Buffett and Munger on See's Candy: Part II

A follow up to this post. Roughly two years ago, Charlie Munger said the following about what he and Warren Buffett learned from buying See's Candy:*

"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important."

You have to be a lifelong learner to appreciate this stuff. We think of it as a moral duty."

Buffett said something very similar in this more recent article:

"We have made a lot more money out of See's than shows from the earnings of See's, just by the fact that it's educated me, and I'm sure it's educated Charlie too."

As always, the price paid relative to value -- paying a plain discount to conservative per share intrinsic value -- matters a whole lot when it comes to reducing risk while increasing potential reward for the long-term investor.**  Otherwise, attractive risk-adjusted returns come from owning a business (or part of a business via marketable common stocks) with characteristics that lead to attractive and durable return on capital.

Well, it's having sustainable pricing power (and a commodity that's in high demand/in short supply doesn't qualify) that is often a key driver of return on capital. Possession of a great brand -- what Buffett calls "share of mind" -- can provide an ongoing source of sustainable pricing power.
(Even if, as in the case of See's, it happens to be primarily regional brand strength developed over many years.)

In the prior post I noted the following:

...if a business can raise price a certain percentage each year and it mostly sticks (i.e. there's no real hit to volume), the increase all falls to the bottom line after taxation. If that same business instead had a similar percentage increase in revenue via greater unit volume, there inevitably has to be an incremental cost -- sometimes significant -- associated with each additional unit. The result being -- at least when there's real pricing power -- not as much of an equivalent increase in revenue actually falls to the bottom line.***

A price increase requires no additional capital and has no incremental cost. What matters is whether price can be increased in a way that doesn't significantly impact volume. Here's Warren Buffett said at the 2005 Berkshire Hathaway Shareholder Meeting:

"We like buying businesses with some untapped pricing power. When we bought See's Candies for $25 million, I asked myself, 'If we raised prices by 10 cents per pound, would sales fall off a cliff?' The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices." 

In contrast, what it takes to support the added unit volume certainly creates additional operating costs and might even require more capital to be employed.

Either way, that means reduced return on capital for similar incremental growth.

Growth, in itself, can be an overrated. Well, at least it can be when it comes to generating attractive risk adjusted shareholder returns. At a minimum, there's a great tendency to overpay for it.

During this interview with the Financial Crisis Inquiry Commission (FCIC), Warren Buffett had the following to say about the importance of pricing power when evaluating a business:

"...the single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you've got a terrible business."

It also helps if the business requires little in the way of capital to maintain or even strengthen its advantages.

See's may, in the very long run, attempt to expand beyond its mostly regional footprint (in fact, there's for the first time some at least limited indication they may) but that will make sense only if they can develop the "share of mind" where they move to next.

Some might wonder why they didn't expand sooner. That takes patience, time, and it's not inevitable that it will work. Enduring some pain in the near-term or longer, the willingness to forgo returns early on to gain a foothold -- what Tom Russo calls the "capacity to suffer" -- can make a lot of sense. Many of the great global consumer franchises do just that but it depends on the specific circumstances. When it comes to the "capacity to suffer", Russo also emphasizes the importance of first mover advantage. Well, one of the reasons See's may not want to move into a new region is the existence of already entrenched brands. The lack of first mover advantage could mean the returns on the incremental capital invested turn out to be unattractive.

The good news is that there's often nothing wrong with striving for more modest growth prospects while using the excess capital wisely elsewhere. That's essentially what Berkshire has been doing with See's for more than 40 years. It depends not just on first mover advantage but also on the competitive landscape more generally (and many other factors, of course).

Those that push for growth -- too often blindly in the context of the capital requirements -- sometimes underestimate this. Exciting growth prospects need to be fully understood in the context of the incremental capital investment. Will it actually be of the high return variety? Could that capital be put to use elsewhere at higher returns and less risk?

High return growth is not a given. Some treat all forms of growth as a good thing or, at least, assume the growth will be high return in nature.

From the 1992 Berkshire Hathaway (BRKa) Shareholder Letter:

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."

Remember, for example, that airlines grew for a long time at impressive rates. Saying the returns from all that capital investment have been poor for those who held common stock in airlines is more than an understatement.
(I'm writing strictly from a common shareholder perspective. Airlines and air travel clearly have been quite important and valuable to civilization in other ways.)

More from the 1992 Berkshire letter:

"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value."

Sometimes growth is pursued where lots of capital must be deployed -- with diminishing and even negative returns -- to continue fueling that growth.

In the short run (and sometimes even much longer), exciting growth can provide for equally exciting stock price action. That's fine, I suppose, if one likes to speculate on such things.

In the long run, investors will have quite a difficult time benefiting from behavior that amounts to growth for its own sake or growth for growth's sake.

Well, at least they will have difficulty benefiting on an intrinsic basis.

Some might decide to treat the See's example as nothing more than a merely interesting curiosity and consider its implications no further.

