Wisdom of Warren Buffett

November 6th, 2005 | Investment

Despite any misques Buffett is still by far one of the most honest CEO’s in the business - and one of a very rare few who doesn’t mind sharing the secrets of his investment success:

$: INTRODUCTION

Cunningham is implicit about the thesis of this collection of disparate writing. “The central theme uniting Buffett’s lucid essays is that the principles of fundamental valuations analysis, first formulated by his teachers Ben Braham and David Dodd, should guide investment practice”. And indeed the theme clearly resonates throughout the collection.

At 21 pages out of a 211 for the book Cunningham’s introduction is comprehensive. It as itself is a superb recap of Buffett’s accomplishments and principles – possibly the best document you could to hand out to your friends as an introduction to the Gospel of Buffett. Each of the book’s five sections is introduced over a few pages complete with relevant quotes. Those sections are: I.) Corporate Governance, II.) Corporate Finance and Investing, III.) Common Stock, IV.) Mergers and Acquisitions, and V.) Accounting and Taxation.

Aggregate career-long statistics are presented here, something that Buffett wouldn’t necessarily discuss in his annual discourses. Most importantly Cunningham notes that since 1964 when Buffett took over Berkshire Hathaway book value per share has increased from $19.46 to roughly $20,000 (in 1998). This is a 23.8% compounded annual growth rate.

Here Buffett makes two clear points. Firstly, shareholders, especially those of the Berkshire variety, deserve to hear directly from the CEO. Warren writes the annual report himself. Secondly, Berkshire communicates to shareholders in a manor that attracts those with long-term views. The policy of no commentary in the quarterly reports, but in-depth CEO-penned annual reports, reflects this priority.

I.A.: OWNER RELATED BUSINESS PRINCIPLES

There are 13 principles that drive Berkshire Hathaway.

Munger and Buffett view their relationship with shareholders as a long-term partnership. It’s to be as if you owned an “a farm or apartment house in partnership with members of your family.”
With over 90% of their net-worth in Berkshire stock, Buffett and Munger put their money, and yours, where their mouth is. “…we can guarantee that your financial fortunes will move in lockstep with ours for whatever period of time you elect to be our partner.”
Here we see Buffett setting shareholder expectations, he warns not to expect more than a 15% increase in intrinsic per-share value. He notes per-share intrinsic value as the key-metric by which performance is measured.
Berkshire’s acquisition policy is clear. The first choice is to completely acquire outstanding businesses, the second choice is to buy parts of outstanding businesses in the public equity markets.
General accounting practices don’t always accurately represent Berkshire’s consolidated earnings statement. As such Buffett will comment individually on the performance and prospects of each of the major Berkshire businesses.
The concept of “look-through earnings” is introduced. This is how Berkshire accounts for the undistributed earnings of its subsidiaries in the annual report.
Berkshire steers clear from potentially hazardous debt levels. Borrowing will take place at favorable rates in long-term contracts. With deferred taxes and the “float” from its insurance operations Berkshire has more attractive capital sources than debt.
Acquisitions are not made for reasons other than boosting long-term performance. There is no “wish list”, or ego-bolstering acquisitions masquerading as a strategic purchases.
On retained earnings. “We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market values of reach $1 retained.” If this test isn’t met, Buffett writes, “we will pay them out and let our shareholders deploy the funds.”
“We will issue common stock only when we receive as much in business value as we give.” Buffett further notes, “Owners unfairly lose if their managers deliberately sell assets for 80¢ that in fact are wroth $1.”
As long as a business generates some cash Berkshire won’t sell it, even though it’s performance is sub-par. Nor will they engage in an expensive rescue operation. Buffett concedes that this is a practice that may hurt performance.
Buffett strives for candor in all reporting and comment about Berkshire. Efforts won’t be made to smooth numbers or mislead investors. He writes, “The CEO who misleads others in public may eventually mislead himself in private.”
The philosophy and performance of Berkshire will be freely discussed, however there may be timely issues that can’t be divulged lest they damage competitive advantage in the securities markets. An Added Principle. Buffett is concerned about shareholder expectations knowing that the market may toy with them. As such he makes it known that, “we would rather see Berkshire’s stock price at a fair level than a high level.”

I.B.: BOARDS AND MANAGERS

Buffett begins here noting that CEO performance is often held against vague standards. He also believes there should be 10 or fewer directors, and those should predominantly hail from outside the company. Three governance scenarios are discussed, one being Berkshire’s where there is a controlling shareholder who is also a manger. The optimal behavior of a board in each scenario is put forth by Buffett. The “ultimate” scenario is also mentioned, should Warren Buffett die all of his stock will go to his wife or a foundation.

Buffett’s treatise on management is simple, “working with only people whom we like and admire.” In doing so he’s able to get results and manage his time effectively, leveraging a flat reporting structure. Many people have pondered the incentives of management to perform after they’ve become independently wealthy, answering this Buffett notes that, “they work because they love what they do and relish the thrill of outstanding performance.”

I.C.: THE ANXIETIES OF PLANT CLOSINGS

“My conclusion from my own experiences and from much observation of other business 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,” Buffet wrote. In the sections prior to this conclusion he detailed the demise of Berkshire Hathaway’s core business, textiles. That business was liquidated after much deliberation and managerial – not capital – effort. His statement that he “won’t close down a business of sub-normal profitability” is half-true, he will, just after a long period of consideration to soften the blows on labor, management, and the community.

I.D.: AN OWNER-BASED APPROACH TO CORPORATE CHARITY

Berkshire Hathaway’s method of charity is very unique. As Buffett describes it, “Each Berkshire shareholder -– on a basis of proportional to the number of shares that he owns -– will be able to designate recipients of charitable contributions by our company. You’ll name the charity; Berkshire will write the check.” This arrangement was made possible by a tax ruling of the US Treasury department.

I.E.: A PRINCIPLED APPROACH TO EXECUTIVE PAY

Buffett warns that shareholders can be easily misled by management’s return on capital. “Just quadruple the capital you commit to a savings account and you will quadruple your earnings.” The math is simple but powerful, “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 goal should be superior returns, not average risk-free returns. In this section Buffett also lampoons the economics of fixed-price options given to management. These options carry no risk for the grantee and do not correctly reward individual performance. He does concede that options may be a worthwhile incentive in some companies, but certainly not his.

II.: CORPORATE FINANCE AND INVESTING

A clear-cut example of an undervalued company was the Washington Post Company in 1973. Buffett calculated the intrinsic value at “$400 to $500 million” while it trading with a market capitalization of $100 million. Naturally, he invested. The opportunity came about because most institutional investors were dilly-dallying with fanciful notions of a purely efficient market.

II.A.: MR. MARKET

Buffett perceives the behavior of the stock market as that of a manic-depressive-obsessive business partner. Obsessive because he will unfailingly offer to buy your equity positions everyday, manic-depressive because his prices are mostly byproducts of emotion. Ben Graham taught him this perceptual trick. Berkshire’s public market purchases are analyzed as private transactions–unless they are discreet arbitrage opportunities. “We do not have in mind any time or price for the sale,” Buffet wrote. The payoff is to come intrinsically not as a capital gain, the later being the result of arbitrage.

II.B.: ARBITRAGE

Buffett writes, “ Arbitrage positions are a substitute for short-term cash equivalents…” Long-term commitments are preferred but Berkshire can be more flush with cash than ideas. Three arbitrage examples are given involving coca beans, tracts of forest, and RJR Nabisco stock. “Berkshire’s arbitrage activities differ from those of many arbitrageurs…we participate in only a few, and usually very large, transactions each year,” remarked Buffett on his near disdain for this sort of deal. In fact participating in arbitrage reminds him of how much he prefers his primary business: investing capital for the long-term in outstanding companies.

II.C.: DEBUNKING STANDARD DOGMA

Efficient market theory, its corollary concept of beta, unreasonable diversification, and portfolio insurance are the targets of Buffett’s debunking in this section. In a study concluding that the Graham-Newman fund earned on average 20% per year from arbitrage from 1926-1956, oodles more than the market earned, Buffett proffers a failing of EMT. On diversification he writes, “…our favorite holding period is forever.” This contrasts the common intuitional practice of taking many short-term positions. It’s better to be exactly a few times than almost write, or totally wrong, hundreds of times. Risk has everything to do with business factors as opposed to an anonymously calculated figure like beta. We should be concerned with, “The certainty with which the long-term economic characteristics of the business can be evaluated.” You can’t attribute a real number to this certainty, but it’s far more important than calculating the real number beta. (Beta measures volatility as a function of price fluctuations over time.) Buffett gives Coca-Cola, with its extraordinary long-term economics, as an ideal concentrated holding. Our time should be spent finding Coca-Colas. Buffett wrote that he’d never sell three stocks: Capital Cities/ABC, GEICO, and The Washington Post. Interestingly he sold 80% of his Disney (whom acquired Capital Cities) stake between 1999 and 2000.

