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.