I happen to think that's a mistake.

To me, it's an essential business and investing lesson.

Adam

Related posts:
Buffett and Munger on See's Candy - June 2013
Aesop's Investment Axiom - February 2013
Grantham: Investing in a Low-Growth World - February 2013
Buffett: Stocks, Bonds, and Coupons - January 2013
Maximizing Per-Share Value - October 2012
Death of Equities Greatly Exaggerated - August 2012
Stock Returns & GDP Growth - July 2012
Why Growth Matters Less Than Investors Think - July 2012
Ben Graham: Better Than Average Expected Growth - March 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Buffett: What See's Taught Us - May 2011
Buffett on Coca-Cola, See's & Railroads - May 2011
Buffett on Pricing Power - February 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - June 2010
High Growth Doesn't Equal High Investor Returns - July 2009
The Growth Myth Revisited - July 2009
Pricing Power - July 2009
The Growth Myth - June 2009
Buffett on Economic Goodwill - April 2009

Long position in BRKb established at much lower than recent prices

* From these notes that are, according to The Motley Fool, "in Munger's own words, lightly edited and condensed for clarity".
** Note that the correlation between risk and reward need not be positively correlated.
*** Even if a modest drop in volume were to occur, the increased price may still make sense as far as total return goes. It all comes down to how much pricing power actually exists. What some might describe as being price inelastic.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Buffett: Cigar Butts & Wonderful Businesses

From the 1989 Berkshire Hathaway (BRKa) Shareholder Letter:

"If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the 'cigar butt' approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the 'bargain purchase' will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.

You might think this principle is obvious, but I had to learn it the hard way..."

Buffett provides one example (Hochschild Kohn, a Baltimore department store) of a bargain that turned out not to be one at all, and says he could offer more.

So, with the mediocre businesses, what seems like it's selling at a big discount at the time often proves otherwise. He then later in the letter added this:

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements."

Businesses with sustainable advantages that generate high return on capital have the capacity over time to do just fine even if the investor, on occasion, mistakenly pays a price that proves to be somewhat expensive. Margin of safety is always a very important aspect of the investing process -- and an investor can't do very well if they often pay too much -- but errors in judgment about current value inevitably happen.

That wind isn't at your back in a low return business. What seems cheap at first isn't at all.

Adam

Buffett: Stocks, Bonds, and Coupons

In the 1992 Berkshire Hathaway (BRKa) Shareholder Letter, there's a condensed version of how John Burr Williams described the equation for value in his book The Theory of Investment Value back in the 1938.*

Buffett explained it as follows in the letter:

"The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."

Notably, as Buffett highlights, the formula is the same for stocks and bonds. The key difference being that bonds have future cash flows defined by the coupon and maturity date. Pretty straightforward unless there's a default of some kind. In contrast, the equity coupons have to estimated by the investor.

"...in the case of equities, the investment analyst must himself estimate the future 'coupons.'"

The size and duration of those coupons have a much wider range of possibilities. More from the letter:

"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite..."

It's easy to overly complicate the investment process, but it pretty much comes down to consistently paying comfortably less than the appropriately discounted present value of future cash flows. In other words, paying less than a well-judged conservative estimate of intrinsic value.**

If an investor is highly confident in their future cash flows estimate (and the appropriate interest rate to use), then a smaller discount would be necessary.

Still, requiring that an appropriate discount to value exists (margin of safety) is all-important to protect the investor against the unforeseen and unforeseeable.

Buffett's "irrespective of whether the business grows or doesn't" comment is worth noting.
(A subject I've covered quite a lot, if nothing else, on this blog.)

Some take it as a given that growth is of primary importance in investing. Well, for example, if $ 1 of earnings in perpetuity can be bought for $ 3, should the investor care if it grows? That's an extreme example, but sometimes the blind pursuit of growth leads an investor to take more risk than necessary to achieve a similar or worse result.

In fact, listen to enough commentary on investing and it seems growth dominates the conversation. That all growth is good growth is, at least, implied. I mean, how could growth not be a good thing, right? Growth is fine if it's of the high return variety and can be bought at a fair price. Unfortunately, many forms of growth do not produce attractive returns and can even destroy value. From the 2000 Berkshire Hathaway Shareholder Letter:

"Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years."

Attractive growth prospects usually sell for a premium. Too often -- even if growth happens to be in a potentially high return form -- the premium price paid means that permanent capital loss is more likely to occur if things do not pan out as expected.

Insufficient margin of safety.

Growth will, of course, often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact.

Many very fine investments have modest to no growth at all while having more predictable outcomes. Lacking excitement, they more often sell cheap. Their relative predictability also means that getting the investment analysis consistently right is more doable. In contrast, where there's high growth often invites in competition and naturally less predictable long range outcomes. With lots more competition there's usually less certainty that the economics will remain attractive during the pursuit of that growth.

So whether the investor can roughly but meaningfully estimate the coupons a business will produce over a very long time frame is far more important than growth. Buffett points out that even for very experienced and able investors, it's still easy to get the estimate of future coupons very wrong.

How does Berkshire deal with that reality? One way is that they stick to what they understand. As Buffett explains, it's easier to get the estimate of future cash flows right with businesses that are "simple and stable"  compared to those that are "complex or subject to constant change". It is not about how much an investor knows. It's about an awareness of what they don't know.

Awareness of limitations.

"An investor needs to do very few things right as long as he or she avoids big mistakes."

The other way they deal with the problem is always buying with a margin of safety. To always pay a price that is substantially lower than their own estimated value of future cash flows.

Finally, as Buffett mentions in the quote above, the current price relative to earnings or book value -- whether seemingly very high or low -- often reveals little about business value. Though, it's worth noting, Buffett has said Berkshire's book value is a rough if quite understated way to gauge the company's intrinsic value. Otherwise, sometimes what seems a low price against current earnings or book value won't turn out to be cheap at all. The opposite is, of course, also true. The price has to be considered against the discounted long run stream of cash that will be generated over time. Sometimes those future cash flows are just too difficult to estimate. In those cases, it's best to avoid the investment no matter how compelling the story is or cheap it appears.

Judging value based upon some simple snapshot measurement will often lead to very big and costly mistakes.

Adam

Related posts:
Maximizing Per-Share Value - October 2012
Death of Equities Greatly Exaggerated - August 2012
Stock Returns & GDP Growth - July 2012
Why Growth Matters Less Than Investors Think - July 2012
Ben Graham: Better Than Average Expected Growth - March 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - June 2010
High Growth Doesn't Equal High Investor Returns - July 2009
The Growth Myth Revisited - July 2009
The Growth Myth - June 2009

* First written as a Ph.D. thesis at Harvard in 1937.
** Page 4 of the Berkshire Hathaway Owner's manual provides a useful explanation of intrinsic value.

Buffett on the "Institutional Imperative": Berkshire Shareholder Letter Highlights

Some of my previous posts have made reference to what Warren Buffett has called for years the "institutional imperative". In a nutshell, it's the tendency for organizations, led by the CEO and others in the executive ranks, to mindlessly imitate the behavior of peers no matter how foolish it may be to do so.

You won't always see the impact of this behavioral tendency in the short run numbers but, over the long haul, it matters a lot when it comes to the creation intrinsic value for owners.

The excerpt below, from the Mistakes of the First Twenty-five Years section of the 1989 Berkshire Hathaway (BRKa) Shareholder Letter, provides a more complete explanation of what Buffett means by "institutional imperative":

My most surprising discovery: the overwhelming importance in business of an unseen force that we might call "the institutional imperative." In business school, I was given no hint of the imperative's existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn't so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.

It's a big factor in many large (and sometimes not so large) organizations. The problem is it's not always visible to an investor. Yet, carefully watch a CEO's and other senior executive behavior and decision-making over time and, on occasion, it will reveal more than you'd expect.

Independent minded, creative CEO's who build organizations that are less susceptible to the "imperative" are out there. Even if hard to gauge from the outside it's worth attempting to figure out who gets it.

Owning shares of the businesses they run certainly doesn't hurt returns.

Adam

Buffett on The Theory of Investment Value: Berkshire Shareholder Letter Highlights

From the 1992 Berkshire Hathaway (BRKa) Shareholder Letter:

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future "coupons." Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity "coupons."

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

Though the mathematical calculations required to evaluate equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons." At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success. 

So...

• Value comes from cash flows discounted at an appropriate rate.
• The lowest price that can be paid relative to the discounted value of cash flows is what matters...not growth.
• Superior businesses can employ large amounts of incremental capital at a high return but are rare.
• The math is not difficult but get outside your circle of competence misjudgments of future coupons will happen. Stick to businesses you can understand.
• Always make sure a substantial margin of safety exists.

Try to figure out where gold fits into all of this.

The above nicely combines what matters in an investment whether stock, bond, or real estate. Basically, any asset that can produce a stream of cash flows (something gold is not going to do). None of it sounds (or is) difficult to understand but staying disciplined about this stuff certainly is not necessarily easy. Consider this:

"More insurers don't copy BRK's model (underwriting for profit and stepping out of the market for extended periods of time when pricing is bad) because our model is too simple. Most people believe you can't be an expert if it's too simple." - Charlie Munger at the 2007 Wesco Meeting

Sidekick has sage advice of his own

I think when some come to learn how Buffett and Munger approach investing, they make the same mistake that other insurers make. They think there's got to be more to it. It also sounds too straightforward so they underestimate how difficult it is to do things like what Buffett describes above consistently well.

I.Q. may matter to an extent but is trumped by discipline and temperament.

Adam

Buffett on Buying "Small Pieces of the Best Businesses": Berkshire Shareholder Letter Highlights

From the 1995 Berkshire Hathaway (BRKa) Shareholder Letter:

The Story of the Man with an Ailing Horse: Visiting the vet, he said: "Can you help me? Sometimes my horse walks just fine and sometimes he limps." The vet's reply was pointed: "No problem - when he's walking fine, sell him." In the world of mergers and acquisitions, that horse would be peddled as Secretariat.

Acquisitions vs Passive Investments: ...we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale - a time when the business is likely to be walking "just fine." 

Even so, we do have a few advantages, perhaps the greatest being that we don't have a strategic plan. Thus we feel no need to proceed in an ordained direction (a course leading almost invariably to silly purchase prices) but can instead simply decide what makes sense for our owners. In doing that, we always mentally compare any move we are contemplating with dozens of other opportunities open to us, including the purchase of small pieces of the best businesses in the world via the stock market. Our practice of making this comparison - acquisitions against passive investments - is a discipline that managers focused simply on expansion seldom use.

Talking to Time Magazine a few years back, Peter Drucker got to the heart of things: "I will tell you a secret: Dealmaking beats working. Dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work . . . dealmaking is romantic, sexy. That's why you have deals that make no sense."

The seller of an entire individual business usually knows far more about the company than the buyer and will put it up for sale when it's most advantageous for the seller.

The "For Sale" sign usually goes up at a time when business conditions are most favorable...to the seller.

So an excited and, at least at times, emotion-driven acquirer meets informed and disciplined seller of an entire business. Once a deal gets in motion the process takes on a life of its own whether it makes sense or not.

The result frequently being "silly purchase prices".

In contrast, the price available for "small pieces of the best businesses" tend to swing wildly above and below intrinsic value in an often emotional and increasingly algorithm driven short-term oriented stock market. The situation, reversed. In this case, an informed and disciplined buyer has little difficulty finding sellers that are less so.

Which scenario is more likely to create better opportunities for a buyer?

Adam

Buffett: Why Growth Is Not Necessarily A Good Thing - Berkshire Shareholder Letter Highlights

From the 1992 Berkshire Hathaway (BRKa) Shareholder Letter:

Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

Some may find the idea that growth could ever be a negative thing for an investor a bit odd.*

If nothing else, it's not necessarily intuitive.

In fact, listen or read carefully someone touting an investment and you'll hear growth potential mentioned in a way that implicitly suggests all growth is good growth.

Buffett later in the same letter added the following:

...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.

So why would anyone running a business pursue growth strategies that do not produce high return for shareholders besides poor judgment or incompetence? Well, first of all as Buffett points out above some industries just do not have favorable economics. There are certainly some other reasons. The desire of a CEO to expand the empire, so to speak, even if in pursuit of that growth it happens to not produce much in the way of long-term returns (though short-term it may look okay especially with clever use of accounting) is one example.

Growth for growth's sake, the financing of profitless growth, happens plenty in the world of business and investors end up hurt badly by it.

I've covered variations of the "growth myth" in other posts. If interested, here are some examples:

Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - June 2010
High Growth Doesn't Equal High Investor Returns - July 2009
The Growth Myth Revisited - July 2009
The Growth Myth - June 2009

Think about this the next time you hear growth prospects at the center of some investment thesis. Growth prospects do tend to be, at least often enough, an overrated component of long run value creation for shareholders.

So, even if not deliberate, growth is at times pursued at shareholder expense and, as part owner of the business, healthy skepticism when it comes to aggressive growth strategies involving the use of shareholder funds is more than justified.

Now there's obviously nothing wrong with high return growth when you can find it at a fair price. Just keep in mind that dynamic high growth frequently invites competition. It is the potential for intense competition that makes the crucial question of whether a business can sustain its high return on capital characteristics (or generally favorable long run economics) tougher to answer.

So growth for growth's sake often ends up producing lousy rates of return for shareholders. The question becomes this. Will a particular growth opportunity involving incremental capital make shareholders wallets fatter or just make the domain the business happens to occupy larger with returns an afterthought?
(I say this only somewhat sarcastically that words like "strategic" or "synergistic" used to justify a large incremental allocation of capital by management is, at times, just code for "we're investing to get bigger possibly at the expense of long run shareholder returns".)

The expensive pursuit of market share at subpar or negative returns is another variation of this.

Some businesses, over an extended period, can put large quantities of incremental capital at high rates of return to work. Unfortunately, that is a rare business. Since most cannot do this, it's preferable for the excess funds to be used for buybacks (when the stock sells below -- ideally nicely below -- intrinsic value) or dividends.

Also, for a business structured like Berkshire Hathaway, one the businesses can send its excess capital to Warren Buffett for deployment into some other high return investment (that's precisely the role that See's Candy has played for decades).

The reality is most high return businesses like See's need little capital and generate lots of it (relative to its size, of course). Keeping those funds inside a business like See's is an invitation for poor use of capital.

Finding businesses with durable high return on capital, with management that knows how to deploy it, and paying a nice discount to a conservative estimate of intrinsic value determines long-term returns for investors...not growth.

