Berkshire Hathaway’s four long-standing criteria in selecting a new board director: owner-oriented, business-savvy, interested and truly independent.
Chairman Warren Buffett said: “I say “truly” because many
directors who are now deemed independent by various authorities and observers are far from that, relying
heavily as they do on directors’ fees to maintain their standard of living. These payments, which come in
many forms, often range between $150,000 and $250,000 annually, compensation that may approach or
even exceed all other income of the “independent” director. And – surprise, surprise – director
compensation has soared in recent years, pushed up by recommendations from corporate America’s
favorite consultant, Ratchet, Ratchet and Bingo. (The name may be phony, but the action it conveys is
“Charlie and I believe our four criteria are essential if directors are to do their job – which, by law,
is to faithfully represent owners. Yet these criteria are usually ignored. Instead, consultants and CEOs
seeking board candidates will often say, “We’re looking for a woman,” or “a Hispanic,” or “someone from
abroad,” or what have you. It sometimes sounds as if the mission is to stock Noah’s ark. Over the years
I’ve been queried many times about potential directors and have yet to hear anyone ask, “Does he think like
an intelligent owner?”
“The questions I instead get would sound ridiculous to someone seeking candidates for, say, a
football team, or an arbitration panel or a military command. In those cases, the selectors would look for
people who had the specific talents and attitudes that were required for a specialized job. At Berkshire, we
are in the specialized activity of running a business well, and therefore we seek business judgment.
“That’s exactly what we’ve found in Susan Decker, CFO of Yahoo!, who will join our board at the
annual meeting. We are lucky to have her: She scores very high on our four criteria and additionally, at 44,
is young – an attribute, as you may have noticed, that your Chairman has long lacked. We will seek more
young directors in the future, but never by slighting the four qualities that we insist upon.”
Source: Chairman Warren Buffett’s FY2006 letter to Berkshire Hathaway shareholders
“Woody Allen once explained that the advantage of being bi-sexual is that it doubles your chance of finding a date on Saturday night,” Warren Buffett said in his FY2015 letter to Berkshire Hathaway. Why did the Berkshire Hathaway chairman say this?
“In like manner – well, not exactly like manner – our appetite for either operating businesses or passive investments doubles our chances of finding sensible uses for Berkshire’s endless gusher of cash. Beyond that, having a huge portfolio of marketable securities gives us a stockpile of funds that can be tapped when an elephant-sized acquisition is offered to us,” Mr Buffett continued.
A stockpile of funds from marketable securities?
Yes a stockpile. “Berkshire increased its ownership interest last year in each of its “Big Four” investments – American Express, Coca-Cola, IBM and Wells Fargo. We purchased additional shares of IBM (increasing our ownership to 8.4% versus 7.8% at yearend 2014) and Wells Fargo (going to 9.8% from 9.4%). At the other two companies, Coca-Cola and American Express, stock repurchases raised our percentage ownership. Our equity in Coca-Cola grew from 9.2% to 9.3%, and our interest in American Express increased from 14.8% to 15.6%. In case you think these seemingly small changes aren’t important, consider this math: For the four companies in aggregate, each increase of one percentage point in our ownership raises Berkshire’s portion of their annual earnings by about $500 million.”
The legendary investor’s subsequent FY2016 letter to Berkshire Hathaway shows the stakes in these Big Four as at end-2016 were: American Express 16.8%, Coca-Cola 9.3%, IBM 8.5% and Wells Fargo 10%. Apple Inc stocks also came into Berkshire Hathaway’s radar screen, with the group owning a stake of 1.1%, which, according to a CNBC report on Feb 27, 2017, had grown in January 2017 to 2.5%. “At this point, Buffett owns US$17 billion worth of the tech giant’s stock,” said the report.
What does Berkshire Hathaway look for in marketable securities?
On the Big Four in the FY2015 letter, Mr Buffett said that the four investees possess excellent businesses and are run by managers who are both talented and shareholder-oriented. “Their returns on tangible equity range from excellent to staggering. At Berkshire, we much prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business. It’s better to have a partial interest in the Hope Diamond than to own all of a rhinestone,” said Mr Buffett.
The Berkshire Hathaway chairman said that if Berkshire’s yearend holdings were used as the marker, its portion of the “Big Four’s” 2015 earnings amounted to US$4.7 billion. “In the earnings we report to you, however, we include only the dividends they pay us – about $1.8 billion last year. But make no mistake: The nearly $3 billion of these companies’ earnings we don’t report are every bit as valuable to us as the portion Berkshire records.”
