An In Depth Book Review by Philip Martin, Law Student Creighton School of Law
Chapter One: Corporate Governance
Warren Buffett and Charlie Munger take a unique approach in the way they run Berkshire Hathaway. Although the company is a corporation, they approach the business as if the shareholders are owner-partners, and they are the managing-partners. To Buffet, this is not just a job where he sits as CEO until a better job offer comes around, rather it is a long-term relationship to the company and the other “owners.” Berkshire Hathaway takes a unique approach to the corporate governance by attempting to align the interests of the executives with the shareholders so everyone will make money in the same manner and in the same proportion. Perhaps the best example of how this is done is the fact that 99% of Buffet’s net worth is tied up in Berkshire Hathaway. When Berkshire Hathaway acquires a new company the manager of that company is told to run the business as if they own 100% of the business, it is the only asset that individual has, and the person cannot sell it or merge it for 100 years.
Buffet places considerable emphasis on full and fair disclosure to shareholders. As a company they will try not to use any unclear accounting methods, and will provide information to shareholder that they would want to know if they were in the shareholder’s shoes. However, Buffet notes that they will not discuss any potential acquisitions or even rumors of acquisitions because “good investment ideas are rare.” In other words, Buffet will not announce he found a potential “gold mine” because once word gets out, others will come rushing in.
Buffet criticizes an accounting method known as EBITDA (earnings before interest, taxes, depreciation, and amortization) because it unrealistically represents the company’s performance and is often a sign that the CEO is hiding something. Buffet does not criticize a CEO for having lofty goals and expectations. But when a CEO makes unsupported long-term predictions, the CEO often looks toward accounting gimmicks like EBITDA to “make the numbers.” This unethical behavior has a tendency to spread and “turn fudging into fraud.”
Executive compensation has gotten out of control and very one-sided since the 1990’s. Buffet criticizes the use of stock options to compensate executives in all but a few circumstances. The problem with using stock options is that even meager growth over a long period of time will eventually double or even quadruple the value of the company. This simple math will eventually allow the executive to exercise the option and receive a considerable bonus for average or below-average performance. However, when the company does poorly, the executive does not share in the loss that the shareholder’s experience. Berkshire Hathaway uses an incentive-based system that allows for high bonuses, but also requires the executives to share in any losses as well.
Chapter Two: Corporate Finance and Investing
This chapter begins with an analogy of the stock market called “Mr. Market.” This is an analogy from Ben Graham that compares the stock market to an unstable business partner. While Mr. Market is generally a very rational and accurate partner, he occasionally suffers from wild emotional swings. Sometimes Mr. Market becomes unrealistically optimistic and increases his prices substantially. Other times Mr. Market suffers from terrible depression and offers to sell stocks at irrationally low prices. Usually the under-valued stocks are for poor or average companies, but every now and then the under-valued stock belongs to a wonderful company. When Mr. Market grossly undervalues a wonderful company, buy it.
Buffet points out an interesting philosophical flaw that investors want to see increasing stock prices. Warren Buffet makes an analogy of buying stocks to buying hamburgers. It is interesting that people who buy hamburgers get upset when prices rise, but people who buy stocks enjoy watching an increase in the stock market. Just as a buyer of hamburgers should not wish to see rising costs of hamburger, a purchaser of stocks should not wish to see rising prices in the stock market. The cheaper an investor can buy the stocks, the more money the investor makes. Ultimately, a purchaser of stocks should only want prices to rise when it is time to sell.
Warren Buffet criticizes several of the current investing philosophies popping up in today’s market, and instead utilizes “value investing.” Value investing is a theory that is based on the underlying premise that price and value are not necessarily the same thing. This type of investing is fairly similar to a savvy consumer waiting for a great sale before making a purchase. Just as the savvy consumer knows a great sale can yield an inconsistency between the price and the value, value investing believes the price of a stock can fall below the value of the stock. This contradicts the “Efficient Market Theory” (EMT) which is a theory that the market is perfectly efficient and all the relevant information about the value of the stock becomes immediately incorporated into the price of the stock itself. Buffet agrees that the market is frequently efficient, but rejects the idea that it is always efficient. He believes there is a big difference between the two and believes it is a shame EMT has been adopted in academics as a “holy scripture.”
