Two value investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about value investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we cover the 1991 letter.
H. H. Brown
Kicking things off, Buffett shared his thinking regarding Berkshire’s sizable acquisition in 1991 of H. H. Brown Company, “the leading North American manufacturer of work shoes and boots” which had a history of earning unusually fine margins on sales and assets. Despite the shoe business being a tough one, Buffett explained that a “distinguishing characteristic” of H. H. Brown was one of the most unusual compensation systems he had encountered. He wrote:
"A number of key managers are paid an annual salary of $7,800, to which is added a designated percentage of the profits of the company after these are reduced by a charge for capital employed. These managers therefore truly stand in the shoes of owners. In contrast, most managers talk the talk but don't walk the walk, choosing instead to employ compensation systems that are long on carrots but short on sticks (and that almost invariably treat equity capital as if it were cost-free). The arrangement at Brown, in any case, has served both the company and its managers exceptionally well, which should be no surprise: Managers eager to bet heavily on their abilities usually have plenty of ability to bet on."
This section on the classic principal-agent problem reminded me of a passage from the 1985 shareholder letter, which read:
"Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I’ll be happy to accept a lottery ticket as a gift - but I’ll never buy one.)"
Remuneration policies are a core part of corporate governance. The fact Buffett put so much emphasis on this means we should also pay attention to it.
Acquisition criteria
Reading Berkshire’s shareholder letters, I have noticed Buffett not only uses the platform to promote the products and services of the companies it owns, but also to solicit deals. He noted what Berkshire looks for:
Large purchases (at least $10 million of after-tax earnings)
Demonstrated consistent earning power (future projections are of little interest to us, nor are "turnaround" situations)
Businesses earning good returns on equity while employing little or no debt
Management in place (we can't supply it)
Simple businesses (if there's lots of technology, we won't understand it)
An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).
Buffett also said Berkshire will not engage in unfriendly takeovers and prefer to buy for cash, but will consider issuing stock when Berkshire receives as much in intrinsic business value as it gives. He also warns brokers that Berkshire is not interested, however, in receiving suggestions about purchases it might make in the general stock market.
Reading between the lines, he is saying Berkshire does its own homework and does not require stock picking ideas. This reminds me of a very smart hedge fund I know who have a “no calls” policy in place for its brokers. They need brokers to execute trades, but they do not want to talk to them on the phone about investment ideas. The message is that broker research, probably because it is heavily conflicted, does not have much value for sophisticated investors.
Marketable common stocks
Buffett told readers that Berkshire’s “stay-put behavior” is based on the view the stock market serves as “a relocation center at which money is moved from the active to the patient.” Only half-jokingly Buffett said the much-maligned "idle rich" have received a bad rap: They have maintained or increased their wealth while many of the "energetic rich" - aggressive real estate operators, corporate acquirers, oil drillers, etc. - saw their fortunes disappear. One imagines that the guru would be a fan of Aesop's fable of the tortoise and the hare.
What Berkshire has been looking for are large, understandable businesses with enduring and attractive economics, which are run by able and shareholder-oriented managements. Buffett reminded readers that this is not the only criteria. Just as importantly are the price paid for the investment and then the business performance follow-through post-acquisition. He wrote:
"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. Indeed, we believe that according the name 'investors' to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic."
Buffett conceded that finding great businesses and outstanding managers is very difficult. He then quoted British economist John Maynard Keynes, “whose brilliance as a practicing investor matched his brilliance in thought,” from a letter written in 1934 that sums up his thinking:
"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."
Conclusions
Although he does not call it that, Buffett thinks deeply about the principal-agent problem and corporate remuneration policies. He also has a clear investment strategy and prefers to back his ideas in size than diversify across too many investments. As we have seen in previous letters, Buffett is happy to tolerate volatility because he sees trading actively as an exercise in futility.