The earnings of Berkshire’s investees retain are often used for repurchases of their own stock – a move that increases Berkshire’s share of future earnings without requiring it to lay out a dime. “The retained earnings of these companies also fund business opportunities that usually turn out to be advantageous. All that leads us to expect that the per-share earnings of these four investees, in aggregate, will grow substantially over time. If gains do indeed materialize, dividends to Berkshire will increase and so, too, will our unrealized capital gains.”
This investment philosophy gives Berkshire Hathaway a significant edge, explained by Mr Buffett this way: “Our flexibility in capital allocation – our willingness to invest large sums passively in non-controlled businesses – gives us a significant edge over companies that limit themselves to acquisitions they will operate.”
Time: May 17, 1984. Legendary investor Warren Buffett was making a speech at a seminar at Columbia Business School to celebrate the 50th Anniversary of the publication of Benjamin Graham and David Dodd’s Security Analysis.
A blurb in the article, The Superinvestors of Graham-and-Doddsville (By Warren E. Buffett), based on the speech by Warren Buffett, said: “”Superinvestor” Warren E. Buffett, who got an A+ from Ben Graham in Columbia in 1951, never stopped making the grade. He made his fortunes using the principles of Graham’s and Dodd’s Security Analysis. Here, in celebration of that classic text, he tracks the records of investors who stick to the “value approach” and have gotten rich going by the book.”
First some useful background: Benjamin Graham (May 8, 1894 – September 21, 1976) is the father of value investing, an investment approach that he began teaching at Columbia Business School in 1928 (Wikipedia). The British-born American professional investor was well-known for his book Security Analysis which was published in 1934. Together with co-author David Dodd, he refined his investment approach through various editions of the book. Since its publication, the book has been widely treated as an investment bible in the investment community. Benjamin Graham’s best known disciple is Warren Buffett of Berkshire Hathaway. Warren Buffett, who himself is widely referred to the Wizard of Omaha, once described Benjamin Graham as the second most influential person in his life after his own father. Warren Buffett once said that Security Analysis was an investment road map that he had been following. Another of Benjamin Graham’s famous books is Intelligent Investor, described by Warren Buffett as “the best book about investing ever written”.
In The Superinvestors of Graham-and-Doddsville, Warren Buffett started by posing this question: “Is the Graham and Dodd “look for values with a significant margin of safety relative to prices” approach to security analysis out of date?”
Warren Buffett used the performance track record of a group of investors who had year in and year out beaten the Standard & Poor’s 500 stock index to counter theorists’ belief that it was all due to luck and that there were no undervalued stocks because of the stock market efficiency . Mr Buffett also used an imagined national coin-flipping contest to make his point.
The group of Superinvestors in the Graham-and-Doddsville presented by Warren Buffett included himself, his Berkshire Hathaway partner Charlie Munger and Walter Schloss, Tom Knapp and Bill Ruane. Warren Buffett, Walter Schloss, Tom Knapp and Bill Ruane were the group of four who worked at Graham-Newmann from 1954 through 1956.
This group of successful investors had one common intellectual patriarch, Benjamin Graham, said Warren Buffett. They had gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply cannot be explained by random chance.
“The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market,” said Warren Buffett.
“Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc. Incidentally, when businessmen buy businesses, which is just what our Graham & Dodd investors are doing through the purchase of marketable stocks – I doubt that many are cranking into their purchase decision the day of the week or the month in which the transaction is going to occur,” said Mr Buffett. “If it doesn’t make any difference whether all of a business is being bought on a Monday or a Friday, I am baffled why academicians invest extensive time and effort to see whether it makes a difference when buying small pieces of those same businesses. Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.”
Mr Buffett said that he selected these men based upon their framework for investment decision-making. “I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament. It’s very important to understand that this group has assumed far less risk than average..”
“While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses. Far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.”
Elsewhere in the text, Warren Buffett said: “I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”
Warren Buffett also explained the need of having a margin of safety. “You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing. ”
In his conclusion about the value approach to investment, Mr Buffett said: “I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I’ve practiced it…. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”
Fast forward to the present. Reflecting the great success of Warren Buffett’s value investment philosophy, Berkshire Hathaway’s 2013 Annual Report showed that “over the last 49 years (that is, since present management took over), book value has grown from US$19 to US$134,973, a rate of 19.7% compounded annually”. These are per-share book values.
American investor Walter Schloss (August 28, 1916 – February 19, 2012) was another famous disciple of the Benjamin Graham school of investing. The noted value investor died in 2012 of leukemia.
Walter Schloss was another great example that disproved the notion that the market was efficient. Talking of market efficiency, here’s a notable quote from legendary investor Warren Buffett in one of his letters to Berkshire Hathaway: “To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these.”
In Walter Schloss’s case, he did not even attend college.