Buffet places less emphasis on the stock, and more emphasis on the business itself. When investing, it is important to think of purchasing stock as buying a part of a business. Just as people would not want to start a business in an area they do not understand, it is also a poor idea to invest in a company in an unfamiliar industry. An owner of a successful business would not likely sell the business, similarly it is foolish to sell stock of a wonderful and understandable business. When Berkshire Hathaway purchases all or part of a company they want: (1) a company they can understand; (2) with a favorable long-term outlook; (3) run by good and competent management; and, (4) available at a low price.
Buffet does not buy into the idea that an investor ought to diversify a portfolio simply for the sake of creating more diversity. He states that he “cannot understand why an investor…elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices.” Instead, Buffet prefers to buy his favorite stock and notes that his “favorite holding period is forever.”
Chapter Three: Alternatives to Common Stock
In this chapter, Buffet makes a prophetic prediction of the banking industry. He notes that many of the banks were over-leveraged, many by as much as a twenty-to-one margin. Buffet noted there was a risk that a financial panic could be so severe it could “endanger almost every highly-leveraged institution, no matter how intelligently run.” Since the banking industry is so prone to mistakes, Buffet emphasizes the importance of proper management. Buffet believed the management at Wells Fargo was the best in the industry, so Berkshire Hathaway acquired about a 10% interest in the company.
Many companies have begun acquiring more debt than is prudent to run the business, and oddly there is a trend that encourages such behavior. The idea is that high debt requires a manager to act more carefully, analogizing it to placing a dagger on the steering wheel of a car. In other words, one mistake and you are dead. Warren Buffet cites Ben Graham who thoroughly rejects this theory and believes such behavior can kill a company before it even begins. Instead, a wise investor will focus on having a margin of safety.
Buffet discusses one of his particularly poor investment decisions. He explains that several years earlier the company had sold off their shares of Cap Cities at about $4 per share, writing the company off as a loss. A few years later, they bought back the shares at $17, and then finally sold off the shares for $63 each. Had Berkshire held onto the stock for one more year, the shares would have been worth over $85 each. Buffet noted he was a “repeat offender” with this particular stock.
Buffet finishes up the chapter by discussing a particularly uncharacteristic investment for Berkshire Hathaway: silver. Buffet notes that when making this deal, they could not find any other great deals and had to place money in this short-term investment. Had the deal gone well, the shareholders would have had significant earnings. However, if it went poorly he personally stood to lose a lot on the deal as well.
Chapter 4: Common Stock
This chapter focuses primarily on the transactional costs of investing. Buffet points out the fact that in aggregate, the owners can only earn what the business earns in aggregate. In other words, when an investor has a diverse portfolio that accurately represents the market, the most that portfolio can earn is the proportional representation to the aggregate of the market. In order to make more money, people began hiring “experts.” In the end, the investor is worse off because the gain is still the aggregate of the market, reduced by the transactional costs. These transactional fees can account for up to 10-20% of the earnings.
Transactional fees become reflected in the price of the stock. Heavy trading can result in severe undervaluation or overvaluation of the security and make it more difficult for a shareholder to sell it at the appropriate price. Berkshire Hathaway wants to avoid this, so they make significant efforts to reduce the transactions of their stock. The company tries to attract only buyers who are willing to stick with the company for the long-hall, does surprising little trading during the year, does not split its stock, will only pay out dividends if the unrestricted earnings cannot be reinvested more effectively in the company, and will not make purchases that will reduce the value of the investment.
Finally, Buffet discusses the innovative new idea of creating the class B shares that are 1/30 the value of the class A shares. Shareholders can convert a class A share into a class B share to avoid having to get rid of an entire $10,000 share of Berkshire Hathaway stock.
Chapter 5: Mergers and Acquisitions
In this chapter, Buffet discusses purchasing other businesses. Whether purchasing the entire business, or just part of it, he recommends purchasing “good businesses at a fair price rather than fair businesses at good prices.” There are two types of investors that buy companies: the kind that purchases only good businesses, and the kind that metaphorically buys a toad and through a magical kiss turns it into a prince. Buffet admits that he is not in the second category and has had little success in that area.
