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Archive for May, 2006

Of Corporate Taxes

In my earlier post, I asked a question on the effects of raised corporate taxes. Will it flow through to the consumers in the form of increased prices?

There are some advocates who insist that any forms of increased in corporate taxes will only lead to higher prices to offset the increase for the corporation. Does this mean that if there is a corporate tax decrease, it will lead to reduced prices for consumers?

On the other hand, there are some who think that corporates will absorb any increase in taxes (as well as enjoy the benefits when taxes are reduced).

Buffett’s view is that it really depends on the strength of the business franchise and regulations.

1) When the franchise is strong and after-tax profits is precisely regulated (eg. utilities), the prices will usually adjust to reflect the change in corporate tax rate.

2) When the business franchise is weak but the industry is price competitive, market forces will usually help to regulate the price.

3) In the case of an unregulated business with a strong franchise, it is usually the corporation that benefits from tax changes. They will increase prices when taxes are increased; and enjoy increased profits (with no reduction in prices) when taxes are reduced.

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The Job of Warren Buffett

Warren Buffett really has only two jobs. One is attracting and keeping outstanding managers to run the various operations. This he has no problems doing as one of the criteria that he uses for buying any business is an outstanding management team.

And he never gets in the way of these managerial stars. They got to where they were because they knew what they were doing. If you were managing a top soccer team and had world class players, would you be teaching them technical skills like how to kick a ball?

Rather, the value a soccer manager bring to the team lies in team selection and formulation of tactics. This is what Buffett’s second job is. The task of capital allocation. This is a challenge as Berkshire generates a lot of capital.

A business earning 23% annually and retaining it all will be far more affected by today’s capital allocations than a business earning 10% and distributing half of that to shareholders.

As far as Buffett is concerned, there are five options to deploy the capital: (1) long-term common stock investments; (2) long-term fixed-income securities; (3) medium-term fixed-income securities; (4) short-term cash equivalents; and (5) short-term arbitrage commitments.

Of these, he likes common stocks the most but in times of greed where stock prices are gloriously uncoupled from the underlying business itself, he would rather not take part in such foolishness. After all, stocks can’t outperform businesses indefinitely.

To have a material difference in the performance of Berkshire, any business acquisition would have to be of a significant amount. And as Berkshire gets larger, any returns are almost certain to drop.

News Hole in Newspapers

In any newspaper, there is an important statistic known as the news hole. This is the portion of the total space in the paper that is devoted to news. A typical newspaper has a news hole of about 40% compared to 50% for “The Buffalo News”.

While 10% might not sound like a lot, it is the reason why “The Buffalo New” has a much greater readership compared to it’s rivals.

A paper with 30 pages of advertisements and a 40% news hole delivers 20 pages of news a day, whereas another paper with a 50% news hole matches 30 pages of ads with 30 pages of news. For the same amount of ads, the latter has 50% more news content!

The Fechheimer Bros. Co

There was a purchase of a company called Fechheimer in the past year. It’s basically a uniform manufacturing and distribution business. The interesting point about this acquisition is that neither Buffett nor Charlie Munger went to Cincinnati, headquarters for Fechheimer, to see their operation.

This is actually Buffett’s usual practice. He does not rely on insights obtained from plant inspections to decide whether or not to purchase a company. Rather, he considers the economics of the business as well as the quality of the people running the show.


I will leave you with a question. If corporate taxes are increased, does it really affect the corporations? Do they pass on the increased taxes to the consumers by increasing prices? Or do they simply absorb the increased taxes?

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It has been a while since my last update as I had been busy with the Singapore elections. Don’t get me wrong; I was neither involved as a candidate nor a member of any political party. :)

Rather, I was reading the news and analysis by other bloggers. For a change, it was refreshing to read about some alternative views. There were also some in-depth articles which were much better than those in our local press.

Anyway, back to the Warren’s letter. This time round, I shall try to add in a bit of my writing style. (Past postings were mostly re-phrased from the actual letters.)

Limits of Growth

Anyone who has studied economics will know about the law of diminishing returns. The same principle applies when a company is growing. A company could be earning a very high return on equity. But as it gets bigger, it will have difficulty substaining this rate of return. “Growth eventually dampens exceptional economics.

In such a case, the company could try looking for other business to invest in (often with disasterous effects) or return the surplus cash generated to shareholders.

Business Value Vs Market Value

The Efficient Market Hypothesis (EMH) says that securities will be appropriately priced and reflect all available information. Which means to say that the market value will be close to business value.

Warren believes that is far from the truth. In his own words, “the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.

Of course, not forgetting three other points: the business must have fine underlying economics, an able management concentrating on the interests of shareholders, and a buyer willing to pay full business value at the time of divestment.

Shutdown of Textile Business

The unprofitability of the textile business was discussed previously. Rather than injecting huge amount of capital to keep it alive (which would have resulted in terrible returns on ever-growing amounts of capital), Warren decided to bite the bullet and shut down the business.

A few years ago, he wrote, “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” His views remain unchanged.

Another lesson learned during the diposal of the textile business was that the assets sold for much less than they were reflected on the books. If you are one of those investors who weigh book value heavily in your stock buying decision, make sure you don’t do it blindly!

Using Options as Compensation

A common argument in using options to reward management is that it puts them in the same boat as shareholders. Boat, yes. Same boat, no. Here are some reasons why:

1) Owners have a burden of capital cost; option holders need not pay nothing.

2) Owners have potential upside rewards as well as downside risk, option holders have no downside.

3) The dividend policy of the company has an opposite effect on owners and option holders. For an option holder, he would prefer that no dividends are paid out so that the earnings (and share price) increase year after year.

Warren prefers using a system of cash reward pegged to performance. The managers can then use these money to purchase the stock of the company from the open market. By accepting both the risks and the carrying costs that go with outright purchases, these managers truly walk in the shoes of owners.

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