Over recent weeks I have been re-reading the Berkshire Hathaway annual reports and shareholder letters from 1965 to 1990 (and will continue to re-read the rest), looking for lessons and tidbits of knowledge from the Oracle of Omaha, continuously taking notes or as some call it, “reading with a purpose.”
Some interesting, straightforward views are provided in various topics such as: convertible preferred shares, zero coupon bonds, EBDIT, capital outlays, commodity based businesses and hiring management.
On Hiring Management: “If each of us hires people who are smaller than we are, we shall become a company of dwarfs. But, if each of us hires people who are bigger than we are, we shall become a company of giants.” – 1986 Shareholder Letter
The quote above provides insight into how recruitment staff and human resource departments (especially small businesses) should be operating their businesses, actively looking for the best candidates, not worried about the potential to be outdone or “shown up” by the new hires, young guns or more experienced, putting ego and superiority aside for the benefit of the business.
On Skipping Capital Outlays: “Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet.” – 1989 Shareholder Letter
It does not take a businesses genius to figure out that a company’s depreciation rate exceeding that of the capital expenditures on a routine basis (in a free market unless it is a bridge or other business based on enormous one time costs) will be plagued by inefficiencies, and surely not thrive against competition. The most likely outcome is the business ultimately cuts to its own demise. Surely you would not eat the bare minimum acceptable to keep you alive?
On Convertible Preferred Shares: “The point you should keep in mind is that most of the value of our convertible preferred is derived from their fixed-income characteristics. That means the securities cannot be worth less than the value they would possess as non-convertible preferred and may be worth more because of their conversion options.”
On Insurance (Commodity-Based Businesses Engaging in Price Wars): “While the lamb may lie down with the lion, the lamb shouldn’t count on getting a whole lot of sleep.” – Woody Allen
Buffett quotes Allen frequently throughout his reports usually with intelligent punches at the perfect timing. This quote reflects the onslaught of competition in commodity-based businesses (unless of course you enjoy being the low-cost producer) and how it feels to be up against the low-cost producer (the lion).
On EBDIT and Investment Bankers Using It: “Our advice: Whenever an investment banker starts talking about EBDIT – or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures – zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures.”
EBDIT stands for earnings before depreciation interest and tax, that is earnings before any deductions. Add in amortization and we have EBITDA. Now this can be beneficial to look at and is sometimes taken as a proxy for cash flow. On the flip side EBDITA can be very misleading in general uses as high indebted companies may not be able to service their interest with working capital and cash flow or a company may be profitable pre-tax and un-profitable afterwards. Furthermore, tax rates may differ if companies being compared within the same industry are not within the same country, all the while EBITDA would paint a much rosier picture.
About the author:
"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain