Prologue: Owner-Related Business Principles 1
Corporate Governance 15
Finance and Investing 20
Investment Alternatives 26
Common Stock 28
Mergers and Acquisitions 31
Valuation and Accounting 33
Accounting Shenanigans 37
Accounting Policy 37
Tax Matters 38
I. Corporate Governance 39
A. Full and Fair Disclosure 40
B. Boards and Managers 43
C. The Anxieties of Business Change 56
D. Social Compacts 63
E. An Owner-Based Approach to Corporate Charity 65
F. A Principled Approach to Executive Pay 72
G. Risk, Reputation and Oversight 82
II. Finance and Investing 87
A. Mr. Market 88
B. Arbitrage 92
C. Debunking Standard Dogma 98
D. “Value” Investing: A Redundancy 110
E. Intelligent Investing 117
F. Cigar Butts and the Institutional Imperative 124
G. Life and Debt 128
III. Investment Alternatives 133
A. Surveying the Field 134
B. Junk Bonds 138
C. Zero-Coupon Bonds 145
D. Preferred Stock 152
E. Derivatives 162
F. Foreign Currencies and Equities 172
G. Home Ownership: Practice and Policy 179
IV. Common Stock 183
A. The Bane of Trading: Transaction Costs 184
B. Attracting the Right Sort of Investor 189
C. Dividend Policy and Share Repurchases 191
D. Stock Splits and Trading Activity 202
E. Shareholder Strategies 204
F. Berkshire’s Recapitalization 205
V. Mergers and Acquisitions 211
A. Bad Motives and High Prices 212
B. Sensible Share Repurchases Versus Greenmail 223
C. Leveraged Buyouts 223
D. Sound Acquisition Policies 226
E. On Selling One’s Business 230
F. The Buyer of Choice 234
VI. Valuation and Accounting 239
A. Aesop and Inefficient Bush Theory 240
B. Intrinsic Value, Book Value, and Market Price 243
C. Look-Through Earnings 249
D. Economic versus Accounting Goodwill 255
E. Owner Earnings and the Cash Flow Fallacy 264
F. Option Valuation 271
VII. Accounting Shenanigans 275
A. A Satire on Accounting Shenanigans 276
B. Standard Setting 284
C. Stock Options 285
D. “Restructuring” Charges 290
E. Pension Estimates 294
F. Realization Events 296
VIII. Accounting Policy 297
A. Mergers 297
B. Segment Data and Consolidation 299
C. Deferred Taxes 300
D. Retiree Benefits 303
IX. Tax Matters 305
A. Distribution of the Corporate Tax Burden 305
B. Taxation and Investment Philosophy 311
Concept Glossary 323
Disposition Summary 325
|Author||Warren Buffett, Lawrence Cunningham (editor)|
|Genre(s)||Business, Investing, Finance|
|Media Type||Print (hardback and paperback)|
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by Warren Buffett (edited by Lawrence Cunningham)
The essays comprising this book, selected mostly from Warren Buffett’s letters to the shareholders of Berkshire, provide a guide to fundamental business analysis and an approach to wise investing. A central point that Buffett makes is that good investors, rather than focusing on the market, should identify good businesses, attempt to buy them at good prices, and hold them for the long term. Buffett has done just this in his management of Berkshire.
Disagreeing with the dogma popular in recent decades known as modern finance theory that holds that market prices efficiently express business values, Buffett instead argues that the market sets prices in a manic-depressive manner. A good investor learns to insulate himself from market emotions and to make a distinction between market price and intrinsic value. Such an investor will not be bothered by such nonsense as a high “beta”—a measure of volatility academic theorists use as a risk factor and warning—but will understand that volatility provides investment opportunities and will use market drops to make good purchases. Eventually, the market will confirm his good sense.
As the CEO of Berkshire, originally a textile company, Buffett has succeeded hugely by purchasing all of or significant portions of good businesses and then left talented managers alone to operate them. His business-centered, rather than market-oriented, approach has involved supporting the development over time of these companies. Buffett eschews the popular notion in investing of diversification, contending rather that an investor should focus on what he can understand.