II.D.: “VALUE” INVESTING: A REDUNDANCY

If you ever wondered what Buffett’s goal for Berkshire is, wonder no more. “Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.” As stated before, controlling acquisitions are preferred. They have two distinct advantages. One, it gives Berkshire the authority to deploy the “excess” capital of the businesses. Two, there is a tax advantage in owning more than 80% of a company versus holding its stock as a marketable security. On value investing Buffett writes, “What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?” In other words, “value investing” is a redundant phrase. He quotes John Burr Williams’ definition of value, “The value of any stock, bond or business today is determined by the cash inflows and outflows—discounted at an appropriate rate of interest—that can be expected to occur during the remaining life of the asset.” To insure value, Berkshire insists on a “margin of safety in our purchase price.” Berkshire’s investment in Capital Cities is cited as an example for the concepts discussed in this section

II.E.: INTELLIGENT INVESTING

Buffett again underlines his views on the holding period for stocks, writing, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.” He gives Coke, Gillette, and See’s candies as examples of business that won’t undergo fundamental changes for a number of decades. These are precisely the type businesses he wants to buy – and hold. “Inactivity strikes us as intelligent behavior,” notes Warren. The goal he implies is to find a good business and stick to it, rather than feverishly trading your “star players” for the sake of arbitrary diversification.

II.F.: CIGAR BUTTS AND THE INSTITUTIONAL IMPERATIVE

Here Buffett lists some simple principles and related mistakes he’s made over the years. First off, he shouldn’t have bought Berkshire Hathaway, concluding that, “It’s far better too buy a wonderful company at a fair price than a fair company at a wonderful price.” Berkshire, along with some others, was of the later type. He classifies this later type in the manor of “cigar butt” investing – finding a cigar butt (paying nothing) and getting the last puff (profit) for free. The lemmingesque behavior of large “institutional” companies is also discussed, “The behavior of peer companies…will be mindlessly imitated.” The section is closed by nearly vowing to work only with management whom he and Charlie “like, trust, and admire”, and to steer clear of high debt levels to improve performance.

II.G.: JUNK BONDS

Half of this section is about junk bonds, the first half is about an investment in Wells Fargo. That investment was $290 million and purchased at a “less than five times after-tax earnings.” Wells Fargo now trades at nearly 20 times earnings. The banking industry at the time was bloodied; Buffett recognized that Wells Fargo was unduly guilty by association. RJR Nabisco junk bonds were bought in late 1989. This successful investment doesn’t typify Berkshire investing practice at first glance – Buffett describes with much chagrin the junk bond issuing business. Another diamond in the rough, Buffett saw that RJR could cover its credit obligations, something the market-at-large didn’t see. Again, this was a rare investment vehicle for Berkshire as he wrote, “However, as we survey the field, most low-grade bonds still look unattractive. The handiwork of the Wall Street of the 1980’s is even worse thane we had thought: Many important businesses have been mortally wounded. We will, through, keep looking for opportunities as the junk market continues to unravel.” Buffett also credits Graham’s idea of a “Margin of Safety” with guiding his investment choices and as and the anti-thesis of the junk bond industry at its most manic.

II.H.: ZERO-COUPON BONDS

Zero-coupon bonds pay no periodic interest, opting instead for one balloon payment when due. Buffett describes the way in which Wall Street abused these bonds. One can intonate the problems caused by “zeros” from the following bit of wisdom. “Our advice: Whenever a investment banker starts talking about EBDIT – or whenever somebody creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out with current cash flow net of ample capital expenditures—zip up your wallet.” Previously in this passage he called EBDIT (earnings before deprecation interest and taxes) an “abomination”. In his eyes EBDIT was concocted to finance ever-shakier deals with zeros.

