Intelligent Investor Club

Berkshire Annual Letter 1999 (Part 4)

There are a couple of conditions which must exist for a share repurchase scheme to be meaningful to shareholders.

The company must available funds (cash plus sensible borrowing capacity) that more than meets the near term needs of the business. These needs consists of:

• expenditures a company must make to maintain its competitive position and
• optional outlays aimed at business growth.

…Continue reading » Share Repurchases

Intrinsic Value and Capital Allocation

When managers make capital allocation decisions, it is important that they act in ways that increase per-share intrinsic value and avoid things that decrease it.

For example, in considering business mergers and acquisitions, many managers tend to focus on whether the transaction would be immediately dilutive or anti-dilutive to earnings per share. This is insufficient.

Consider our previous example on college education. If a 25-year-old first year MBA student were to merge his future economic interests with that of a 25-year-old laborer, it would enhance his near-term earnings since he isn’t earning anything at the moment.

But such a deal would be downright silly for the MBA student.

Similarly in corporate transactions, it is important to look not just at the current earnings of the prospective acquiree, but to look at the effect on the intrinsic value of the acquiree.

Unfortunately, with the way many major acquisitions are done, they only serves to benefit the shareholders of the acquiree and increase the income of the acquirer’s management, but reduces the wealth of the acquirer’s shareholders.

A really good business will always end up generating more cash than it can use after its early years. While this money could be distributed to shareholders by way of dividends or share repurchases, often the CEO will engage some consultants or investment bankers for acquisition advice.

As Warren said, “That’s like asking your interior decorator whether you need a $50,000 rug.“

In Berkshire, the managers of the individual businesses will first look for ways that they can deploy their excess capital in their own businesses. The balance that is left will be sent to Warren Buffett and Charlie Munger, who will use those funds in ways that build per-share intrinsic value.

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Berkshire Hathaway seldom issues out shares. On 1st October 1964, there were 1,137,778 shares outstanding. On March 1993, that number has increased to 1,152,547 shares.

This is due to Warren Buffett’s firm policy about issuing shares of Berkshire only when they receive as much value as they give. Bershire’s size should only be increased when doing so increases the wealth of its owners.

The long term goal of Berkshire is to increase its per-share intrinsic value at a 15% annual rate.

This objective cannot be attained in a smooth manner because a high proportion of Berkshire’s net worth is represented by common stocks. Generally accepted accounting principles(GAAP) accounting rules require that these securities be valued at their market prices (less an adjustment for tax on any net unrealized appreciation).

Frequent changes in equity prices will ensure a great deal of fluctuations in their annual results. This is especially so when you compare it to the typical industrial company.

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Purchase of Marketable Securities

The selection of securities that Warren buys can be classfied under five categories: (1) long-term common stock investments, (2) medium-term fixed-income securities, (3) long-term fixed income securities, (4) short-term cash equivalents, and (5) short-term arbitrage commitments.

He has no particular bias when it comes to choosing from these categories. The aim is to achieve for the highest after-tax returns as measured by “mathematical expectation,” limiting himself always to investment alternatives that he can understand. His criteria have nothing to do with maximizing immediately reportable earnings; rather, is to maximize eventual net worth.

Common Stocks

In 1987, Mr Market was on a major rampage until Oct, when it had a sudden seizure. The net result was a gain of 2.3% for the Dow.

Many prestigious money managers now focus on what they expect other money managers to do in the days ahead, rather than on what the business will do. An extreme example of what their attitude leads to is “portfolio insurance”, where a downtick of a given magnitude automatically produces a huge sell order.

Considering that huge sums are controlled by managers following such practices, is it any surprise that markets sometimes behave in illogical fashion?

After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price?

Such markets are ideal for any investor – small or large – so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
Mr. Market will offer us opportunities – you can be sure of that – and, when he does, we will be willing and able to participate.

Bonds

Warren continues to parking most of his money in medium-term tax-exempt bonds, with an aversion to long-term bonds. Even back in 1986, he is already not optimistic about the long term future of U.S. currency due to the enormous trade deficit.