When Berkshire Hathaway acquires a new business it almost always pays cash rather than give a portion of its shares as payment. The reason for doing so is because Berkshire Hathaway has such an impressive collection of businesses, purchased at such a great price, that it is unlikely the company it is acquiring can equal or beat what it is selling. Furthermore, Berkshire Hathaway will not provide the management for the business, but instead will let the company run as it had prior to the acquisition. Strangely, Berkshire Hathaway seems to make a surprisingly small number of deals throughout the year, and is very specific in the types of businesses they are willing to acquire.
Chapter 6: Accounting and Valuation
Buffet emphasizes the importance of recognizing that accounting is merely a method to show what the company is made of financially. It should only be used as a tool for investing; it should not be the driving force behind the decisions. Buffet begins the chapter with an analogy of a company using accounting methods to disguise their poor performance over the last several years. The point is that an investor needs to look beyond the numbers and see what the company is actually doing because regardless of the accounting method used, eventually the truth will come out. Buffet particularly notes the accounting difficulties that occur after a merger or acquisition occurs, and how two different accounting methods can make the same company look very different.
Rather than focusing solely on the numbers, Buffet emphasizes the importance of focusing on the “economic goodwill” of the company because a good company is worth far more than the sum of all its tangible assets. While the book value of a business is relatively easy to ascertain with accurate accounting methods, the intrinsic value of a company is more difficult to determine.
Chapter 7: Accounting Policy and Tax Matters
The final chapter, unfortunately, does not end with any great twist such as a surprise wedding between Warren and his partner Charlie, or perhaps Ann Hathaway coming to reclaim the Berkshire that was wrongfully taken from her family. Instead, this chapter deals with the ever-exciting accounting and tax policy. Continuing on the accounting methods, Buffet explains that businesses are too complex for a single set of accounting rules to be all-inclusive and even a well-intentioned accountant can stretch the numbers to yield more favorable numbers. Unfortunately, in the last few decades accountants have become more relaxed in their standards, and Congress and the SEC have allowed it to happen. In essence, the laws have created an “honor system” approach. Buffet particularly criticizes the dishonest accounting practice that does not require companies to report stock options given to executives as compensation.
Finally, Buffet addresses taxes. He recognizes there is an argument that customers and businesses share the taxes when taxes are increased. He notes that policymakers are not asking whether customers and businesses share the benefit of a tax decrease. His conclusion is that sometimes the benefits are passed through, and sometimes they are not. “What determines the outcome is the strength of the corporation’s business franchise and whether the profitability of the franchise is regulated.” By keeping the tax rates so low, Buffet predicts that the fiscal problems in Washington will result in higher taxes, inflation, or both.
Warren Buffet is an expert in investing, but a lot of people can benefit from this book even if they are not investors. This is a great book, and it is particularly valuable for managers, entrepreneurs, attorneys, accountants, and private citizens. The book is valuable for managers and entrepreneurs because it demonstrates the value in treating a company loyally. Treating the company as your only asset for 100 years that you cannot sell or trade is some of the best advice for managers and entrepreneurs I have ever heard. This book is beneficial for lawyers and accountants because, sadly, a large percentage of the unethical business practice discussed in this book was accomplished through the use of accountants and lawyers. Certainly these practices are not solely to blame. However, it is interesting that such calamity occurred because accountants used an accepted, but deceptive form of accounting. Attorneys drafted documents in accordance with the laws, but those documents were not in the shareholders’ best interests. This book demonstrates that acceptable behavior within a professional occupation is no substitute for ethics and acting for the benefit of society. This book shows that accountants and attorneys need to recognize that their actions might have significant consequences, and they need to consider the consequences of their actions beyond the realms of their personal employment. Finally, this book is beneficial to every citizen because it not only discusses the need for tax reform, but demonstrates the problems that are created when government allows managers to act within their own self-interests and ignore the shareholder. In the end it is not just the shareholder that pays, but every American.