II.I.: PREFERRED STOCK

Buffett on Berkshire’s preferred stock positions, “In summation, Charlie and I feel that our preferred stock investments should produce returns moderately above those achieved by most fixed-income portfolios and that we can play a minor but enjoyable and conservative role in the investee companies.” He details a near blunder in USAir preferred stock, being rescued only by clause that paid Berkshire penalties on late interest payments. Other notable preferred positions were in Gillette, Salomon Brothers, and Champion (the paper products company).

III.: COMMON STOCK

Buffett on dealing with the manic swings of the market, “Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” Poor investment choices, driven by emotion, and transaction costs conspire against the investor and his returns.

III.A.: THE BANE OF TRADING: TRANSACTION COSTS

Berkshire listed on the NYSE in 1988. Buffett’s desire was to reduce the transaction costs of Berkshire shareholders with the listing. It wasn’t in the hopes of increasing the valuation of Berkshire shares. He writes, “The NYSE listing should not induce you to buy or sell; it simply should cut your costs somewhat should you decide to do either.” Buffett abhors transaction costs writing that they are a “hefty tax on owners.”

III.B.: ATTRACTING THE RIGHT SORT OF INVESTOR

Buffett hopes that Berkshire shares will trade near their intrinsic value, neither undervalued nor overvalued. “If our stock price instead consistently mirrors business value, each of our share holders will receive an investment result that roughly parallels the business results of Berkshire during his holding period.” E.g., the shareholders will know what they are getting into and their expectations, though never wildly exceeded, should always be met. He’s not a booster of shareholder turnover, writing, “Our goal is to attract long-term owners who, at the time of purchase, have no timetable or price target for sale but plan instead to stay with us indefinitely.”

III.C.: DIVIDEND POLICY

Buffett categorizes earnings as “restricted” or “unrestricted”. The restricted sort belong to companies that need to heavily reinvest in their asset base to maintain their economic position. Companies with unrestricted earnings can choose whether to retain them for reinvestment or distribute them to shareholders as dividends. For this decision Buffett has a rule: “Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners.”

III.D.: STOCK SPLITS AND TRADING ACTIVITY

Splitting a share does nothing to affect the underlying business characteristics of a company. For this reason Buffett won’t split Berkshire stock. He wants rational long-term investors, investors who shouldn’t be attracted by such an arbitrary action. He writes, “We want those who think of themselves as business owners and invest in companies with the intention of staying a long time. And, we want those who keep their eyes focused on business results, not market prices,” continuing in this vein, “Were we to split the stock or take other actions focusing on stock price rather than business value, we would attract an entering class of buyers inferior to the exiting class of sellers.”

III.E.: SHAREHOLDER STRATEGIES

As Berkshire’s share price has grown over the years some shareholders have found it taxing (pun intended) to give as a gift. It is for this noble reason that some requested the stock be split. Buffett declined the request. Instead he offers some creative workarounds for gifting shares in this section. The strategies aren’t perfect, still having tax implications, but they can help.

III.F.: BERKSHIRE’S RECAPITALIZATION

Solving the gifting problem in the previous section, Berkshire issued class B shares in 1996. The intention however had nothing to do with solving that problem, rather, as Buffet writes, “As I have told you before, we made this sale in response to the threatened creation of unit trusts that would have marketed themselves as Berkshire look-alikes. In the process, they would have used our past, and definitely nonrepeatable record to entice naïve small investors and would have charged these innocents high fees and commissions.” Buffett also foresaw these trust creating an artificial demand for Berkshire shares, thus creating a price bubble sure to eventually disappoint many shareholders. The class B shares have 1/30th the rights of class A shares, and 1/200th the vote.

IV: MERGERS AND ACQUISITIONS

Buffett tells us of his initial shortcomings as an investor: investing in things simply because they looked cheap. He now looks for good business at fair prices, versus the other way around. This isn’t exactly the strategy of most CEO’s he quips. Many are simply “acquisition-hungry” and “apparently mesmerized by their childhood reading of the story about the frog-kissing princess.”

