In his letter to shareholders in 1981, Warren Buffett discussed his ideas on reported non-controlled earnings and acquisition.
Non-controlled ownership earnings
Non-controlled ownership earnings do not reflect in the financial statements of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B). However, Warren Buffett believed those undistributed earnings (or unrecorded earnings) would be translated into tangible value for shareholders just as surely as if the subsidiaries Berkshire controlled had earned, retained and reported earnings.
"This translation of non-controlled ownership earnings into corresponding realized and unrealized capital gains for Berkshire will be extremely irregular as to time of occurrence. While market values track business values quite well over the long periods, in any given year the relationship can gyrate capriciously. Market recognition of retain earnings also will be unevenly realized among companies."
Buffett mentioned that overall, the non-controlled businesses have more favorable underlying economic characteristics than the controlled ones. "Small portions of exceptionally good businesses are usually available in the securities markets at reasonable prices. But such businesses are available for purchase in their entirety rarely, and then almost always at high prices."
Buffett at that time often found values more easily through the stock market by purchasing fractional positions in companies with excellent business characteristics. "We expect that undistributed earnings from such companies will produce full value (subject to tax when realized) for Berkshire and its shareholders. If they don't, we have made mistakes as to either: (1) the management we have elected to join; (2) the future of economics of the business; or (3) the price we have paid."
"For personal as well as more objective reasons, however, we generally have been able to correct such mistakes far more quickly in the case of non-controlled businesses (marketable securities) than in the case of controlled subsidiaries. Lack of control, in effect, often has turned out to be an economic plus."
General Acquisition Behavior
The insurance and trading stamps businesses looked for in major investments were mainly in marketable securities due to their liquidity requirements. Berkshire Hathaway acquisition goals are to maximize real economic benefits, not for either managerial domain or for accounting purposes. "In the long run, managements stressing accounting appearance over economic substance usually achieve little of either."
"Regardless of the impact upon immediately reportable earnings, we would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share. Most corporate managers prefer just the reverse, and have no shortage of stated rationale for their behaviour."
There were three motivations, usually unspoken for high-premium takeovers:
- Leaders seldom are deficient in animal spirits and often relish increased activity and challenge.
- Most organizations measure themselves, are measured by others, and compensate their managers far more by the yardstick of size than by any other yardstick.
- Many executives were overexposed, like the story of the imprisoned prince released from a toad's body by a kiss from a beautiful princess. So they hope their managerial kiss will do wonders for the profitability of the target.
Warren Buffett pointed out two major categories of acquisition:
"The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored businesses has 02 characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital."
"The second category involves the managerial superstars – men who can recognize that rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise."
Buffett had been consistently seeking the first category. With management of ordinary ability, the business would still be doing well.
He has posted his ideas on various topics that most investors find very useful and interesting. In the past letter to shareholders, he shared his views on bond valuation of insurers and its impact on insurers' investment decisions. Interested readers can find it here.