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August 19 - September 18, 2017
At Berkshire's 2011 annual meeting, Charlie stressed to me how different Berkshire had become in the fifteen years since our symposium—and yet how much it remained the same. Back then, Berkshire looked more like a mutual fund, with 80 percent of its assets in minority common stock positions and 20 percent in wholly owned businesses; today, the ratio is reversed and Berkshire looks more like a conglomerate.
The central theme uniting Buffett's lucid essays is that the principles of fundamental business analysis, first formulated by his teachers Ben Graham and David Dodd, should guide investment practice. Linked to that theme are management principles that define the proper role of corporate managers as the stewards of invested capital, and the proper role of shareholders as the suppliers and owners of capital.
While they prefer negotiated acquisitions of 100% of such a business at a fair price, they take a “double-barreled approach” of buying on the open market less than 100% of some businesses when they can do so at a pro-rata price well below what it would take to buy 100%.
allocating capital by concentrating on businesses with outstanding economic characteristics and run by first-rate managers.
Berkshire retains and reinvests earnings when doing so delivers at least proportional increases in per share market value over time. It uses debt sparingly and sells equity only when it receives as much in value as it gives.
For Buffett, managers are stewards of shareholder capital. The best managers think like owners in making business decisions.
Buffett and Berkshire avoid making predictions, a bad managerial habit that too often leads other managers to fudge their financial reports.
What matters is selecting people who are able, honest, and diligent. 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.
Buffett identifies between CEOs 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.
Major reforms are often directed toward aligning management and shareholder interests or enhancing board oversight of CEO performance. Stock options for management were touted as one method; greater emphasis on board processes was another. Separating the identities and functions of the Chairman of the Board and the CEO or appointment of standing audit, nominating and compensation committees were also heralded as promising reforms. Perhaps the most pervasive prescription is to populate boards with independent directors.
CEO alignment with shareholders tools
take great care in identifying CEOs who will perform capably regardless of weak structural restraints.
shareholders must exercise their power to oust CEOs that do not measure up to the demands of corporate stewardship.
Directors therefore must be chosen for their business savvy, their interest, and their owner-orientation. According to Buffett, one of the greatest problems among boards in corporate America is that members are selected for other reasons, such as adding diversity or prominence to a board—or, famously, independence.
To maximize board effectiveness in this situation, Buffett believes the board should be small in size and composed mostly of outside directors. The strongest weapon a director can wield in these situations remains the threat to resign.
Holding regular meetings without the chief executive to review his or her performance can produce a marked improvement in corporate governance.
CEOs at Berkshire's various operating companies enjoy a unique position in corporate America. They are given a simple set of commands: to run their business as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for fifty years.
Many corporations pay their managers stock options whose value increases simply by retention of earnings, rather than by superior deployment of capital. As Buffett explains, however, simply by retaining and reinvesting earnings, managers can report annual earnings increases without so much as lifting a finger to improve real returns on capital. Stock options thus often rob shareholders of wealth and allocate the booty to executives. Moreover, once granted, stock options are often irrevocable, unconditional, and benefit managers without regard to individual performance. It is possible to use
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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.
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.
The inquiry is whether after-tax returns on an investment are at 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.
Buffett's investment knitting does not prescribe diversification. It may even call for concentration,
The fashion of beta, according to Buffett, suffers from inattention to “a fundamental principle: It is better to be approximately right than precisely wrong.”
imposes huge transaction costs in the forms of spreads, fees and commissions, not to mention taxes.
Graham held that price is what you pay and value is what you get. These two things are rarely identical, but most people rarely notice any difference.
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.
Another leading prudential legacy from Graham is his margin-of-safety principle. This principle holds that one should not make an investment in a security unless there is a sufficient basis for believing that the price being paid is substantially lower than the value being delivered.
Buffett notes, by distinguishing between “growth investing” and “value investing.” Growth and value, Buffett says, are not distinct. They are integrally linked since growth must be treated as a component of value.