IV.A.: BAD MOTIVES AND HIGH PRICES

Buffett is skeptical about the virtue of most mergers. He feels they are largely driven by a CEO’s “animal spirits”, where those spirits urge the CEO to increase his managerial domain. It’s also many a CEO who feels they can turn a frog into a prince. Buffett doesn’t suffer from this illusion, noting, “We have tried occasionally to buy toads at bargain prices with results that have been chronicled in past reports. Clearly our kisses fell flat.” He warns against the advice of investment bankers in mergers, “Don’t ask the barber if you need a haircut.”

Buffett gives a simple illustration of the peril in trying to only increase your managerial domain. “If (1) your family owns a 120-acre farm and (2) you invite a neighbor with 60 acres of comparable land to merge his farm into an equal partnership – with you to be managing partner, then (3) your managerial domain will have grown to 180 acres but you will have permanently shrunk by 25% your family’s ownership interest in both acreage and crops.”

Buffett offers an alternative way of thinking about mergers. “If Company A announces that it will issue shares to merge with Company B, the process is customarily described as ‘Company A to Acquire Company B’, or ‘B Sells to A’. Clearer thinking about the matter would result if a more awkward but more accurate description were used: ‘Part of A sold to Acquire B’, or ‘Owners of B to receive part of A in exchange for their properties.’”

In the end Buffett sees that many mergers are good for the acquiree, good for the management of the acquirer, especially good for investment bankers, but not so good for the shareholders of the acquirer. He will only issue shares if Berkshire receives as much in intrinsic business value as it gives.

IV.B.: SENSIBLE STOCK REPURCHASES VERSUS GREENMAIL

Greenmail is a practice Buffett finds “odious and repugnant”; a “mugging” dished out by a “transient” shareholder. He finds stock repurchases “encouraging and rewarding”. Repurchases increase per-share intrinsic value and engender more rational share prices. He condemns the manager who regularly declines to engage in shareholder enriching repurchases.

IV.C.: LEVERAGED BUYOUTS

This section was written by Charlie Munger and enumerates his thoughts on LBOs (leveraged buy outs). Some of his views are political – he asks if we are to view highly leveraged corporations as weakened social institutions. He sees the major business incentive of an LBO as a tax benefit. LBOs directly effected Wesco, “the hordes of leveraged-buy-out operators now with us raise the general level of acquisition prices to the detriment of other would be acquirers, including Wesco, which are not willing to maximize tax benefits through maximized borrowing.”

IV.D.: SOUND ACQUISITION POLICIES

“In any case, why potential buyers even look at projections prepared buy sellers baffles me. Charlie and I never give them a glance,” wrote Buffett. His acquisition strategy is simple, “we don’t have a strategic plan.” Rather they engage in a process of simply comparing opportunity costs (including the opportunity of doing nothing) when considering a purchase. When a purchase is made Berkshire can guarantee the business sellers a pleasant and autonomous management “structure”. Berkshire has a list of standing criteria for business acquisitions, they are (paraphrased): (1) Big purchases (enough pre-tax earnings to be relevant; this changes as Berkshire grows) (2) A history of consistent earnings (3) Handsome returns on equity; little or zero debt (4) Existing management (5) A business that is easy to understand (6) An asking price; Berkshire will not participate in unfriendly takeovers

Upon submitting your proposal you can expect a prompt return, “customarily within 5 minutes.”

VI.E.: ON SELLING ONE’S BUSINESS

Buffett warns that most acquirers will try to run an acquired business “better” than the current owners or they’ll be of the LBO school waiting to restate accounting metrics and resell the business. Berkshire is different and has proven so. “We buy to keep, but we don’t have, and don’t expect to have operating people in our parent organization,” he writes that the seller knows best, “…the sellers go on running it just as the did before the sale; we adapt to their methods rather than vice versa.” One technical consideration is the percentage of ownership, Buffett likes to acquire 80% of a business for tax purposes and to keep the sellers more than interested in continuing managerial excellence vis-à-vis their remaining 20% share.

V.: ACCOUNTING AND TAXATION

Buffett realizes that because he and Charlie have most of their money in Berkshire Hathaway many shareholders take reporting on “faith” and don’t require too technical of an “analysis”. However, some still do want such an analysis, hence the ensuing sections.

