products, competitors, and debt levels. The inquiry is whether after-tax returns on an investment are least equal to the purchasing power of the initial investment plus a fair rate of return. The primary relevant factors are the long-term economic characteristics of a business, the quality and integrity of its management, and future levels of taxation and inflation.
Buffett points out the absurdity of beta by observing that “a stock that has dropped very sharply compared to the market… becomes ‘riskier’ at the lower price than it was at the higher price”-that is how beta measures risk.
Also besides what is described above, beta can’t distinguish the risk inherent in a “single product toy company selling pet rocks or hula hoops from another toy company whose sole product is Monopoly or Barbie. Ordinary investors say that they can make the distinctions just by thinking about consumer behavior and the way consumer products companies compete, and can also figure out when a huge stock-price drop signals a buying opportunity.
Long term investing success depends not on studying betas and maintaining a diversified portfolio, but on recognizing that as an investor, one is the owner of a business.
One of Graham’s most profound contributions is a character who lives on Wall Street, Mr. Market. He is your hypothetical business partner who is daily willing to buy your interest in a business or sell you his at prevailing market prices. Mr. Market is moody, prone to manic swings from joy to despair. Sometimes he offers prices way higher than value; sometimes he offers prices way lower than value. The more manic depressive he is, the greater the spread between price and value, and therefore the greater the investment opportunities he offers. Buffett reintroduces Mr. Market, emphasizing how valuable Graham’s allegory of the overall market is for disciplined investment knitting- even though Mr. Market would be unrecognizable to modern finance theorists. Another leading prudential legacy from Graham is his margin-of-safety principle. This principle holds that one should not make an investment in security unless there is a sufficient basis for believing that the price being paid is substantially lower than the value being delivered. Buffett follows the principle devotedly, noting that Graham had said that if forced to distill the secret of sound investment in three words, they would be: margin of safety. Over forty years after firs reading that, Buffet still thinks those are the right words. While modern finance theory enthusiasts cite market efficiency to deny there is a difference between price(what you pay) and value (what you get), Buffett and Graham regard it as all the difference in the world.
Strategies that do not employ this comparison of price and value do not amount to investing at all, but to speculation- the hope that price will rise, rather than the conviction that the price being paid is lower than the value being obtained.
Arbitrage, traditionally understood to mean exploiting different prices for the same thing on two different markets, for Buffet describes the use of cash to take short-term positions in a few opportunities that have been publicly announced. It exploits different prices for the same thing at different times. Deciding whether to employ chaos this way requires evaluating four common-sense questions abused on information rather than rumor: the probability of the event occurring, the time the funds will be tied up, the opportunity cost, and the downside if the event occurs.
The ultimate result of the institutional imperative is a follow-the-pack mentality producing industry imitators, rather than industry leaders. This is what Buffett calls a lemming like approach to business.
Wall Street tends to embrace ideas based on revenue-generating power, rather than on financial sense, a tendency that often perverts good ideas to bad ones. In a history of zero-coupon bonds, for example, Buffett shows that they can enable a purchaser to lock in a compound rate of return equal to a coupon rate that normal bond paying periodic interest would not provide. Using zero-coupons thus for at time enabled a borrower to borrow more without need of additional free cash flow to pay the interest expense. Problems arose, however, when zero-coupon bonds started to be issued by weaker and weaker credits whose free cash flow could not sustain increasing debt obligations. Buffett aments, “as happens in Wall Street all too often, what the wise do in the beginning, fools do in the end.”
Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest.
Buffett’s mindset when he buys any stock is, “if we aren’t happy owning a piece of that business with the exchange closes, we are not happy with the exchange open.” Berkshire and Buffett are investors for the long haul; Berkshire’s capital structure and dividend policy prove it.
Buffett doesn’t want to pay high transaction costs like brokerage fees is another reason why he invests for the long haul.
Buffett’s conviction of earnings and dividend policy is, “each dollar of earnings should be retained if retention will increase market value by at least a like amount; otherwise it should be paid out. Earnings retention is justified only when “capital retained produces incremental earnings equal to, or above, those generally available to investors.” If my company makes $100 in net income in 2009 and I give out no dividends that means that the next year I should make at least $100 in net income in 2010 and pay no dividends.
Stock splits have three consequences: they increase transaction costs by promoting high share turnover; they attract shareholders with short-term, market oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead to prices than depart materially from intrinsic business value. With no offsetting benefits, splitting Berkshire’s stock would be foolish. Not only that, Buffett adds, it would threaten to reverse three decades of hard work that has attracted to Berkshire a shareholder group comprised of more focused and long-term investors than probably any other major public corporation.