Adam

* Growth, of course, will often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact. In fact, growth can actually reduce value if it requires capital inputs in excess of the discounted value of the cash that will be generated over time. Sometimes, the highest growth opportunities attract lost of capable competition and capital that ruins the long run economics. Sometimes, high growth requires expensive but needed capital raising that dilutes existing shareholders and reduces per share returns.

Finally, even if growth that materializes does have favorable economics, some investors tend to pay a large premium upfront for those growth prospects. That hefty price paid may turn attractive long-term business results into not so attractive investment results.

Buffett on Wells Fargo - Part II: Berkskhire Shareholder Letter Highlights

A follow up to this post.

More from what Buffett said in the 1990 Berkshire Hathaway (BRKa) Shareholder Letter about Wells Fargo (WFC):

Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.

A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.

When the above was written the extensive use of derivatives was not in vogue yet. Their current prevalent use create systemic risks and risks unique to each institution that is difficult to gauge.

From the 2002 Berkshire Hathaway Shareholder Letter:

...derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running.

The shares of Wells Fargo have increased in value well over 1,800% including dividends since Buffett wrote about the bank in the 1990 letter (though Buffett has bought many shares since with lesser gains). I doubt many banks will produce those kind of returns over the next twenty years or so but some of the better ones will certainly do quite well.

It's an example of what high return on equity (or preferably high return on capital for a non-financial) bought at 5x earnings, what Buffett paid for Wells back then, can produce in value when compounded over 20 years.

Yesterday's post covered this. Pay a lot less than what a business is worth now and make sure it is capable of producing a high return on tangible capital in the future. The cheap price provides a margin of safety in the near term. The high return on capital drives value long-term.

Joel Greenblatt on Stocks

Still, as I said in the earlier post, with so many inexpensive non-financial businesses available I'm not certain any bank is worth the trouble (considering the unique risks involved with owning shares of a bank) for most investors.

Adam

Long WFC

Buffett on Wells Fargo: Berkshire Shareholder Letter Highlights

Below is an excerpt from the 1990 Berkshire Hathaway (BRKa) Shareholder Letter.

Starting in 1989 and continuing into 1990, Buffett was buying lots of Wells Fargo (WFC) shares for the first time. Here is what he had to say about Wells back then:

Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.

The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

This next excerpt from the letter sounds like something that would just as aptly describe banks during the more recent financial crisis...

Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.

As always, the price paid is the best way to regulate the specific risks of an investment. Future outcomes are always uncertain and unknowable despite what those in the business of forecasting say.

Most forecasters are, if nothing else, reliably unreliable.

"We have two classes of forecasters: those who don't know, and those who don't know they don't know." - John Kenneth Galbraith in the Wall Street Journal (January 1993)

Making a judgment on the known strengths and weaknesses of a business and whether the price is low enough to provide an acceptable margin of safety seems, by comparison, more doable on a regular basis.

The good news is effective macro forecasting is not a prerequisite of successful investing.

"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter

"A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter

Now Back to Wells Fargo.

Normally, at 5x after-tax earnings, if the investor has a long-term investing horizon, an awful lot has to go extraordinarily wrong for even a decent business (for a lousy business like an airline no multiple is cheap enough...all bets are off).

At that kind of multiple, the problem can't just be something like ugly headlines or a dysfunctional board. It has to be along the lines of a collapse in the core economics of a business (economic moat wrecked) or an event that causes massive shareholder dilution at prices well below intrinsic value (often the result of extreme leverage).

Most times, not much has to go right with an equity investment that cheap. A multiple that low implies the business will stagnate or maybe even shrink a bit. If a business shrinks yet maintains most of its favorable economic advantages, with patience very solid long run returns can still be had at that kind of multiple.

So a 5x multiple (a 20% earnings yield) compensates the investor for quite a lot of risks and uncertainties.

Now, a bank always has a unique set of risks mostly related to the inherent leverage used but also the systemic variety. In the context of today's investing environment and, considering other available very inexpensive non-financial investment alternatives, I'm not sure those kinds of risks are worth the trouble.

Buffett made the judgment back in 1990 that Wells Fargo still had an excellent franchise and terrific economics and once the noise of the moment passed its value would become clear. Berkshire Hathaway shareholders were compensated handsomely for Buffett getting that judgment right.

He seems to be making the same call this time around with Wells Fargo and U.S. Bancorp (USB). If the worst kinds of systemic failures do not occur some of the better banks like Wells and U.S. Bancorp will likely end up with, if not the same as what has happened since 1990, a solid long run outcome (Buffett's Bank of America: BAC investment is a little different since he went the preferred shares route and the terms are uniquely favorable).

Once again, it's just that considering the number of attractive alternatives available, I'm not convinced banks need to be anything more than a small portion of an equity portfolio.

The risks unique to investing in banks have always been significant. The better banks right now would be more interesting if there were not so many other 5-7x multiple non-financial stocks.