Furthermore, a good investor needs to make decisions by regarding a business opportunity on its own terms and in its specific environment. These principles, he demonstrates, were unfortunately forgotten in the mania of the 1980s and 1990s during which “junk” and zero-coupon bonds became popular investment modes and stock prices got out of sync with values, bringing financial disaster for many. The merger movements of these years especially damaged shareholders in the acquiring companies because the mergers often involved undervalued stock of these companies being exchanged for overvalued stock of the acquired companies.
For Buffett, acquisitions provide an example of but one of many ways in which the actions of managements have conflicted with shareholder interests. He demonstrates in these essays that as a CEO he sees an identity between his interests and those of Berkshire shareholders. While most company heads would wish their stock to be sold at the highest possible price, Buffett wants the shares of Berkshire to maintain a close relationship with their intrinsic values; in this way shareholders should receive profits that represent company results over the period of their holdings. Furthermore, under Buffett’s leadership Berkshire avoided stock splits, which he considers mainly as marketing tools.
In the last chapters of the book, Buffett explores both the value and limitations of corporate accounting and laments how pressures to report a profit have damaged accounting integrity. The focus by companies on their stock prices—antagonistic to Buffett’s approach—has produced target prices that have encouraged accounting manipulations. The argument of many executives that stock options should not be considered a cost represents another pressure tending to corrupt honest accounting. As a way to allow a more effective evaluation of a business’s finances, Buffett offers the concept of “look-through earnings” that will credit both retained and distributed earnings. Above all, these essays provide good examples showing there is no substitute for honest, clear, and full disclosure in business.
Introduction: by Lawrence Cunningham
Lawrence Cunningham begins by stating that Warren Buffet’s letters to the shareholders of Berkshire Hathaway Inc., which he has selected and arranged for this volume, provide in clear language an exceptional education on the basic principles of sound business practice. Their central theme is that fundamental analysis should guide business investment, a theme discussed in regard to understanding the proper roles of managers and shareholders, finance, mergers, valuation, and accounting. Cunningham points out that many of Buffet’s principles contradict the central dogmas of the past thirty years held in the major business schools, Wall Street, and corporate America.
Buffett has applied these principles as CEO since 1964 of Berkshire Hathaway, a textile business he purchased and transformed into a holding company that came to own completely or to have substantial stock holdings in a number of profitable companies. (In 1988 nearly 75% of Berkshire’s total net worth was concentrated in three companies: GEICO, The Washington Post, and Capital Cities/ABC.) Buffett’s business principles are what he calls “owner-related”: he considers the shareholders as owners for whom he and Charlie Munger, his managing partner at Berkshire, work to serve their interests, and he gives the managers of the constituent companies held by Berkshire the kind of autonomy they would have were they the actual owners.
In this lengthy introduction, Cunningham discusses each of the major sections into which Buffett’s writing falls. Regarding “Corporate Governance,” having companies managed by first-rate people that Buffett admires and can trust is far more important than devising organizational hierarchies. So-called modern finance and portfolio theory, which assumes market efficiency and stresses diversification and random stock selection, is a poor approach to “Corporate Finance and Investing” because it slights the importance of carefully learning about individual companies. Buffett’s opinions in “Alternatives to Common Stock” and “Common Stock” lament that the widespread short-term, market-oriented approach favored by institutional investors has become dominant in contrast to the long-term, business-oriented approach that he practices. Providing clarity on “Mergers and Acquisitions,” Buffett makes the point that shareholders of the acquiring companies frequently are losers when companies combine. Finally, in the last two sections, devoted to accounting matters, Buffett discusses the proper use of financial information.
I: Corporate Governance
In an extended “Owner’s Manual” provided for Berkshire shareholders—the first selection in this chapter—Buffett summarizes his basic business principles, elaborated in much greater detail throughout the book. As the chief manager of Berkshire, he stresses here his role as a partner with the shareholders and asserts that his interest is identical with theirs: the long-term progress of the companies Berkshire holds. Buffett argues for the need for full and fair reporting by management. CEOs, he says, should avoid predictions since these invariably create targets that lead to unwholesome maneuvering with regard to earnings statements.