Berkshire’s (Buffets’) acquisition policy is the double-barreled approach: buying portions or all of business with excellent economic characteristics and run by managers Buffett and Munger like, trust, and admire. Contrary to common practice, Buffett argues that in buying all of a business, there is rarely any reason to pay a premium. The rare case in paying a premium is if they are franchised and can raise prices easily.
Buffett attributes high premium takeovers outside those unusual categories to three motives of buying-managers: the thrill of an acquisition, the thrill of enhanced size, and excessive optimism about synergies.
If the worst thing to do with undervalued stock is to use it to pay for an acquisition, the best thing is to buy it back. Obviously, if a stock is selling in the market at half its intrinsic value, the company can buy $2 in value by paying $1 in cash. There would rarely be better uses of capital than that.
Permissive laws made by leveraged buy outs hugely profitable in the 1980’s, Munger tells us, but the leveraged buyouts weakened corporations, put a heavy premium on cash generation to pay for enormous debt obligations, and raised the average cost of acquisition.
Finding the best value-enhancing transactions requires concentrating on opportunity costs, measured principally against the alternative of buying small pieces of excellent business through stock market purchases.
Buffett emphasizes that useful financial statements must enable a user to answer three basic questions about a business: approximately how much a company is worth, its likely ability to meet its future obligations, and how good a job its managers are doing in operating the business.
Economic goodwill is the combination of intangible assets, like brand name recognition, that enable a business to produce earnings on tangible assets, like plant and equipment, in excess of average rates.
When valuing a business use owner’s earnings. Owner’s earnings are operating earnings plus non cash charges minus required reinvestment in the business. Required reinvestment in the business is defined as the average 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 describes intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life.
When management of a company has a high amount of their net worth in their business this is a very comforting sign for the investor. Buffett and his wife have about 99% of his net worth in Berkshire and Charlie Munger has about 90% in Berkshire.
Businesses don’t report all earnings in their net income and all their expenses. This is referred to by Buffett as look through earnings. It is helpful to be aware of this and to attempt to profit from it. Look for businesses who report earnings by GAAP less than they really should be. This means you look for what business they have under a 20% investment in.
Warren Buffett had a textile business that he tried to save and make profitable. Rather than liquidate the business he sold it and got a new manager whom he trusted and knew had the managerial honest and brilliance he looks for in managers. In other words management wasn’t the problem. The problem was the business couldn’t be saved and one of the reasons was due to high United States wages compared to wages in other foreign countries. Sometimes a business can’t be saved and you should always evaluate business before you look at management. “The situation is suggestive of Samuel Johnson’s horse: A horse that can count to ten is a remarkable horse- not a remarkable mathematician.” Likewise to this example is, a textile company that allocates capital brilliantly within its industry is a remarkable textile company-not a remarkable business. Buffett wrote, “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”
Whenever Munger and Buffett buy common stocks for Berkshire’s insurance companies (leaving aside arbitrage purchases) they approach the transaction as if we were buying into a private business. They look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely o long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts.
If you are playing poker and you don’t know who the patsy is, then you are they patsy.
Buffett believes that the Wall Street saying, “You can’t go broke taking a profit” is foolish because you shouldn’t sell a business to take a profit. You should sell it because the underlying facts have diminished and the fundamentals don’t reflect the true intrinsic value. If you are taking a profit because of this saying it has come to my attention that you are scared and playing it safe.
When you are trying to arbitrage you need to answer four questions. 1) How likely is it that the promised event will indeed occur? 2) How long will your money be tied up? 3) What chance is there that something still better will transpire-a competing takeover bid for example? And 4) What will happen if the even does not take place because of anti trust action, financing glitches, etc?
Buffet, “We do not trade on rumors or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities.”
Charlie and Buffett are right in saying that it is very difficult to make 100’s of smart decisions over a lifetime. They claim to make only a few smart decisions. They settle for one good idea (one good stock pick) a year. This puts hard effort on their theory of long term investing and how long term investing is superior to short term investing. Pick a few good business you love and understand and stick with them.
If Buffett were to engage in the business acquisition process of private businesses in Ohio, he 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. This doesn’t seem to me to differ at all from the way he buys public companies therefore these are common aspects that should always be looked at when analyzing a business.
Possibly to me the most important excerpt in this book is written by 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 on 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 enterprise 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.”