Adam

Long USB and WFC

Buffett & Munger on Berkshire's Stock

From this Bloomberg article:

Buffett can't get analysts to say buy Berkshire

Warren Buffett's Berkshire Hathaway Inc. (BRK/A) can't get a buy recommendation from equity analysts, even as it trades in New York at the cheapest price relative to book value since March 2009.

I think the best quote award goes to the analyst in the article who said the following:

"It's the cheapest that I've seen it in a while," said Tom Lewandowski, an analyst with Edward Jones & Co., who has a "hold" rating on Berkshire shares. "It's hard for me to get really positive on that."

Geez. What would it take to get positive? For it to be more expensive than it has been in a while?

From the 1988 Berkshire Hathaway Shareholder Letter:

...we do not want to maximize the price at which Berkshire shares trade. We wish instead for them to trade in a narrow range centered at intrinsic business value (which we hope increases at a reasonable - or, better yet, unreasonable - rate).

The article goes on to point out that Berkshire is of little interest to brokerages and research firms because its trading volume is low then references this comment by Buffett from the 1988 letter (I've included a slightly longer excerpt from the letter than the one used in the article):

...we wish for very little trading activity. If we ran a private business with a few passive partners, we would be disappointed if those partners, and their replacements, frequently wanted to leave the partnership. Running a public company, we feel the same way. 

Our goal is to attract long-term owners who, at the time of purchase, have no timetable or price target for sale but plan instead to stay with us indefinitely. We don't understand the CEO who wants lots of stock activity, for that can be achieved only if many of his owners are constantly exiting. At what other organization - school, club, church, etc. - do leaders cheer when members leave? 

It also mentions Munger's comment at the final Wesco Financial annual meeting in July that "Berkshire stock went to a price we never thought..."

At that same meeting Munger also said the following:

Investors owning Berkshire at current prices will do quite all right just sitting on their rear ends.

The Class A shares traded between $115,230 and $117,250 on that day. The Bloomberg article also points out:

Buffett said on Jan. 20, 2010, that Berkshire was "undervalued" in the market. That day, Class A shares traded between $100,000 and $105,001.

As I write this, the Class A shares currently trades at $ 102,300/share.

It's at least notable that Munger and Buffett would even comment on  Berkshire's stock (never mind say or imply that it is cheap). They are not exactly known for pumping Berkshire's stock in the past.

Actually they have historically done very much the opposite.

Adam

Long BRKb

Diageo's Global Franchise

David Herro, Morningstar's International Stock Fund Manager of the Decade, said the following about Diageo (DEO) in this interview:

"There is one nice, stable, well-managed company that at this stage does not appear very expensive, and it's a stock you could hold for a long, long time, unless it spikes way up. Again, you cannot forget price. That stock is Diageo (DEO). It is the world's largest drinks company."

Then later he added...

"...the profit dynamics of this business are great. It's extremely well managed. Remember my two criteria of a quality business: the return structure, and are they good at allocating capital. This company strongly ticks both of those boxes, and at the same time today you could buy at a relatively low valuation somewhere around ten times gross cash flow. So if you get a good quality company that has moderate long-term growth prospects, low financial risk, unless you believe we're going to have global prohibition, this is going to be a very good stock to own."

In the 1991 Berkshire Hathaway(BRKa) Shareholder Letter, Guinness was revealed as a holding for the first time.

These days, Guinness is one of the many leading global brands of Diageo.

From the 1991 Berkshire Hathaway (BRKa) Shareholder Letter:

Our Guinness holding represents Berkshire's first significant investment in a company domiciled outside the United States. Guinness, however, earns its money in much the same fashion as Coca-Cola and Gillette, U.S.-based companies that garner most of their profits from international operations. Indeed, in the sense of where they earn their profits - continent-by-continent - Coca- Cola and Guinness display strong similarities. (But you'll never get their drinks confused - and your Chairman remains unmovably in the Cherry Coke camp.) 

We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-oriented managements. This focus doesn't guarantee results: We both have to buy at a sensible price and get business performance from our companies that validates our assessment. But this investment approach - searching for the superstars - offers us our only chance for real success. Charlie and I are simply not smart enough, considering the large sums we work with, to get great results by adroitly buying and selling portions of far-from-great businesses. Nor do we think many others can achieve long-term investment success by flitting from flower to flower. 

Diageo's strategic brands include the likes of: Johnnie Walker, Smirnoff, Ketel One, Baileys, Captain Morgan, Jose Cuervo, Tanguerey, Guinness, Crown Royal, and J&B.

Diageo was first mentioned on this blog, as part of the six stock portfolio*, as a business with an attractive share price when it was selling at around $ 45/share. At that price it sported a dividend of around 5%. The current price is more like $ 76.

It's still a terrific franchise with intrinsic value that should grow nicely over time but the stock is a lot less interesting at current prices.