V.A.: A SATIRE ON ACCOUNTING SHENANIGANS

This essay was published by Warren Buffett but written by Benjamin Graham. It’s a fictitious account about a recapitalization of US Steel meant to show just how absurd and creative accounting changes can be. Six major actions are proposed from writing down the Plant Account to minus $1,000,000,000, paying all employees with option warrants in lieu of salary, to replacing preferred with “non-interest bearing bonds redeemable at a 50% discount.” The effects are extraordinary; EPS are increased from a negative $2.67 to $49.80. Implausible as the scenario is, it’s a worthwhile cautionary tale given the hoard of “restatements” during the tail end of our latest tech-driven bull market.

V.B.: LOOK THROUGH EARNINGS

“In our view, the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used – and not by the size of one’s ownership percentage,” wrote Buffet, on a seemingly obvious principle. However due to GAAP companies can only report the earnings of subsidiary firms according to what percentage they own in them. In 1990 Berkshire owned 17% of Cap Cities, their true share of Cap Cities’ earnings was $83 million, but they only reported $530,0000 (which was paid as dividends) in GAAP earnings because their ownership share is less than 20%. In 1980 unreported earnings actually exceeded reported earnings. These unreported earnings are what Buffett refers to as “look through earnings”. He writes, “The goal of each investor should be to create a portfolio (in effect, a ‘company’) that will deliver him or her the highest possible look-through earnings a decade or so from now.”

V.C.: ECONOMIC GOODWILL VERSUS ACCOUNTING GOODWILL

Products require resources to produce, these are formally known as assets. If you have to increase your unit volume of production you may very well have to invest in more assets. There are businesses however that do not require major outlays of capital to increase production. Buffett likes these businesses, they are seen as possessing tremendous goodwill. They are embattled for inflation. “During inflation, Goodwill is the gift that keeps on giving,” he noted. See’s Candy is this type of business; See’s earned $2 million on assets of $8 million in 1972, $27 million on $11 million in 1982, $50 million on $5 million in 1995. Buffett believes that the GAAP convention of amortizing goodwill against earnings is fallacious. He wrote, “In evaluating the wisdom of business acquisitions, amortization charges should be ignored…” Buffett thinks that less really is more regarding the assets needed to produce the earnings stream you are buying. The company’s liquidation value may be lower, but it’s ready for an inflationary environment — this goes against conventional wisdom that says assets are a hedge against inflation.

V.D.: OWNER EARNINGS AND THE CASH FLOW FALLACY

“Purchase price adjustments” must be made when a business is acquired. These adjustments align the income statements with GAAP by adjusting asset values to current asset values. When Berkshire acquired Scott Fetzer the changes resulted in lower reported earnings because the amortization charges were increased as asset values increased. Buffett writes that, “We consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes,” he defines “owner earnings” as, “(a) reported earnings plus (b) deprecation, 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.” Buffett’s views on “cash flow”: “All of this points up the absurdity of the ‘cash flow’ numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) – but do not subtract (c).”

V.E.: INTRINSIC VALUE, BOOK VALUE, AND MARKET PRICE

“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple,” writes Buffett. While he regularly reports per-share book value as a standard metric, he warns that book value is not the same as intrinsic value but a rough approximation. He asks us to compare the book value and intrinsic value of a college education (before the degree) to get an idea of how they differ. Buffett on GAAP book value: “Our mental approach to this accounting schizophrenia is to ignore GAAP figures and to focus solely on the future earning power of both our controlled and non-controlled businesses.” He hopes that the share price of Berkshire trades close to intrinsic value because, “in the end business gains must equal investor gains.”

V.F.: SEGMENT DATA AND CONSOLIDATION

Though he’s not fond of GAAP Buffett writes, “I would hate to have the job of devising a better set of rules. The limitations of the existing set, however need not be inhibiting…” Indeed there is a problem inherent with devising a standard set of accounting rules for the many diverse businesses of the world. To this point Buffett feels that companies should break out segment data if they are involved in multiple industries. The onus is on the CEO to ensure exhaustive reporting, which will usually mean going beyond GAAP.

V.G.: DEFERRED TAXES

Tax laws changed in the early 1990s such that Berkshire had to carry an increased deferred tax liability on capital gains for unsold appreciated securities. This resulted in non-cash charges and reduced book value. Buffett wasn’t sold on the this decree from the Feds, writing, “[W]e would owe taxes of more than $1.1 billion were we to sell all of our securities at year-end market values. Is this $1.1 billion liability equal, or even similar, to a $1.1 billion liability payable to a trade creditor 15 days after then end of the year? Obviously not—despite the fact that both items have exactly the same effect on audited net worth, reducing it by $1.1 billion.” Holding securities a long time has a two-fold advantage for Buffett: one, he gets to be close to outstanding managements, two, there is an increased long-term compounding effect on returns by abstaining from cashing in every year.