Buffett 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 cash this way requires evaluating four commonsense questions based 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 does not occur.
The circle of competence principle is the third leg of the Graham/Buffett stool of intelligent investing, along with Mr. Market and the margin of safety. This commonsense rule instructs investors to consider investments only concerning businesses they are capable of understanding with a modicum of effort.
The ultimate result of the institutional imperative is a follow-the-pack mentality producing industry imitators, rather than industry leaders—what Buffett calls a lemming-like approach to business.
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 a normal bond paying periodic interest would not provide. Using zero-coupons thus for a time enabled a borrower to borrow more without need of additional free cash flow to pay the interest expense.
Trading is the rearrangement of who owns what shares. The rearrangement entails paying commissions to brokers, fees to investment managers and cash to financial planners and business consultants who sell even more advice during this process. Of late, these frictional costs have escalated into whole industries that describe themselves variously as hedge funds and private equity firms. Buffett estimates that total costs may consume some 20% of the country's total annual corporate earnings.
the costs of trading activity can impair long-term results. Indeed, Buffett estimates that the transaction costs of actively traded stocks—broker commissions and market-maker spreads—often amount to 10% or more of earnings. Avoiding or minimizing such costs is necessary for long-term investment success, and Berkshire's listing on the New York Stock Exchange helped contain those costs.
earnings payout versus retention decision should be based on a single test: 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.”
Share repurchases of underpriced stock can be a value-enhancing way to allocate capital, though these are not always what they seem.
These value-destroying share repurchases often are intended to prop up a sagging share price or to offset the simultaneous issuing of stock under stock options exercised at much lower prices. Buffett lays out the rationale and terms under which Berkshire occasionally embarks on share repurchase programs: when the stock trades at a deep discount to intrinsic value.
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 that depart materially from intrinsic business value.
Two important consequences have followed from Berkshire's high stock price and its dividend policy. First, the extraordinarily high share price impaired the ability of Berkshire shareholders to effect gifts of their equity interest to family members or friends, though Buffett has offered a few sensible strategies like bargain sales to donees to deal with that. Second, Wall Street engineers tried to create securities that would purport to mimic Berkshire's performance and that would be sold to people lacking an understanding of Berkshire, its business, and its investment philosophy. In response
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Some expressed surprise at Buffett and Munger's cautionary statement, since most managers tell the market that newly-issued equity in their companies is being offered at a very good price. You should not be surprised by Buffett and Munger's disclosure, however. A company that sells its stock at a price less than its value is stealing from its existing shareholders. Quite plausibly, Buffett considers that a crime.
Berkshire's acquisition policy is the double-barreled approach: buying portions or all of businesses 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 cases involve businesses with franchise characteristics—those that can raise prices without impairing sales volume or market share and only require incremental capital investment to increase both.
The second category of rare cases is where extraordinary managers exist who can achieve the difficult feat of identifying underperforming businesses, and apply ...
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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.
Buffett notes that sellers in stock acquisitions measure the purchase price by the market price of the buyer's stock, not by its intrinsic value. If a buyer's stock is trading at a price equal to, say, half its intrinsic value, then a buyer who goes along with that measure gives twice as much in business value as it is getting.
practice of greenmail, the repurchase of shares from an unwanted suitor at a premium price to fend off his acquisition overtures. While share repurchases available to all shareholders can be value enhancing, Buffett condemns this practice as simply another form of corporate robbery.
Finding the best value-enhancing transactions requires concentrating on opportunity costs, measured principally against the alternative of buying small pieces of excellent businesses through stock market purchases. Such concentration is alien to the manager obsessed with synergies and size, but a vital part of Berkshire's double-barreled investment approach.
Berkshire has additional advantages in acquisitions: a high quality stock to pay with and a substantial amount of managerial autonomy to offer once a deal is done—both rare in an acquiring company, Buffett says.
intrinsic value, “the discounted value of the cash that can be taken out of a business during its remaining life.”