More from Buffett's 1991 letter:

If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long- term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products? (I was tempted to say "the real thing.") Our motto is: "If at first you do succeed, quit trying." 

John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F. C. Scott, on August 15, 1934 that says it all: "As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. . . .One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence." 

Diageo has many great qualities but, unlike Herro, I think it is a bit expensive now. 

Recently, Diageo participated in the Barclays Back To School Consumer Conference.

Here's an article with some notes from that conference.

Adam

*The six stock portfolio is up 67% compared to 37% for the S&P 500 over the same time period (including dividends for both the portfolio and the benchmark). There was no trading over that time frame. The portfolio is simply six good businesses bought at discounts to value with the intention of very long-term ownership. The economics of these businesses (bought with a margin of safety to account for unknowables) will generally drive returns over time...not trading skills. It's intentionally concentrated. Will rarely sell one of these if something materially damages one of these franchises long run viability or if opportunity cost becomes very high.

Buffett on Bold & Imaginative Accounting: Berkshire Shareholder Letter Highlights

From the 1998 Berkshire Hathaway (BRKa) Shareholder Letter:

A distressing number of both CEOs and auditors have in recent years bitterly fought FASB's attempts to replace option fiction with truth and virtually none have spoken out in support of FASB. Its opponents even enlisted Congress in the fight, pushing the case that inflated figures were in the national interest.

Still, I believe that the behavior of managements has been even worse when it comes to restructurings and merger accounting. Here, many managements purposefully work at manipulating numbers and deceiving investors. And, as Michael Kinsley has said about Washington: "The scandal isn't in what's done that's illegal but rather in what's legal."

It was once relatively easy to tell the good guys in accounting from the bad: The late 1960's, for example, brought on an orgy of what one charlatan dubbed "bold, imaginative accounting" (the practice of which, incidentally, made him loved for a time by Wall Street because he never missed expectations). But most investors of that period knew who was playing games. And, to their credit, virtually all of America's most-admired companies then shunned deception.

In recent years, probity has eroded. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers -- CEOs you would be happy to have as spouses for your children or as trustees under your will -- have come to the view that it's okay to manipulate earnings to satisfy what they believe are Wall Street's desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.

These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don't produce the result hoped for, these CEOs resort to unadmirable accounting stratagems. These either manufacture the desired "earnings" or set the stage for them in the future.

Rationalizing this behavior, these managers often say that their shareholders will be hurt if their currency for doing deals -- that is, their stock -- is not fully-priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does. Once such an everybody's-doing-it attitude takes hold, ethical misgivings vanish. Call this behavior Son of Gresham: Bad accounting drives out good.

In a post back in May, I said that the best defense for investors is to buy businesses run by managers with a strong reputation and track record of fostering a conservative accounting culture. This is, unfortunately, not as easy to identify or find as it ought to be.

Buffett on Earnings Precision

The term "earnings" has a precise ring to it. And when an earnings figure is accompanied by an unqualified auditor's certificate, a naive reader might think it comparable in certitude to pi, calculated to dozens of decimal places.

In reality, however, earnings can be as pliable as putty when a charlatan heads the company reporting them. - Warren Buffett in the 1990 Berkshire Hathaway Shareholder Letter

All things being equal (and they never are, of course) I'd buy a slightly inferior business if I thought the management could be trusted to not inflate the score.

Accounting standards provides useful tools. Yet, understanding the inherent limitations of the tools is crucial for investors. The numbers that go into a company's 10-K or 10-Q are not nearly as absolute as we'd all like them to be.

Obviously, you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was o­nce the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.

But you have to know enough about it to understand its limitations - because although accounting is the starting place, it's o­nly a crude approximation. - Charlie Munger in a talk he gave in 1994 at USC Business School

The problem is that earnings are not particularly precise even when management is doing its best to report the numbers honestly. Yet, when you're confident that the numbers management and the auditor's agree to put up on the scoreboard are a conservative representation of performance, the limitations of accounting should matter a whole lot less.

Conservative scorekeeping makes it easier to be certain you are, in fact, obtaining share ownership with the appropriate margin of safety. You'll be less likely to pay an inflated price resulting from either being misled deliberately by management, or the inherent limits of accounting itself.

So own businesses run by honest and capable management who tend to report the numbers conservatively. This, itself, won't make you rich but it will reduce the probability of waking up some morning only to find out that something you own is actually worth 50 cents on the dollar or worse.

Adam

Charlie Munger at USC Business School in 1994

Buffett on "The Inevitables": Berkshire Shareholder Letter Highlights

From the 1996 Berkshire Hathaway (BRKa) Shareholder Letter:

I was recently studying the 1896 report of Coke (and you think that you are behind in your reading!). At that time Coke, though it was already the leading soft drink, had been around for only a decade. But its blueprint for the next 100 years was already drawn. Reporting sales of $148,000 that year, Asa Candler, the company's president, said: "We have not lagged in our efforts to go into all the world teaching that Coca-Cola is the article, par excellence, for the health and good feeling of all people." Though "health" may have been a reach, I love the fact that Coke still relies on Candler's basic theme today - a century later. Candler went on to say, just as Roberto could now, "No article of like character has ever so firmly entrenched itself in public favor." Sales of syrup that year, incidentally, were 116,492 gallons versus about 3.2 billion in 1996.

