Event: Terry College of Business (University of George)
Date: July 18, 2001
In his letter to Berkshire Hathaway’s stockholders as far back as March 14, 1978 for FY2007, Warren Buffett has this to say about record earnings: “Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.”
This statement is worth repeating and highlighting: “After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.”
What then is a more appropriate measure of managerial economic performance?
Here is Warren Buffett’s answer in the same letter to Berkshire Hathaway shareholders: “Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.”
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.”
In his letter to Berkshire Hathaway shareholders (March 1, 1996) for Year 1995, Warren Buffett said: “A few years back, management consultants popularized a technique called “management by walking around” (MBWA). At Berkshire, we’ve instituted ABWA (acquisitions by walking around).”
What is this ABWA that Mr Buffett was talking about?
“In May 1994, a week or so after the Annual Meeting, I was crossing the street at 58th and Fifth Avenue in New York, when a woman called out my name. I listened as she told me she’d been to, and had enjoyed, the Annual Meeting. A few seconds later, a man who’d heard the woman stop me did so as well. He turned out to be Barnett Helzberg, Jr., who owned four shares of Berkshire and had also been at our meeting,” said Mr Buffett.
The interesting thing was not about the four Berkshire shares that Mr Helzberg owned. The interesting thing was that this chance meeting led to Berkshire Hathaway buying Helzberg’s Diamond Shops in 1995. That was one example of Mr Buffett’s ABWA: acquisitions by walking around.
Besides finding that “Helzberg’s was the kind of business that we wanted to own”, Mr Buffett also liked it for its good management. “Buying a retailer without good management is like buying the Eiffel Tower without an elevator,” he said.
In his letter dated March 3, 1980 for FY1979 to Berkshire Hathaway stakeholders, Warren Buffett said: “Phil Fisher, a respected investor and author, once likened the policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A restaurant could seek a given clientele – patrons of fast foods, elegant dining, Oriental food, etc. – and eventually obtain an appropriate group of devotees. If the job were expertly done, that clientele, pleased with the service, menu, and price level offered, would return consistently.”
The letter cautioned that restaurant could not change its character constantly and end up with a happy and stable clientele.
“If the business vacillated between French cuisine and take-out chicken, the result would be a revolving door of confused and dissatisfied customers,” said the letter. “So it is with corporations and the shareholder constituency they seek. You can’t be all things to all men, simultaneously seeking different owners whose primary interests run from high current yield to long-term capital growth to stock market pyrotechnics, etc.”
One thing that Warren Buffett found puzzling is “the reasoning of managements that seek large trading activity in their shares”. “In effect, such managements are saying that they want a good many of the existing clientele continually to desert them in favor of new ones – because you can’t add lots of new owners (with new expectations) without losing lots of former owners,” said the FY1979 letter.
“We much prefer owners who like our service and menu and who return year after year. It would be hard to find a better group
to sit in the Berkshire Hathaway shareholder “seats” than those already occupying them. So we hope to continue to have a very
low turnover among our owners, reflecting a constituency that understands our operation, approves of our policies, and shares
our expectations. And we hope to deliver on those expectations,” said the Warren Buffett letter.
To the prophets of doom, Warren Buffett has this to say: “The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.”
In the FY2010 letter (26 February 2011), Warren Buffett said that last year – in the face of widespread pessimism about our economy – “we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment.”
Here is a great excerpt from his letter:
“Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of ‘great uncertainty.’ But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.
“Don’t let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.
“We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.”