Category Archives: Management

Book value as proxy for intrinsic value

In his annual letter (February 26, 2011) to Berkshire Hathaway shareholders for Year 2010, chairman Warren Buffett shared his and Charlie Munger’s thoughts on intrinsic value as a measurement of performance:

“Charlie and I believe that those entrusted with handling the funds of others should establish performance goals at the onset of their stewardship. Lacking such standards, managements are tempted to shoot the arrow of performance and then paint the bull’s-eye around wherever it lands.

“In Berkshire’s case, we long ago told you that our job is to increase per-share intrinsic value at a rate greater than the increase (including dividends) of the S&P 500. In some years we succeed; in others we fail. But, if we are unable over time to reach that goal, we have done nothing for our investors, who by themselves could have realized an equal or better result by owning an index fund.

“The challenge, of course, is the calculation of intrinsic value. Present that task to Charlie and me separately, and you will get two different answers. Precision just isn’t possible.

“To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value – book value – when measuring our performance. To be sure, some of our businesses are worth far more than their carrying value on our books…But since that premium seldom swings wildly from year to year, book value can serve as a reasonable device for tracking how we are doing.”

Recommended reading:

(1) The Essays of Warren Buffett: Lessons for Corporate America, Third Edition

(2) Berkshire Hathaway Letters to Shareholders, 1965-2013

Warren Buffett on partnership

When it comes to owning shares in Berkshire Hathaway, Warren Buffett’s hope, as spelt out in one of Berkshire Hathaway’s business-related principles in its owner’s manual, is that “you do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous”. The idea is to “visualize yourself as a part owner of a business that you expect to stay with indefinitely”. Berkshire Hathaway does not view its shareholders as “faceless members of an ever-shifting crowd, but rather as co-venturers”. One of Berkshire Hathaway’s owner-related business principles adopts the attitude of treating its business as a partnership although it is corporate in form.

Warren Buffett and Charlie Munger think of their shareholders as “owner-partners”, and of themselves as “managing partners”. “Because of the size of our shareholdings we are also, for better or worse, controlling partners. We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.”

Recommended reading:

(1) The Essays of Warren Buffett: Lessons for Corporate America, Third Edition

(2) Berkshire Hathaway Letters to Shareholders, 1965-2013

How Warren Buffett handles management succession

Warren Buffett is a great believer in succession planning. In his chairman’s letter (28 February 2006) to Berkshire Hathaway shareholders for Year 2005, he said: “As owners, you are naturally concerned about whether I will insist on continuing as CEO after I begin to fade and, if so, how the board will handle that problem. You also want to know what happens if I should die tonight.”

Mr Buffett said: “That second question is easy to answer. Most of our many businesses have strong market positions, significant momentum, and terrific managers. The special Berkshire culture is deeply ingrained throughout our subsidiaries, and these operations won’t miss a beat when I die.

“Moreover, we have three managers at Berkshire who are reasonably young and fully capable of being CEO. Any of the three would be much better at certain management aspects of my job than I. On the minus side, none has my crossover experience that allows me to be comfortable making decisions in either the business arena or in investments. That problem will be solved by having another person in the organization handle marketable securities. That’s an interesting job at Berkshire, and the new CEO will have no problem in hiring a talented individual to do it. Indeed, that’s what we have done at GEICO for 26 years, and our results have been terrific.”

Mr Buffett added: “Berkshire’s board has fully discussed each of the three CEO candidates and has unanimously agreed on the person who should succeed me if a replacement were needed today. The directors stay updated on this subject and could alter their view as circumstances change – new managerial stars may emerge and present ones will age. The important point is that the directors know now – and will always know in the future – exactly what they will do when the need arises.”

Addressing the other question, Mr Buffett said:  “The other question that must be addressed is whether the Board will be prepared to make a change if that need should arise not from my death but rather from my decay, particularly if this decay is accompanied by my delusionally thinking that I am reaching new peaks of managerial brilliance. That problem would not be unique to me. Charlie and I have faced this situation from time to time at Berkshire’s subsidiaries. Humans age at greatly varying rates – but sooner or later their talents and vigor decline. Some managers remain effective well into their 80s – Charlie is a wonder at 82 – and others noticeably fade in their 60s. When their abilities ebb, so usually do their powers of self-assessment.

“Someone else often needs to blow the whistle.”

Mr Buffett also said: “When that time comes for me, our board will have to step up to the job. From a financial standpoint, its members are unusually motivated to do so. I know of no other board in the country in which the financial interests of directors are so completely aligned with those of shareholders. Few boards even come close. On a personal level, however, it is extraordinarily difficult for most people to tell someone, particularly a friend, that he or she is no longer capable.

“If I become a candidate for that message, however, our board will be doing me a favor by delivering it.

“Every share of Berkshire that I own is destined to go to philanthropies, and I want society to reap the maximum good from these gifts and bequests. It would be a tragedy if the philanthropic potential of my holdings was diminished because my associates shirked their responsibility to (tenderly, I hope) show me the door. But don’t worry about this. We have an outstanding group of directors, and they will always do what’s right for shareholders.

“And while we are on the subject, I feel terrific.”

Recommended reading:

(1) The Essays of Warren Buffett: Lessons for Corporate America, Third Edition

(2) Berkshire Hathaway Letters to Shareholders, 1965-2013

Berkshire Hathaway principles on manager-owner relationship

Among Warren Buffett’s letters to Berkshire Hathaway stakeholders, one that gave shareholders a good summary of Berkshire Hathaway’s major business principles pertaining to the manager-owner relationship is that of March 14, 1984 for Year 1983.

Here is a gist of the summary:

* Although Berkshire Hathaway’s form is corporate, its attitude is partnership, treating shareholders as owner-partners, with Warren Buffett and Charlie Munger as managing partners.

* In line with the owner-orientation, its directors are all major shareholders of Berkshire Hathaway. “In the case of at least four of the five, over 50% of family net worth is represented by holdings of Berkshire. We eat our own cooking.”

* Berkshire Hathaway’s long-term economic goal (subject to some qualifications) is to maximize the average annual rate of gain in intrinsic business value on a per-share basis.

* Berkshire Hathaway’s preference is to reach this goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Its second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by its insurance subsidiaries.

* “Because of this two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I (Warren Buffett), both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance. These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them.”

* Accounting consequences do not influence Berkshire Hathaway’s operating or capital-allocation decisions. When acquisition costs are similar, it much prefers to purchase $2 of earnings that is not reportable by it under standard accounting principles than to purchase $1 of earnings that is reportable. “In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.”

* Berkshire Hathaway rarely uses much debt and, when it does, it attempts to structure it on a long-term fixed rate basis. “We will reject interesting opportunities rather than over-leverage our balance sheet.”

* A managerial “wish list” will not be filled at shareholder expense. “We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders.”

* “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.”

* “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.”

*”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, and are 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 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.”

* “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.”

“That completes the catechism,” said the letter.”

Recommended reading:

(1) The Essays of Warren Buffett: Lessons for Corporate America, Third Edition

(2) Berkshire Hathaway Letters to Shareholders, 1965-2013