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Berkshire Hathaway | Owner's manual Pt. 2

Owner-related business principles cont'd.

5. Because of our two-pronged approach to business ownership and because of the 
limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance. These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them.

Warren Buffett and Charlie Munger are very knowledgeable about accounting and its limitations in presenting the best performance of companies consolidated on Berkshire's financial statements. They analyze each business and the environment that they operate in and relay their conclusions to their shareholders. They basically assist shareholders in making well-informed decisions about the operating businesses of Berkshire Hathaway. They are very honest with their evaluations as can be seen in the Chairman's letters; when businesses do well, they acknowledge that and when businesses perform below expectations, they are not shy about stating those facts either. You cannot put enough value on honest management, especially today.


6. Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.

It is obvious that Warren Buffett takes does not focus totally on reportable numbers that appear of financial statements (using GAAP standards), but puts more emphasis on the true earnings of a company because he knows that eventually, it will be reflected in the intrinsic value of the business. It is important to buy businesses that are of greater overall value based on actual earnings and not reportable earnings; the rest will take care of itself. He also understands that there are many ways undistributed earnings can be allocated within the company that will add value to the underlying business such as repurchasing shares or reinvesting in the business. He believes these to be alternatives that should be considered as effective use of capital at certain times.


7. We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care. (As one of the Indianapolis “500” winners said: “To finish first, you must first finish.”)

Berkshire's management does not believe in having a lot of leverage and because of the nature of the businesses they own, they generate a lot of cash (from insurance businesses) that can be used for investments and financing purchases. This cash is referred to as float and it is free once Berkshire's insurance operations break even. A no debt structure, even though, may prevent them from making huge investments that will increase returns, allows Buffett and Munger to sleep well at night because they have nothing to worry about when it comes to debt maturity dates and such. In this current turbulent times, the $40 billion in cash he has available is serving us shareholders very well. In several years, I assure you the economic value of the business will be greatly improved.


8. A managerial “wish list” will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.

Buffett and Munger are the most shareholder-friendly managers you can find in business today. All the purchases they make are done with the intentions of improve Berkshire's per-share intrinsic value. Once you read this document, you will see that this should serve as a model of corporate governance for all companies.

For the detailed reading of The Owner's Manual, please refer to Berkshire's Hathaway's website.

Related Links:
Berkshire Hathaway | Owner’s Manual Part 4
Berkshire Hathaway | Owner’s Manual Part 3
Berkshire Hathaway | Owner’s Manual Part 2
Berkshire Hathaway | Owner’s Manual Part 1

Berkshire Hathaway | Owner's manual Pt. 1

[Source: www.berkshirehathaway.com | Owner's manual]

Warren E. Buffett, Berkshire's Chairman, issued what he calls "An Owner's Manual" to the shareholders of Berkshire Hathaway in 1996. This booklet contains 13 economic principles to assist new shareholders to clearly understand the way Berkshire is run. Many corporations lay out corporate governance guidelines for their owners, but none has been down in a very simplified and conversational way, as Warren Buffett is typically known for. This would be a great way for new investors to learn what one should look for in great management and also understand the way Buffett thinks as well.

The owner's manual series will be divided into 3 parts. We will first concentrate on the first 3 principles of the manual in this posting and highlight key points that should be noted.


Owner-Related Business Principles

1. Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.

i. Mr. Buffett and Mr. Munger both view shareholders as owner-partners. Warren Buffett truly emphasizes the importance management plays in his decisions to buy into businesses. He is no different and truly sets that example. They fully grasp and respect that shareholders are owners of public corporations and that their decisions should be based on what is ultimately best for the shareholders and disregard personal interests.

ii. They both are highly invested in the company.  They both have the majority of their net worth in Berkshire stock and is therefore, as Mr. Buffett would say, "eating their own cooking." This is an important point to consider when looking at investments. What percentage of the stock does management own? Are their interests aligned with that of the shareholders? Well, a great way to tell is if they own their own company's stock.

iii. The corporate entity does not own the business. Legally, the creation of a corporation frees management from liability. However, what Mr. Buffett is indicating in this first principle is that they view the company merely as a vehicle through which shareholders own the assets of the business. This first point alone says a lot of the management of Berkshire Hathaway and as soon as you are able to find management in other companies that exhibit the same qualities in a great business, you know that this is a company that you should look into further and buy and hold on forever. Such companies are hard to find; such management are even more rare. What he expects of shareholders as well is that they view themselves as owners that are in it for the long haul. He invests with a long term horizon and would like his shareholders to have that time horizon as well; therefore they should be willing to own the stock for the rest of their lives.


2. In line with Berkshire’s owner-orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking.

Charlie Munger's family has 90% or more of its net worth in Berkshire shares.

Warren Buffett has about 99%. His relatives also keep a large portion of their net worth 
in  Berkshire stock as well.

He continues to explain under this second principle that Berkshire Hathaway is a diversified group of quality business, and even though they are unable to guarantee results, they will make money when their shareholders make money and also lose money when their shareholders lose money.


3. Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. We are certain that the rate of per-share progress will diminish in the future — a greatly enlarged capital base will see to that. But we will be disappointed if our rate does not exceed that of the average large American corporation.

The important point to understand from this third principle is that the management of Berkshire is focused on per-share intrinsic business value gains.

Also, Mr. Buffett has been telling his shareholders for a long time that this rate of gain will decrease as the amount of capital they have to work with increases. They will have to find larger investment opportunities that will have a significant impact on the intrinsic business value.


4. Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries. The price and availability of businesses and the need for insurance capital determine any given year’s capital allocation.