Buffett addresses the often-difficult relationship between boards and CEOs: it is all too common for inadequate people in the latter positions to be tolerated indefinitely because performance standards for their jobs rarely exist (in contrast with that of subordinate positions) and because directors often are incapable of or unwilling to make needed changes. These sorts of problems generally are not found in the companies Buffett has assembled for Berkshire, companies led by talented managers he admires whom he wishes to leave alone to do their jobs.
Managers of most public corporations in making charitable donations, Buffett points out, never solicit the opinion of their owner-shareholders. At Berkshire, he has devised a unique model that allows shareholders to designate charitable recipients in a way that is included within the company’s tax deduction allowances. Another common problem in corporate America that Buffett has attempted to solve is how stock options benefit executives in a manner detached from their real job performance. For managers of Berkshire companies, Buffett has designed an incentive compensation system that seeks to provide rewards on the basis of results achieved rather than stock price.
II. Corporate Finance and Investing
The key to successful investing, Buffett posits, is to purchase shares in good businesses at times when market prices are at a large discount from business values. This might seem commonsense, but Buffett points out that most institutional investors in the 1970s, under the spell of business school professors who contended that markets were totally efficient in establishing stock prices, considered underlying business values to be of little importance.
Buffett uses the example of the hypothetical Mr. Market, a creation of his teacher, Ben Graham. A manic-depressive, Mr. Market spews out price quotations that reflect his severe emotional pathology. A headache for many investors, this is good news for the wise investor able to insulate himself from these contagious emotions and make investment decisions based on the real values of businesses he can understand. Following this approach, such investors will find that times of declining stock prices provide the best opportunities. Eventually, Buffett knows, the market will validate their decisions.
Investment decisions, rather than being based on opinions about short-term market prospects, instead should reflect judgments about long-term prospects of specific companies. What makes sense for a business owner is the same as what is smart for a shareholder: holding onto a piece of an outstanding business with tenacity. “According the name ‘investors’ to institutions that trade actively,” he writes, “is like calling someone who repeatedly engages in one-night stands a romantic.” While Buffett concedes that he might sometimes make slightly higher profits were he an active trader, he justifies his holding strategy in part on the value of the trusting relationships he has formed with his talented managers.
When it comes to conventional portfolio theory, Buffett disagrees with the popular notion of diversification in investing, arguing rather that investors should focus on what they understand. The overuse of “betas” as measures of risk in stock purchasing he considers ridiculous since it is exactly the volatility of stocks that provides opportunities for investors who’ve taken the trouble to determine the intrinsic value of companies. For Buffett the idea of “value investing” is redundant. His definition of the best businesses to own are those that over an extended period can employ large amounts of capital at very high rates of return. In acquiring such, whether they are complete companies or large share portions, he insists on the importance of a margin of safety: the price paid should not exceed value.
III. Alternatives to Common Stock
In the selections making up this chapter, Buffett applies his principles to various investment categories areas that fulfill the criteria of being both understandable and offering good deals. He stresses the need to comprehend specific business situations as opposed to following investing trends. Purchasing low-grade bonds has sometimes been a good strategy for Buffett, but when this became a widespread practice in the “junk bond” mania of the 1980s and 1990s, it produced financial disasters. Similarly, zero-coupon bonds at times made good investments, but these produced unfortunate results when issued by companies with weaker and weaker credit. Buffett here also shows the breadth of his investment wisdom in discussions about convertible preferred stocks and about experiences with oil and silver investments.
IV. Common Stock
In contrast to CEOs who wish their company’s stock to trade at the highest possible price, Buffett wants Berkshire shares to sell at close to their intrinsic value so that holders of shares for any particular period will benefit according to the company’s business results during that period. To make real this intention, he has sought to attract shareholders who have a long-term perspective rather than a short-term, market-oriented strategy.
