Any investors would love to park money for the long term in sustainable growing businesses managed by talented and outstanding managers. Warren Buffett had discussed moats around business as well as outstanding managers over and over again in his talks as well as in his letters to shareholders.
According to him, book value is just a historical number and it does not indicate the true value of a businesses. Book value is what has been put in, intrinsic value is what can be taken out. What really counts is the gain in per-share business value, not book value. Nevertheless, in the case of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), two valuations tracked rather closely, with the growth rate in business value over time somehow matching with the growth rate in business value. For other corporations, in many cases, their book values and their business value were much unrelated. Buffett has pointed out the example of LTV and Baldwin-United reporting the book value amount of $652 million and $397 million respectively just before they went bankrupt. In contrast, Belridge Oil, the famous situation that Charlie Munger mentioned in his talk, got its book value at $177 million, and was acquired by Shell in 1979 for $3.6 billion, 20 times of its book value.
In order to evaluate the economic performance of certain enterprises, we should know how much total capital — both debt and equity — was needed to produce the earnings. Dated back 1987, for the seven largest non-financial units of Berkshire Hathaway, it reported to have operating earnings before interest and taxes of $160 million. And debt played a very minor role. Interest expenses in 1987 was only $2 million. Thus, the pre-tax earnings on equity capital employed by these businesses amounted to $178 million, and this equity, on an historical basis — was only $175 million. Buffett mentioned that if these seven business units were operated as a single company, their 1987 after-tax earnings would have been around $100 million, creating the return of around 57% on their capital. With the benchmark of 1988 Investor’s Guide, Fortune said among 500 largest industrial companies and 500 largest service companies, only six got the average ROE of over 30%, during the previous decade.
Then he drew three important inferences from the figures he cited in the 1987 letter to shareholders for these seven non-financial units. First, the current business value of these units was far above the historical book value and also far above the value at which they were carried in the balance sheet of Berkshire Hathaway. Second, because of little demand for reinvestment capital expenditure, the business can grow while concurrently making nearly all of the earnings available for deployment in new opportunities. Third, these businesses were run by truly extraordinary managers. That was why Charlie Munger and Warren Buffett did not have to get involved in the operations; those managers didn’t need to be taught how to swing, and if Munger and Buffett did more into separate business operations, less would be accomplished.
Buffett wrote: “We have no corporate meetings, no corporate budgets, and no performance reviews (though our managers, of course, sometimes find such procedures useful at their operating units).”
One of the sentences I profoundly agree with Buffett on is, “Severe change and exceptional returns usually don’t mix.” Most investors in the stock market behave as if just the opposite was so true. Many of them confer highest P/E ratios on exotic-sounding businesses that hold out promise of feverish change. That would lead investors to dream of future profitability rather than face today’s reality.
He went further: “Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major errors. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.”
Then he cited the Fortune study showing that out of 1,000 companies, only 25 meet the test of excellence with ROE of over 20% in 10 years from 1977 to 1986, and no year worse than 15%. The great fundamental performance had translated into the stock market price during the same period. Twenty-four out of 25 companies reported outperformed the S&P 500. Those companies used very little leverage as really good businesses don't need to borrow. In addition, out of 25, one company was high tech, several others manufactured pharmaceutical drugs and the rest were in businesses that seemed mundane. Most of them sold non-sexy products or services in the same manner as they had done in the previous 10 years.
According to him, book value is just a historical number and it does not indicate the true value of a businesses. Book value is what has been put in, intrinsic value is what can be taken out. What really counts is the gain in per-share business value, not book value. Nevertheless, in the case of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), two valuations tracked rather closely, with the growth rate in business value over time somehow matching with the growth rate in business value. For other corporations, in many cases, their book values and their business value were much unrelated. Buffett has pointed out the example of LTV and Baldwin-United reporting the book value amount of $652 million and $397 million respectively just before they went bankrupt. In contrast, Belridge Oil, the famous situation that Charlie Munger mentioned in his talk, got its book value at $177 million, and was acquired by Shell in 1979 for $3.6 billion, 20 times of its book value.
In order to evaluate the economic performance of certain enterprises, we should know how much total capital — both debt and equity — was needed to produce the earnings. Dated back 1987, for the seven largest non-financial units of Berkshire Hathaway, it reported to have operating earnings before interest and taxes of $160 million. And debt played a very minor role. Interest expenses in 1987 was only $2 million. Thus, the pre-tax earnings on equity capital employed by these businesses amounted to $178 million, and this equity, on an historical basis — was only $175 million. Buffett mentioned that if these seven business units were operated as a single company, their 1987 after-tax earnings would have been around $100 million, creating the return of around 57% on their capital. With the benchmark of 1988 Investor’s Guide, Fortune said among 500 largest industrial companies and 500 largest service companies, only six got the average ROE of over 30%, during the previous decade.
Then he drew three important inferences from the figures he cited in the 1987 letter to shareholders for these seven non-financial units. First, the current business value of these units was far above the historical book value and also far above the value at which they were carried in the balance sheet of Berkshire Hathaway. Second, because of little demand for reinvestment capital expenditure, the business can grow while concurrently making nearly all of the earnings available for deployment in new opportunities. Third, these businesses were run by truly extraordinary managers. That was why Charlie Munger and Warren Buffett did not have to get involved in the operations; those managers didn’t need to be taught how to swing, and if Munger and Buffett did more into separate business operations, less would be accomplished.
Buffett wrote: “We have no corporate meetings, no corporate budgets, and no performance reviews (though our managers, of course, sometimes find such procedures useful at their operating units).”
One of the sentences I profoundly agree with Buffett on is, “Severe change and exceptional returns usually don’t mix.” Most investors in the stock market behave as if just the opposite was so true. Many of them confer highest P/E ratios on exotic-sounding businesses that hold out promise of feverish change. That would lead investors to dream of future profitability rather than face today’s reality.
He went further: “Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major errors. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.”
Then he cited the Fortune study showing that out of 1,000 companies, only 25 meet the test of excellence with ROE of over 20% in 10 years from 1977 to 1986, and no year worse than 15%. The great fundamental performance had translated into the stock market price during the same period. Twenty-four out of 25 companies reported outperformed the S&P 500. Those companies used very little leverage as really good businesses don't need to borrow. In addition, out of 25, one company was high tech, several others manufactured pharmaceutical drugs and the rest were in businesses that seemed mundane. Most of them sold non-sexy products or services in the same manner as they had done in the previous 10 years.