Warren Buffett not only owns great businesses, but also owns percentages of great businesses as well. He mentions in the commentary following the fourth principle that the difficulty arises when they have too much cash on hand and not many great investment opportunities. However, he reassures us that a depressed market, [like today], provides great opportunities to buy entire businesses, or add to the ownership of the great businesses as well. These companies also repurchase their own stock in depressed markets as well, so the shareholders benefit even more.


For the detailed reading of The Owner's Manual, please refer to Berkshire's Hathaway's website.

Related Links:
Berkshire Hathaway | Owner’s Manual Part 4
Berkshire Hathaway | Owner’s Manual Part 3
Berkshire Hathaway | Owner’s Manual Part 2
Berkshire Hathaway | Owner’s Manual Part 1

Warren Buffett U.N.C. 1996 lecture | Part 6: Berkshire's performance, children and inheritance

1996 U.N.C. Lecture Series continued...

Talking about Berkshire's performance...

"The greater the capital we work with at Berkshire, the worst we are going to do, everything else being equal, in terms of percentage return on equity."

He says the more capital you have, the smaller the number of investments you can make that would have an impact on the overall net worth of the company. Berkshire's size has increased so much that only huge investments would make sense for the shareholders.

Talking about family, inheritance and money...

"You should leave your children with enough money so that they can do anything, but not enough where they would do nothing."

This is one of my favorite quotes and I like this idea when it comes to inherited wealth. You would want endless possibilities for your children, but you would also want them to be independent and learn from life's challenges as well. The majority of us learned a great deal through the difficult periods of our lives. No one should be robbed of those experiences.

I also admired when Buffett acknowledged that this society was responsible for the majority of his wealth, so he felt the obligation to give back. A very honorable and respectable motivation behind his charitable nature.

We have come to the end of the 1996 U.N.C. lecture series and I hope you can see why I believe this to be one of my favorite sources of Warren Buffett's wisdom online. I hope you have come appreciate not only his investing wisdom, but also gained insight into his character of integrity as well. Thank you for sharing this journey; I hope it helped you build on your foundation of investing or added to your current system.


My next series will be an in-depth analysis of his Chairman's letters going as far back as we could find. This should carry on for several months, but any student of Warren Buffett knows that this is a must-read in order to understand how he thinks about his investments and policy decisions.

Warren Buffett U.N.C. 1996 lecture | Part 5: Buying stocks, bank consolidations and franchise value

1996 U.N.C. Lecture Series continued...

From your point of view, what's the difference between investing in the whole company like See's Candy, or a piece of the company like The Coca Cola Company?

Warren Buffett does not believe there to be a difference in the two. The same considerations and due diligence should be made if one is seeking to invest in stock or purchase companies completely. However, the two main advantages of owning businesses Buffett highlights are:

  1. If you buy the entire company, you have the ability to change the entire management, if necessary. However, he emphasizes that he would not be buying the company if he had the change the management anyway. In previous lectures, we know how important management is to Buffett, therefore if management was not capable and honest, the company would not be an investment worthy of making. This is because he many not know anything of running the business himself. However, you do have the option of changing management at some point in time if you think this is necessary for the future success of the company.
  2. You would have the ability to take the capital of the company and allocate it appropriately. As he does with his holding company of 70+ businesses, all managers send him excess capital, and he allocates capital as he sees fit towards marketable securities or outright purchasing of companies.

Talk about banking consolidation.

"I do not see economies of scale beyond certain points. There is always an advantage to being dominant in a market, but I am not sure whether you have got $200 billion spread across the country and 15% market shares, that you are going to have a better business than someone that has 30% market share in Rockford, Illinois. We used to own a bank in Rockford, Illinois which made 2% on assets after tax and was conservative in every respect but that bank would earn less money as part of a larger institution. So, I don't see great advantages to shareholders in terms of major expansions of banks. ...The acquiring bank's shareholders will be better off in most situations than the acquirer's shareholders."

I was wondering if you comment on your perspective of investments outside of the U.S. and in particular, address how you would hedge currency risk?

" We like companies that can do well in international markets obviously, particularly where they are largely untapped. Would be buy Coca Cola, if instead of being domicile in Atlanta, it was domicile in London or Amsterdam or someplace? The answer is obviously yes. Would I like it just as well? Probably a tiny notch less. Well, there may be nuances of corporate structures or tax factors or attitudes towards capitalists that I do not quite understand as well. So I prefer, by a small margin to many countries and by a large margin to other countries, U.S. domicile operations. But I also prefer companies that earn high returns on capital. We will look any place to find a good business, and I find it easier to find them in the U.S. because I understand the economy a lot better and I understand how they would function in the future than in some other country, but I don't rule them out."

I agree with this as well. A great way to play currencies is to invest in large U.S. corporations that earn a great share of their earnings outside of the U.S. Buffett mentions a couple examples of Coca Cola and Gillette. Other examples include Johnson and Johnson, Proctor and Gamble (acquired Gillette) and Nike. These are all companies in his portfolio.

What companies do you perceive as having franchise value right now?

Warren Buffett defines it using the idea that will people be willing to pay extra for a particular product versus a cheaper alternative. Does your product create that 'share of mind' in customers head? Are they willing to go through the extra effort to purchase your product than settle for another? He then refers to franchise value as a moat around your business. These questions must be asked. How big is the moat and how durable is that moat? The moat could be based on patents, research, pricing etc. You will need a moat in business to prevent a guy from coming along and taking market share.

See the beginning of the final video for the remaining response to this question.



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