The pileup of “claim checks” in the hands of foreigners will ultimately lead to an increased pressure on the issuer to dilute their value by inflating the currency.

While recognizing the possibility that he may be wrong and that present interest rates may adequately compensate for the inflationary risk, Warren retains a general fear of long-term bonds.

Market Rumours

It is often reported in the press about Berkshire’s purchase or sale of various securities. Warren does not comment in any way on rumors, whether they are true or false. If he were to deny the incorrect reports and refuse comment on the correct ones, he would in effect be commenting on all.

His advice for anyone who wants to participate in whatever Berkshire is doing, is to simply buy the Berkshire stock!

About Debt

It is likely that Berkshire could improve its return on equity by moving to a much higher, though still conventional, debt-to-business-value ratio. It’s even more likely that we could handle such a ratio, without problems.

However, “likely” is not good enough for Warren. He wishes to be “certain”. Thus he adheres to policies – both in regard to debt and all other matters – that will allow them to achieve acceptable long-term results under extraordinarily adverse conditions, rather than optimal results under a normal range of conditions.

Good business or investment decisions will eventually lead to economic gains, even without the use of excessive leverage. However, he is willing to borrow as long as the amount does not pose a threat to Berkshire’s well being.

His strategy is to finance in anticipation of need rather than in reaction to it. A business obtains the best financial results possible by managing both sides of its balance sheet well. This means obtaining the highest-possible return on assets and the lowest-possible cost on liabilities.

It is often that opportunities for intelligent action on both fronts do not coincide. Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky. Therefore, his action on the liability side should sometimes be taken independent of any action on the asset side.

This fund-first, buy-or-expand-later policy almost always penalizes near-term earnings. For example, Berkshire is now earning about 6.5% on the $250 million they recently raised at 10%, a disparity that is currently costing them about $160,000 per week.

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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.

Taxes

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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This year’s letter started with a reiteration of something that was mentioned in the previous year’s letter. Even though undistributed and unrecorded earnings of non-controlled holdings will not be reflected in the accounts, they will eventually be translated into tangible value over the long run.

A note on general acquisition behaviour. Buffett would rather buy 10% of X company at Y per share than 100% of X at 2Y per share. Most corporate managers however, prefer just the reverse. This results in a larger empire, but poorer citizens.

There are however some dazzling exceptions and most of them fall into two major categories.

The first category involves purchase of business that are well adapted to an inflationary environment. These businesses are able to raise their price without fear of significant fear of loss of market share or unit volume. They are also able to accomodate large increases in their volume with only minor addition of investment capital.

The second category involves the mangerial superstar – people who are able to recognise businesses that are “the rare prince disguised as a toad”.

Buffett finds values most easily through the open-market purchase of fractional positions in companies with excellent business franchises and competent, honest managements.

In most cases, undistributed earnings from such companies will produce full value for Berkshire and its shareholders. If they don’t, it could be due to three reasons: (1) the management (2) the future economics of the business; or (3) the price that was paid.

There follows a lengthy discussion on “Equity Value-Added”. To justify an investment in equity, there should be additional earnings above passive investments returns. This is derived from the employment of managerial and entrepreneurial skills in conjunction with that equity capital.

Also, since an equity capital position requires additional risks, we should be getting a higher return for the risk.

When a business is able to achieve this, a dollar of each is usually valued at more than a hundred cents. Conversely, if investment returns of passive instruments are higher than the returns from a business, such a business will be valued at less than a dollar for each dollar.

The bottomline? Interest rates (an inflation rates) would and will affect the valuation of any business.

An ironic situation is that a “bad” business will usually need to retain most of it’s capital to continue operating. Consider if you have a 5% bond and current rates were about 10%. Will you take the coupons from the bond and pay hundred cents on the dollar for more 5% bonds when the same dollar will buy you a 10% bond? Yet, that is what “bad” business are doing by retaining capital. Shareholders would be better served receiving the earnings as dividends and re-investing them elsewhere.

On the other hand, a “good” business with a high return on equity should retain all it’s capital so that shareholders can earn premium returns on enhanced capital.