“We really don’t see many fundamental differences between the purchase of a controlled business and the purchase of marketable holdings…” This explains what I talked about before. Buffett buys securities just as if he were buying private businesses. (Omaha example) Buffett and Munger’s goal are to find outstanding business at sensible prices, not mediocre businesses at a bargain price.
It must be noted that your chairman, always a quick study, required only 20 years recognizing how important it was to buy good business. In the interim, I searched for “bargains” –and had the misfortune to find some. My punishment was an education in the economics of short line farm implement manufacturers, third-place department stores, and New England textile manufacturers. In other words finding mediocre businesses at bargain prices did nothing in terms of appreciating his portfolio. It only taught him about the economics of the business.
In practice, however, this advantage is somewhat illusory: Management changes, like marital changes, are painful, time-consuming, and chancy.
Managers aren’t very good at allocating capital. This is because managers mainly rose to the CEO position because they excelled in marketing, production, engineering, administration-or sometimes even institutional politics.
Buffet wrote in the 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.”
In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: 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.
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.
Don't invest in an overheated market because if you do it may often take an extended period for the the value of even an outstanding company to catch up with the high price paid.
Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected": You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important, knowing its boundaries, however, is vital.
Your goal as an investor should simply be to purchase at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards- so when you see one that qualifies, you should buy a meaningful amount of stock. "If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.
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.
"Time is the friend of the wonderful business, the enemy of the mediocre.
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.
Intelligent and experienced management doesn't automatically make rational decisions. 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.
Thomas J. Watson of IBM once said, "I'm no genius. I'm smart in spots-but I stay around those spots."
According to Buffett when you are constantly buying businesses year in and year out, declining prices for businesses benefits him and rising prices hurts him.
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.
Bertrand Russell's observation about life somewhat applies in the financial world. He once said, "Most men would rather die than think. Many do.
What happens on Wall Street according to Buffett is, "What as the wise do in the beginning, fools do in the end."
Buffett's purchase of US Air preferred stock was one of his biggest investment mistakes he made. It was what we calls sloppy analysis as the dividend was suspended in September. Even though he made a mistake Buffett says you don't need to make [your losses] back the way that you lost it.
"In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competitor" [My note: Buffett is referring to the airline business.]
Pg 103-118 Explains some of Buffet's experiences with preferred stock and zero coupon bonds.
Buffett and Munger's goal is to attempt to be fearful when others are greedy and greedy when others are fearful.
It is awarding for the shareholders when managers repurchase stock because major repurchases at prices well below per-share intrinsic business value (which is when managers should repurchase stock) immediately increase the stock value. Another benefit is that management is clearly demonstrating to the shareholders that his interest is to enhance the wealth of shareholders, rather than to actions that expand management's domain. "Seeing this, shareholders and potential shareholders increase their estimates of future returns from business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are entirely rational." Overall from this we want to see managers only repurchase stock when the stock is below their intrinsic value.
In any case, why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, but instead keep in mind the story of the man with an ailing horse. Visiting the vet, he said: "Can you help me? Sometimes my horse walks just fine and sometimes he limps." The vet's reply was pointed: "No problem-when he's walking fine, sell him." In the world of mergers and acquisitions, that horse would be peddled as secretariat. At Berkshire, we have all the difficulties in perceiving the future that other acquisition-minded companies do. Like they [sic] also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale- a time when the business is likely to be walking "just fine". In other words, sellers will sell their business when it appears to be fine but it really isn't fine. If it really was a good business then why wouldn't they want to keep it?
Buffet says that "It's simple to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation."
An approach of this kind will force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results. It's true, of course, that, in the long run, the scoreboard for investment decision is market price. But prices will be determined by future earnings. In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard.
Buffett and Munger's first lesson in terms of economic vs accounting 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.
Economic goodwill is more likely to increase than decrease because inflation. An example of goodwill is when you want a soda and you buy a coke because of the brand name. That brand name or that reason why you specifically choose a certain product is economic goodwill.
To illustrate how economic goodwill increases over time in nominal value proportionally with inflation we take into account the following example: When Buffett and Munger purchased See's in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earnings only 11% on required tangible, assets that mundane business would posses little or no economic goodwill.
If you cling to any belief that accounting treatment of Goodwill is the best measure of economic reality, I suggest one final item to ponder. Assume, a company with $20 per share of net worth, all tangible assets. Further assume the company has internally developed some magnificent consumer franchise, or that it was fortunate enough to obtain some important television stations by original FCC grant. Therefore, it earns a great deal on tangible assets, say $5 per share, or 25%. With such economics, it might sell for $100 per share or more, and it might well also bring that price in a negotiated sale of entire business. Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill (just as would a corporate purchaser buying the whole company). Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calculate "true" earnings per share? And, if so, should the new "true" earnings of 3$ per share cause him to rethink his purchase price?