V.H.: RETIREE BENEFITS AND STOCK OPTIONS

Future retiree benefits had to be fully and presently recorded according to an accounting change in 1993. Buffett expressed his lack of concern, “In making acquisitions, Charlie and I have tended to avoid companies with significant post retirement liabilities.” He did however agree with the change. He thought it “reckless” for management to promise “open-ended” future benefits and then not properly account for their costs. Not accounting for costs is also is his rallying point against stock option accounting, which he again discusses here. “It seems to me that the realities of stock options can be summarized quite simply: If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where should they go?”

V.I.: DISTRIBUTION OF THE CORPORATE INCOME TAX

Here Buffett outlines the changes at Berkshire after the Tax Reform Act of 1986. The personal capital gains rate increased from 20% to 28%, corporate capital gains went from 28% to 34%, corporate income tax decreased from 46% to 34%, and corporate dividend income increased from 15% to 20%. “Our conclusion is that in some cases the benefits of lower corporate taxes fall exclusively, or almost exclusively, upon the corporation and its shareholders, and that in some cases the benefits are entirely, or almost entirely, passed through to the customer,” wrote Buffett on the society-wide affects of the tax change. Buffett claimed that Berkshire’s businesses were of the type where the shareholders benefited from tax cuts.

V.J.: TAXATION AND INVESTMENT PHILOSOPHY

Buffett co-opts a tale from the comic strip Lil’l Abner to illustrate his take on taxation and the investor. Buffett writes, “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. But I suspect many Berkshire shareholders figured this out long ago.”

Despite Berkshire’s fantastic record we conclude with more caution than optimism. As Berkshire’s capital base increases Buffett warns that investors won’t see a duplicate of past returns. There simply aren’t enough large investment opportunities. “A fat wallet is the enemy of superior investment results,” writes Buffett. He also notes that as of 1994 Berkshire can’t consider investments below $100 million. He writes that he’ll continue to ignore macroeconomic forecasts observing that none of the “blockbuster” events of the past 30 years (Vietnam, the fall of the USSR, etc.) had much of an effect on Ben Graham’s principles. “Fear is the foe of the faddist, but the friend of the fundamentalist.”

And, as a long-time Buffett fan I thought I’d also share some of my favorites.

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
“Wide diversification is only required when investors do not understand what they are doing.”
“We enjoy the process far more than the proceeds.”
“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
“Chains of habit are too light to be felt until they are too heavy to be broken.”
“Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised.”
“I always knew I was going to be rich. I don’t think I ever doubted it for a minute.”
“I am quite serious when I say that I do not believe there are, on the whole earth besides, so many intensified bores as in these United States. No man can form an adequate idea of the real meaning of the word, without coming here.”
“I buy expensive suits. They just look cheap on me.”
“I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.”
“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”
“If a business does well, the stock eventually follows.”
“If past history was all there was to the game, the richest people would be librarians.”
“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”
“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”
“Of the billionaires I have known, money just brings out the basic traits in them. If they were jerks before they had money, they are simply jerks with a billion dollars.”
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
“Our favorite holding period is forever.”
“Price is what you pay. Value is what you get.”
“Risk comes from not knowing what you’re doing.”
“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
“The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.”
“The first rule is not to lose. The second rule is not to forget the first rule.”
“The investor of today does not profit from yesterday’s growth.”
“The only time to buy these is on a day with no “y” in it.”
“The smarter the journalists are, the better off society is. For to a degree, people read the press to inform themselves-and the better the teacher, the better the student body.”
“There seems to be some perverse human characteristic that likes to make easy things difficult.”
“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.”
“Why not invest your assets in the companies you really like? As Mae West said, ‘Too much of a good thing can be wonderful’”.
“You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”
“You only have to do a very few things right in your life so long as you don’t do too many things wrong.”
“Your premium brand had better be delivering something special, or it’s not going to get the business.”
“A public-opinion poll is no substitute for thought.”

Nofie Iman