What I've Been Reading

The Essays of Warren Buffett: Lessons for Corporate America by Warren Buffett and Lawrence A. Cunningham.
George Orwell once said "To see what is in front of one's nose is a constant struggle". Buffett pretty much explains what is in front of our nose with great clarity and simplicity. Since our minds are clouded with mirages induced by those lords of the finance, one need has to re-read his essays a number of times to keep those unicorns at bay.

• Contrary to textbook rules on organizational behavior, mapping an abstract chain of command on to a particular business situation, according to Buffett, does little good. What matters is selecting people who are able, honest, and hard-working. Having firstrate people on the team is more important than designing hierarchies and clarifying who reports to whom about what and at what times.
• According to Buffett, one of the greatest problems among boards in corporate America is that members are selected for other reasons, such as adding diversity or prominence to a board— or, famously, independence.
• The CEOs at Berkshire’s various operating companies enjoy a unique position in corporate America. They are given a simple set of commands: to run their business as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for a hundred years. This enables Berkshire CEOs to manage with a long-term horizon ahead of them, something alien to the CEOs of public companies whose short-term short-term oriented shareholders obsess with meeting the latest quarterly earnings estimate. Short-term results matter, of course, but the Berkshire approach avoids any pressure to achieve them at the expense of strengthening long-term competitive advantages.
• Buffett emphasizes that performance should be the basis for executive pay decisions. Executive performance should be measured by profitability, after profits are reduced by a charge for the capital employed in the relevant business or earnings retained by it. If stock options are used, they should be related to individual performance, rather than corporate performance, and priced based on business value. Better yet, as at Berkshire, stock options should simply not be part of an executive’s compensation. After all, exceptional managers who earn cash bonuses based on the performance of their own business can simply buy stock if they want to; if they do, they “truly walk in the shoes of owners,” Buffett says.
• Buffett points out the absurdity of beta by observing that “a stock that has dropped very sharply compared to the market . . . becomes ‘riskier’ at the lower price than it was at the higher price”— that is how beta measures risk.
• Another leading prudential legacy from Graham is his margin-of-safety principle. This principle holds that one should not make an investment in a security unless there is a sufficient basis for believing that the price being paid is substantially lower than the value being delivered. Buffett follows the principle devotedly, noting that Graham had said that if forced to distill the secret of sound investment into three words, they would be: margin of safety.
• Unlike many CEOs, who desire their company’s stock to trade at the highest possible prices in the market, Buffett prefers Berkshire stock to trade at or around its intrinsic value— neither materially higher nor lower. Such linkage means that business results during one period will benefit the people who owned the company during that period. Maintaining the linkage requires a shareholder group with a collective long-term, business-oriented investment philosophy, rather than a short-term, market-oriented strategy.
• Berkshire’s dividend policy also reflects Buffett’s conviction that a company’s earnings payout versus retention decision should be based on a single test: each dollar of earnings should be retained if retention will increase market value by at least a like amount; otherwise it should be paid out. Earnings retention is justified only when “capital retained produces incremental earnings equal to, or above, those generally available to investors.”
• Stock splits have three consequences: they increase transaction costs by promoting high share turnover; they attract shareholders with short-term, market-oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead to prices that depart materially from intrinsic business value. With no offsetting benefits, splitting Berkshire’s stock would be foolish.
• Moreover, acquisitions paid for in stock are too often (almost always) described as “buyer buys seller” or “buyer acquires seller.” Buffett suggests clearer thinking would follow from saying “buyer sells part of itself to acquire seller,” or something of the sort. After all, that is what is happening; and it would enable one to evaluate what the buyer is giving up to make the acquisition.
• Buffett emphasizes that useful financial statements must enable a user to answer three basic questions about a business: approximately how much a company is worth, its likely ability to meet its future obligations, and how good a job its managers are doing in operating the business.
• It is common on Wall Street to value businesses using a calculation of cash flows equal to (a) operating earnings plus (b) depreciation expense and other non-cash charges. Buffett regards that calculation as incomplete. After taking (a) operating earnings and adding back (b) non-cash charges, Buffett argues that you must then subtract something else: (c) required reinvestment in the business. Buffett defines (c) as “the average amount of capitalized expenditures for plant and equipment, etc., that the business requires to fully maintain its long-term competitive position and its unit volume.” Buffett calls the result of (a) + (b) - (c) “owner earnings.”
• Criticizing the view against treating stock options as expenses when granted, Buffett delivers this laconic argument: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?” So far, he has gotten no answers.
• Three suggestions for investors: First, 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.
• Charlie and I know that the right players will make almost any team manager look good. We subscribe to the philosophy of Ogilvy & Mather’s founding genius, David Ogilvy: “If each of us hires people who are smaller than we are, we shall become a company of dwarfs. But, if each of us hires people who are bigger than we are, we shall become a company of giants.”
• To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire— a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?
• A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them.
• Except for token amounts, we shun debt, turning to it for only three purposes: (1) We occasionally use repos as a part of certain short-term investing strategies that incorporate ownership of U.S. government (or agency) securities. Purchases of this kind are highly opportunistic and involve only the most liquid of securities. (2) We borrow money against portfolios of interest-bearing receivables whose risk characteristics we understand. (3) [Subsidiaries, such as Mid-American, may incur debt that appears on Berkshire’s consolidated balance sheet, but Berkshire does not guarantee the obligation.]
• Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.
• The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends. If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula.
• Myron C. Taylor, Chairman of U.S. Steel Corporation, today announced the long awaited plan for completely modernizing the world’s largest industrial enterprise. Contrary to expectations, no changes will be made in the company’s manufacturing or selling policies. Instead, the bookkeeping system is to be entirely revamped. By adopting and further improving a number of modern accounting and financial devices the corporation’s earning power will be amazingly transformed.
• Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles: “How many legs does a dog have if you call his tail a leg?” The answer: “Four, because calling a tail a leg does not make it a leg.” It behooves managers to remember that Abe’s right even if an auditor is willing to certify that the tail is a leg.
• We will stick with the approach that got us here and try not to relax our standards. Ted Williams, in The Story of My Life, explains why: “My argument is, to be a good hitter, you’ve got to get a good ball to hit. It’s the first rule in the book. If I have to bite at stuff that is out of my happy zone, I’m not a .344 hitter. I might only be a .250 hitter.” Charlie and I agree and will try to wait for opportunities that are well within our own “happy zone.”