Buffett and Munger believe managers and investors alike should view intangible assets from two perspectives. One is in the analysis of operating results-that is, in evaluating the underlying economics of a business unit- amortization charges should be ignored. What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the operation's economic Goodwill. Also in evaluating the wisdom of business acquisitions, amortization charges should be ignored also. They should be deducted neither from earnings nor from the cost of business. This means forever viewing purchased Goodwill at its full cost, before any amortization. furthermore, cost should be defined as including the full intrinsic business value-not just the recorded accounting value-of all consideration give, irrespective of market prices of the securities involved at the time of merger and irrespective of whether pooling treatment was allowed.
Owner's earnings are (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges, minus (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. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in the calculation of (c). However, business following the LIFO inventory method usually do not require additional working capital if unit volume doesn't change.
Most managers probably will acknowledge that they need to spend something more than (b) on their business over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists- that is, when (c) exceeds (b)- GAAP earnings overstate owner earnings. Frequently this overstatement is substantial. The oil industry has in recent years provided a conspicuous example o this phenomenon.
Buffett writes, But "cash flow" is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c) is always significant. To be sure, business of this kind may in a given year be able to defer capital spending. But over a five-or ten-year period, they must make the investment-or the business decays.
Buffett believes that analysts use cash flow equations because when GAAP earnings (a) doesn't look good to cover debt charges etc. for a company, analysts believe they can cover this up by using cash flow. Analysts will focus on GAAP earnings (a) + non cash charges like amortization and depreciation (b) but this isn't the end of the analysis. 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 (c) needs to be added as well. The company or investor believing that the debt-servicing ability or the equity valuation or an enterprise can be measured by totaling (a) and (b) while ignoring (c) is headed for certain trouble.
To sum up: in the case of both Scott Fetzer and our other businesses, we feel that (b) on an historical-cost basis-i.e., with both amortization of intangibles and other purchase-price adjustments excluded-is quite close in amount to (c). (The two items are not identical, of course. For example, at See's we annually make capitalized expenditures that exceed depreciation by $500,000 to $1 million, simply to hold our ground competitively.) Our conviction about this point is the reason we show our amortization and other purchase-price adjustment items separately...and is also our reason for viewing the earnings of the individual businesses...as much more closely approximating owner earnings than the GAAP figures.
Intrinsic value is an all important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply as: The discounted value of the cash that can be taken out of a business during its remaining life. It is an estimate that must be changed if interest rates or the forecasts of future cash flows change. pg 187
Book value give you somewhat of an idea of intrinsic value although it isn't exactly intrinsic value. The percentage change in book value in any given year is likely to be reasonably close to that year's change in intrinsic value.
You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education's cost as its book value. If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job. For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.
Under Berkshire's controlled companies, accountants must show full earnings in their income account but never change asset values on their balance sheet, no matter how much value of a business might have increase since purchase. Buffett and Munger's mental approach to this accounting schizophrenia is to ignore GAAP figures and to focus solely on the future earning power of both their controlled and non-controlled businesses.
A story that Benjamin Graham told about 60 years ago to describe the irrational behavior of institutional investors and managers to demonstrate the "following the leader approach" goes like this, An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. "Your're qualified for residence", said St. Peter, "but, as you can see, the compound reserved for oil men is packed. There's no way to squeeze you in." After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, Oil discovered in hell." Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. "No," he said, "I think I'll go along with the rest of the boys. There might be some truth to that rumor after all."
What needs to be reported is data-whether GAAP, non GAAP, or extra-GAAP-that helps financially-literate readers answer three 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 must been dealt? In most cases, answers to one or more of these questions are somewhere between difficult and impossible to glean from the minimum GAAP presentation. The business world is simply too complex for a single set of rules to effectively describe economic reality for all enterprises, particularly those operating in a wide variety of businesses, such as Berkshire. Further complicating the problem is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to overcome. Too often their accountants willingly assist them. ("How much," says the client, "is two plus two?". Replies the cooperative accountant, "What number did you have in mind?" Even honest and well-intentioned managements sometimes stretch GAAP a bit in order to present figures they think will more appropriately describe their performance. Both the smoothing of earnings and the “big bath” quarter are “white lie” techniques employed by otherwise upright managements. Then there are managers who actively use GAAP to deceive and defraud. They know that many investors and creditors accept GAAP results as gospel. So these charlatans interpret the rules “imaginatively” and record business transactions in ways that technically comply with GAAP but actually display an economic illusion to the world. Buffett and Munger have observed many accounting based frauds of staggering size. Few of the perpetrators have been punished; many have not even been censured. It has been far safer to steal large sums with a pen than small sums with a gun.
