Warren Buffett: There is seldom one cockroach in the kitchen

In his annual letter dated Feb 21, 2003, to Berkshire Hathaway shareholders, chairman Warren Buffett had three suggestions for investors.

Mr Buffett’s first suggestion was for investors to beware of companies displaying weak accounting. “If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes.”

“There is seldom just one cockroach in the kitchen,” the legendary investor added.

The Berkshire Hathaway chairman also said that trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) “is a particularly pernicious practice” as it “implies that depreciation is not truly an expense, given that it is a “non-cash” charge”.

“That’s nonsense,” said Mr Buffett. “In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business.” To drive home this point, Mr Buffett said imagine a company paying – at the beginning of a year – all of its employees for the next ten years of their service (“in the way they would lay out cash for a fixed asset to be useful for ten years”).

Compensation in the following nine years would be a “non-cash” expense – a reduction of a prepaid compensation asset. “Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?” asked Mr Buffett.

The second suggestion Mr Buffett had for investors pertained to unintelligible footnotes, saying such notes “usually indicate untrustworthy management”. “If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to…”

His third suggestion for investors: “…be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers). Charlie (Berkshire Hathaway vice-chairman) and I not only don’t know today what our businesses will earn next year – we don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future…”

“Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers,” said Mr Buffett.