I can't resist one more Candler quote: "Beginning this year about March 1st . . . we employed ten traveling salesmen by means of which, with systematic correspondence from the office, we covered almost the territory of the Union." That's my kind of sales force.

Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables." Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.

In the letter, Buffett mentions that the stock prices of businesses like Coca-Cola (KO) and Gillette (now part of Procter & Gamble: PG) end up out of line with value. He also says that even outstanding businesses have historically been susceptible to management that become distracted and unfocused from time to time.

You can, of course, pay too much for even the best of businesses. The overpayment risk surfaces periodically and, in our opinion, may now be quite high for the purchasers of virtually all stocks, The Inevitables included. Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.

A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged. Unfortunately, that is precisely what transpired years ago at both Coke and Gillette. (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette?) Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding. All too often, we've seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.

Around the time that letter was written, stocks like Coca-Cola were beginning to sell at multiples of earnings that made little sense. Even an outstanding business like Coca-Cola, if bought at 40-50x earnings, almost guarantees the investor a stagnant or worse decade ahead (in terms of stock performance) as the intrinsic value* of the business catches up to market price (or market price falls more in line with current value).

These are value creating machines but paying too much in anticipation of future worth will naturally damage investor returns.

Many stocks, of course, would go on to get even more expensive after he wrote that letter and it certainly was not just the tech stocks.

These days, Wal-Mart (WMT) is often cited as a stock that has gone nowhere in the past decade. The listless performance has more to do with the price paid by market participants for Wal-Mart's stock, especially in the 1st half of the past decade, not business performance over that time.

The business itself did just fine.

Over that time the Wal-Mart's business more than tripled its earning power. Not a bad decade of work especially for a company that size.

A decade ago market participants were willing to pay around forty dollars for every dollar of Wal-Mart's earnings. Now, investors are paying less than 12 dollars for every dollar of earnings.

Unless something material is going to happen to Wal-Mart's moat, at current market price the next decade should be a much different story as far as that stock goes.

Adam

* From the Berkshire Hathaway Owner's Manual (pages 4-5):
"Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are 5 revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures."

Buffett: An Ordinary Horse Sold As Secretariat - Berkshire Shareholder Letter Highlights

From the 1995 Berkshire Hathaway (BRKa) Shareholder Letter:

...sellers and their representatives invariably present financial projections having more entertainment value than educational value. In the production of rosy scenarios, Wall Street can hold its own against Washington.

In any case, why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, but instead keep in mind the story of the man with an ailing horse. Visiting the vet, he said: "Can you help me? Sometimes my horse walks just fine and sometimes he limps." The vet's reply was pointed: "No problem - when he's walking fine, sell him." In the world of mergers and acquisitions, that horse would be peddled as Secretariat.

A business run by management in the habit of paying Secretariat prices for so-called strategic acquisitions is a sell.

In most cases, that so-called strategic deal is just a cloak around the reality that a wealth transfer from acquirer to acquiree shareholders is taking place. A company with entrenched management that behaves this way materially reduces the growth in intrinsic value of a business (in fact may shrink it) and, of course, shareholder wealth.

Imagine Berkshire Hathaway without all the smart deals done over the years. Intrinsic value today would be an awful lot less.

Any use of the words like strategic or synergistic to justify a deal warrants skepticism. Consider those words as code for "we are getting bigger at shareholder expense". When these terms are employed, it's almost guaranteed that management overpaid and is selling the rich price to shareholders on the basis of some mysterious hidden value. The likely reality is that animal spirits kicked in during the acquisition process and management began buying the kind of "rosy scenarios" that Buffett refers to above.

So the pitch to shareholders on the merits of the deal will often be under the guise that value not yet revealed will, out of thin air, somehow emerge. Naturally, once the deal is done if that value does not appear down the road there is no recourse. The wealth transfer will have happened with acquiring shareholders feeling (in fact being) a bit poorer.

The bottom line is that management should, in most cases, pay only for the proven economics of a business...not promise.

If not a rule it's the next best thing.

The intrinsic value of a business is raised by having a management team in place that consistently makes smart acquisitions at fair, or better yet, limping horse prices.

Adam

Buffett on Macro Forecasts: Berkshire Shareholder Letter Highlights

From the 1994 Berkshire Hathaway Shareholder Letter:

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.

These comments by Buffett are worth considering the next time one of the many who are in the business of making macro forecasts opines on business news.

At the very least, remember it the next time someone confidently predicts what the macroeconomic future will be and then makes a specific investing strategy recommendation based upon it.

Adam