In making acquisitions, Buffett and Munger have tended to avoid companies with significant post-retirement liabilities. I need to admit, though, that we had a near miss: In 1982 I made a huge mistake in committing to buy a company burdened by extraordinary post-retirement health obligations. [My note: the deal never went through for reasons Buffett didn’t explain and the company eventually went bankrupt]
There has been a lot of fuzzy and often partisan commentary about who really pays corporate taxes - businesses or their customers. The argument, of course, has usually turned around tax increases, not decreases. Those people resisting increases in corporate rates frequently argue that corporations in reality pay none of the taxes levied on them but, instead, act as a sort of economic pipeline, passing taxes through to consumers. According to these advocates, any corporate-tax increase will simply lead to higher prices that, for the corporation, offset the increase. Having taken this position, proponents of the "pipeline" theory must also conclude that a tax decrease for corporations will not help profits but will instead flow through, leading to correspondingly lower prices for consumers. Consequently, reductions in corporations taxes largely end up in the corporation's pockets rather than the pockets of the customers. While this may be impolitic to state, it is impossible to deny. If you are tempted to believe otherwise, think for a moment of the most able brain surgeon or lawyer in your area. Do you really expect the fees of this expert (the local "franchise holder" in his or her specialty) to be reduced now that the top personal tax rate is being cut from 50% to 28%.
Buffett and Munger say they would follow a buy and hold policy even if they ran a tax-exempt institution. We think it the soundest way to invest, and it also goes down the grain of our personalities. A third reason to favor this policy, however, is the fact that taxes are due only when gains are realized.
Through my favorite comic strip, Lu'l Abner, I got a chance during my youth to see the benefits of delayed taxes, though I missed the lesson at the time. Making his readers feel superior, Li'l Abner bungled happily, but moronically, through life in Dogpatch. At one point he became infatuated with a New York tempress, Appassionatta Van Climax, but despaired of marrying her because he had only a single silver dollar and she was interested solely in millionaires. Dejected, Abner took his problem to Old Man Mose, the front of all knowledge in Dogpatch. Said the sage: Double your money 20 times and Appassionatta will be yours (1,2,3,8....1,048,576) My last memory of the strip is Abner entering a roadhouse, dropping his dollar into a slot machine, and hitting a jackpot that spilled money all over the floor. Meticulously following Moses's advice, Abner picked up two dollars and went off to find his next double. Mose clearly was overrated as a guru: Besides failing to anticipate Abner's slavish obedience to instructions, he also forgot about taxes. Had Abner been subject, say, to the 35% federal tax rate that Berkshire pays, and had he managed one double annually, he would after 20 years only have accumulated $2,370. Indeed, had he kept on both getting his annual doubles and paying a 25% tax on each, he would have needed 7 and half more years to reach the $1 million required to win Appassionatta. But what if Abner had instead put his dollar in a single investment and held it until it doubled the same 27.5 times? In that case, he would have realized about $200 million pre-tax or, after paying a $70 million tax in the final year, about 130 million after-tax. For that, Appassionatta would have crawled to Dogpatch. Of course, with 27 and a half years having passed, how Appassionatta would have looked to a fellow sitting on $130 million is another question. What this little tale tells us is that tax paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate.
Charlie Munger, "If something is not worth doing at all, it's not worth doing well."
Ted Williams, in the The Story of My Life, explains why: "My argument is, to be a good hitter, you've got to get a good ball to hit. It's the first rule in the book. If I have to bite at stuff that is out of my happy zone, I'm not a .344 hitter. I might only be a .250 hitter." Charlie and Buffett agree and will try to wait for opportunities that are well within their own "happy zone".
There were many blockbuster events that happened throughout time like the Vietnam war, a one day drop of 508 points, treasury bill yields fluctuating between 2.8% and 17.4% but none of these events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to Buffett and Munger, then, if they had let a fear of unknowns cause them to defer or alter the deployment of capital. Indeed, they have usually made their best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.
A different set of shocks is sure to occur in the next 30 years. Buffett and Munger will neither try to predict these nor to profit from them. If they can identify businesses similar to those that they have purchased in the past, external surprises will have little effect on their long term results.