Another area in which Berkshire has diverged from common corporate practices involves dividend policy. For each dollar retained by a corporation, Buffett believes that at least one dollar of market value should be created for the owners. Berkshire has never paid a dividend. Buffett believes that a major reason for its success has been his ability to deploy effectively the cash generated by Berkshire’s component businesses, resulting in the company’s stock prices increasing at rates well in excess of market averages. It is all too common elsewhere for corporate managers to invest in subsidiary businesses that may inflate their egos but often provide poor returns. In Buffett’s opinion, managers should put themselves in the place of shareholders with regard to payout decisions. He specifically applauds those managements which decide to purchase their own companies’ shares when available at prices less than the intrinsic value.
In keeping with the importance of maintaining a rational stock price and a business—rather than market—orientation, Berkshire has never split its stock. Finally, in 1996 Buffett did authorize the issuance of Class B shares (with 1/30 the rights of the existing shares) mainly to stop Wall St. operators who had created clones of Berkshire with investment trusts that attracted buyers who didn’t understand Berkshire’s business philosophy.
V. Mergers and Acquisitions
Buffett demonstrates that in making acquisitions companies commonly reduce the wealth of their shareholders because the exchange is an unequal one in which the acquirer gives up $2 to receive $1 in value. The often-missed irony, Buffett points out, is that were the buying company to sell its entire business, it could likely get full intrinsic value. However, in making an acquisition—which in fact involves a partial sale of itself via the issuing of shares—it can get a price no higher than what the market assigns it, which is frequently lower than intrinsic value. In regard to acquisitions (which illustrate but one way that a CEO’s goals are often at odds with the interests of shareholders), Buffett differs from the practices of most corporate heads: Berkshire strongly prefers to use cash instead of stock in buying companies.
Unusually for an acquiring company, Berkshire seeks to purchase companies from owners whom it wishes to retain as managers and who are promised autonomy to run their businesses. Buffett makes it clear that he especially prefers to buy from owners who have lovingly built businesses and will be most happy continuing to operate them, freed from having to deal with the various enticements to which generating excess cash would have subjected them.
VI. Accounting and Valuation
Buffett’s selections in this chapter show both the importance and limitations of accounting methods in understanding a business or investment. He discusses the differences between accounting earnings and economic earnings, between accounting goodwill and economic goodwill, and between book value and intrinsic value. As a set of conventions, accounting can be manipulated, demonstrated here in a satire by Ben Graham on how U.S. Steel could report greatly enhanced earnings without spending extra cash or increasing sales.
One concept Buffett offers to help evaluate a company’s finances he calls “look-through earnings.” Because conventional accounting calls for reporting only dividends received by an investor and ignores the undistributed earnings that are a large part of the value received for a company such as Berkshire, this concept can be a valuable tool for an investor.
VII. Accounting Policy and Tax Matters
Whatever accounting methods are chosen, Buffett states that the key challenge is to report data that helps readers answer three questions: What is a company’s real value? How able is it to meet its future obligations? How effective are its managers in running the business? With regards to a continuing accounting debate over whether mergers should be considered purchases of one company by another (favored by accounting purists) or the pooling of two companies (favored by managers), Buffett offers what he believes a realistic solution: the asset should be recorded for goodwill but should not be charged against future earnings.
Buffett addresses in this chapter pressures that tend to corrupt the independence and integrity of accounting practices. On the issue of whether stock options should be considered a business expense—a position generally contested by management—Buffett believes that the argument that they are difficult to estimate carries little water.
The common practice of handling “restructuring” charges, which often represent costs incurred over years, by placing them in a single quarter misrepresents a company’s earnings record and is thus deceptive, even if legal. Furthermore, the general assumption by executives that their job is to maximize a company’s share price leads to unsavory accounting maneuvers.
In the final sections, Buffett addresses various tax matters. On the debate over whether changes in taxation rates are reflected in the prices paid by consumers or absorbed by corporations (as either increased or decreased earnings), Buffett explains how the answer varies according to market conditions. The federal income taxes paid by Berkshire are substantial, but Buffett points out in conclusion that his business policies—long-term investing and a strong preference for owning 100% of businesses—have provided not only business benefits but also valuable tax advantages.