Investing like Warren Buffett | Part 3

Part 3 of our Investing like Warren Buffett series discusses his 1979 Chairman’s letter to shareholders of Berkshire Hathaway Inc. Let’s see what important investment advice he leaves with us this year.

Click here for 1979 Chairman’s Letter to Shareholders

 

“The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”

On Long Term Results

It is more important to pay attention to the long term results of stock ownership, rather than the short term performance. Unrealized gains or losses from stock ownership should be viewed different from the actual earnings from operations.

“In measuring long term economic performance - in contrast to yearly performance - we believe it is appropriate to recognize fully any realized capital gains or losses as well as extraordinary items, and also to utilize financial statements presenting equity securities at market value. Such capital gains or losses, either realized or unrealized, are fully as important to shareholders over a period of years as earnings realized in a more routine manner through operations; it is just that their impact is often extremely capricious in the short run, a characteristic that makes them inappropriate as an indicator of single year managerial performance.”

 

Be aware of those asset-intensive businesses with great economics, they may not always be great investments. Sometimes, a simple business is the better choice.

“In some businesses - a network TV station, for example - it is virtually impossible to avoid earning extraordinary returns on tangible capital employed in the business. And assets in such businesses sell at equally extraordinary prices, one thousand cents or more on the dollar, a valuation reflecting the splendid, almost unavoidable, economic results obtainable. Despite a fancy price tag, the “easy” business may be the better route to go.”

 

“We can speak from experience, having tried the other route. Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment. By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing. But the purchase was a mistake. While we labored mightily, new problems arose as fast as old problems were tamed.”

On Turnarounds;

“Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.”

On attracting shareholders that have similar expectations through communication and policies;

“In large part, companies obtain the shareholder constituency that they seek and deserve. If they focus their thinking and communications on short-term results or short-term stock market consequences they will, in large part, attract shareholders who focus on the same factors.  And if they are cynical in their treatment of investors, eventually that cynicism is highly likely to be returned by the investment community.”

“Phil Fisher, a respected investor and author, once likened the policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A restaurant could seek a given clientele - patrons of fast foods, elegant dining, Oriental food, etc. - and eventually obtain an appropriate group of devotees. If the job were expertly done, that clientele, pleased with the service, menu, and price level offered, would return consistently. But the restaurant could not change its character constantly and end up with a happy and stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revolving door of confused and dissatisfied customers.”

Lessons learned from this report:

1. Think long term when it comes to investing.
   
2. Buy businesses that are simple and easy to understand.
   
3. It is better to buy a good business at a fair price than a poor business at a bargain price.
   
4. Look for management that are honest and consistent in the communication and policies.

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Berkshire Hathaway | Owner's Manual Pt. 3

Owner-related business principles cont'd

9. We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.

This has been the reason why Berkshire has not and will not pay dividends. If they continue to find opportunities to effectively deploy capital, they will not issue the funds to shareholders in the form of dividends. They have continuously proven that retained earnings are being effectively used, therefore shareholders should appreciate the fact that they have one of the best capital allocators in the world investing for them.

 

10. We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance — not only mergers or public stock offerings, but stock-for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company — and that is what the issuance of shares amounts to — on a basis inconsistent with the value of the entire enterprise.

The important point to understand here is that Berkshire does not dilute the owners' common stock by issuing shares. The only time that issuing shares make sense is when there is an equitable trade in value. Also, pay attention to when companies you own issue stock and question whether or not the stock is undervalued; this is normally an indication that the managers are not wisely investing your money.

 

11. You should be fully aware of one attitude Charlie and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub-par businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.) Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.

This principle speaks to the competency of the management. They will not invest unnecessarily in a sub-par business and will not exit a business if it can still act as a cash cow and add to the float. They will however, take action if a company problem's can be cured.

 

12. We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less. Moreover, as a company with a major communications business, it would be inexcusable for us to apply lesser standards of accuracy, balance and incisiveness when reporting on ourselves than we would expect our news people to apply when reporting on others. We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private.

This is one of the most important principles that investors should pay attention to. Buffett is as clear and honest as possible when he reports results to the owners of Berkshire Hathaway. His annual reports are seen as some of the most valuable investment documents in the value investing world. They are filled with precious information about his investing philosophy and decisions over the years and is considered a must read for all in the business. His reporting techniques should be used as a model for the industry.

 

13. Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we normally will not talk about our investment ideas. This ban extends even to securities we have sold (because we may purchase them again) and to stocks we are incorrectly rumored to be buying. If we deny those reports but say “no comment” on other occasions, the no-comments become confirmation.

Buffett makes it clear that they do not discuss their investment ideas because these ideas are rare and may be subject to competitive appropriation. He fully believes in discussing his investment philosophy which he learned from Benjamin Graham.

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.

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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 3: We want partners in Berkshire.

 

More questions from the U.N.C. Lecture Series.

3. Mr. Buffett, you invest in companies with managers you say you trust and admire. I would like to know who you trust and admire in business and politics today?

He mentions CEO of Cap Cities, Tom Murphy. He also admires the great two manager combination at The Coca Cola Company, (Roberto and Don) that took the market value from $5 billion to $60 billion in about 11 years. He also includes Bill Gates. Even though he understands nothing about Microsoft's business, he has great respect for Bill Gates as a businessman.

The most important advice he gave in his response to this question is:

"I think it is crazy to work with people that make your stomach churn, and if you are in a job like that, think about changing. Working with people you don't like in a business is kind of like marrying for money, which is probably a bad idea under normal circumstance, but it's crazy if you are rich. I work with people I like, I tap dance to work everyday and work with people who are terrific."

4. Have you considered splitting the stock?

Many have asked this question of Mr. Buffett previously and Berkshire has the highest price of any company that trades on the NYSE. His response was as always classic and consistent with his previous remarks.

"At Berkshire, I want to get people as shareholders, as partners of mine, who have the same expectations, same time horizons, the same methods of measurement that I have. It's crazy to go into business with people that have entirely different expectations than you have. The only way that I can affect that, since Berkshire is a public company, is through communication and policies. Therefore, I will try to have policies so that the right kind of people with similar expectations will be attracted to the company. I would like to have people as owners who would expect to own it the rest of their lives."

Essentially he goes on to say that by not splitting the stock, he eliminates people who are in the markets to trade actively, and these are not the people he would like as partners in Berkshire.

5. Discuss some of your investment mistakes.

Buffett says that he makes the most mistakes when he has a lot of cash available. Usually cash is king, but in more recent lectures, he states that cash is only king if it is being put to good use. Cash has no value if it just sits there doing nothing; it actually loses value.

Please refer to the video for the rest of his comments.