Here’s an excerpt from a Wikipedia account of him: “Schloss did not attend college. In 1934 at the age of 18, he started work as a runner on Wall Street. Schloss took investment courses taught by Graham at the New York Stock Exchange Institute. One of his classmates was Gus Levy, the future chairman of Goldman Sachs. He eventually went to work for Graham in the Graham-Newman Partnership.
“In 1955, Schloss left Graham’s company and started his own investment firm, eventually managing money for 92 investors. By maintaining a manageable asset size, Schloss averaged a 15.3% compound return over the course of four and a half decades, versus 10% for the S&P 500.”
Walter Schloss won the 2012 Irving Kahn Lifetime Achievement Award from the New York Society of Security Analysts. Part of the citation said: “In his 2006 Letter to Shareholders, (Warren) Buffett said, “Let me end this section by telling you about one of the good guys of Wall Street, my long-time friend Walter Schloss, who last year turned 90. From 1956 to 2002, Walter managed a remarkably successful investment partnership, which he did not take a dime from unless his investors made money. My admiration for Walter, it should be noted, is not based on hindsight. A full 50 years ago, Walter was my sole recommendation to a St. Louis family who wanted an honest and able investment manager.”
In 1984, Warren Buffett named Walter Schloss as one of The Superinvestors of Graham-and-Doddsville. The naming was in celebration of the fiftieth anniversary of the classic text, Security Analysis, by Graham and Dodd.
Here’s what the Columbia Businees School said in reference to The Superinvestors of Graham-and-Doddsvilleby Warren Buffett: “Superinvestor” Warren E. Buffet, who got an A+ from Ben Graham at Columbia in 1951, never stopped making the grade. He made his fortune using the principles of Graham and Dodd’s Security Analysis. Here, in celebration of the fiftieth anniversary of that classic text, he tracks the records of investors who stick to the “value approach” and have gotten rich going by the book.”
Back to Walter Schloss. Here’s what Warren Buffett said of him in 1984 in The Superinvestors of Graham-and-Doddsville: “Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. He owns many more stocks than I do — and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.”
The underlying investment approach of Walter Schloss and Warrent Buffett is value investing. Where they differed was perhaps in the number of stocks owned and in the thinking on the underlying nature of a business. Warren Buffett said Walter Schloss “was far less interested in the underlying nature of the business”.
Warren Buffett said in his letter (dated Feb 28, 1997 for FY1996) to Berkshire Hathaway shareholder: “Should you choose…to construct your own portfolio, there are a few thoughts worth remembering. “Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
Later in the letter, Warren Buffet said: “In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
“A moat is a deep, broad ditch, either dry or filled with water, that surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defence.” – Wikipedia.
Legendary investor Warren Buffett coined the term “moat” in finance. A company needs a moat to protect its profitability and to fence itself against competitors.
If you’re an investor looking for the stock of a company that has an economic moat, remember that Warren Buffett actually went one step further by saying that the moat has to be one that is enduring.
“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital,” Mr Buffett said in his letter to Berkshire shareholders (February 2008) for Year 2007.
“The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed.”
So what industries does Mr Buffet rule out then?
“Our criterion of ‘enduring’ causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s ‘creative destruction’ is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
“Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.
“But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.”
In Pat Dorsey’s book, The Five Rules For Successful Stock Investing, Pat Dorsey listed four steps to help analyze a company’s economic moat:
(1) Evaluate the firm’s historical profitability. The true litmus test of whether a firm has built an economic moat around itself is to see whether it has been able to generate a solid return on its assets and on shareholders’ equity.
(2) If the firm has solid returns on capital and consistent profitability, assess the sources of the firm’s profits. Ask questions like why the company is able to keep competitors at bay and what keeps competitors from stealing its profits.
(3) Estimate how long a firm will be able to hold off competitors, which is the company’s competitive advantage period. Some companies are able to fend off competitors for a few years while some are able to do it for decades.
(4) Analyze the industry’s competitive structure. Ask whether the firm is in an attractive industry with many profitable firms or a hypercompetitive one in which the players struggle just to stay afloat.
A December 31, 2014, report, Warren Buffett On Why America Has The ‘Secret Sauce’, quoted Warren Buffett as reiterating this when asked about why he’s bullish on America: “The luckiest person ever born in the history of the world is the baby being born in America today. We have the secret sauce, and it unleashes human potential like no system has ever unleashed it in history.”
Warren Buffett, Chairman and CEO of Berkshire Hathaway, said this when he was in Detroit earlier in the month. “The billionaire sat down with Quicken Loans Chairman and Founder Dan Gilbert, along with President and Chief Marketing Officer Jay Farner, for an hour-long chat,” said the report.
One issue Warren Buffett discussed was America itself.
When asked about the simple truth that most people misunderstand, Warren Buffett replied: “I would think currently, most people think America is on the wrong track. They think that the American dream is gone or something.”