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 go over the 1988 letter.
The 1988 shareholder letter has two interesting sections; the first is Buffett’s comments on accounting and financial disclosures and the second is on arbitrage.
Accounting and finanical disclosures
Buffett starts by saying despite the “shortcomings” of GAAP, he would hate to have the job of devising a better set of rules. However, he says GAAP should not be inhibiting for CEOs and that they should “treat GAAP statements as a beginning rather than an end to their obligation to inform owners and creditors.”
"After all, any manager of a subsidiary company would find himself in hot water if he reported barebones GAAP numbers that omitted key information needed by his boss, the parent corporation's CEO. Why, then, should the CEO himself withhold information vitally useful to his bosses - the shareholder-owners of the corporation?"
Buffett goes on to say there are three key things that need to reported, regardless of whether or not they are GAAP, so that investors can answer three important questions:
- Approximately how much is this company worth?
- What is the likelihood that it can meet its future obligations?
- How good a job are its managers doing, given the hand they have been dealt?
Buffett suggested that minimum GAAP reporting will not fully answer these questions as the business world is “is simply too complex for a single set of rules to effectively describe economic reality for all enterprises, particularly those operating in a wide variety of businesses, such as Berkshire.”
What Buffett wrote next is still true today:
"As long as investors - including supposedly sophisticated institutions - place fancy valuations on reported 'earnings' that march steadily upward, you can be sure that some managers and promoters will exploit GAAP to produce such numbers, no matter what the truth may be."
The usefulness of conventional financial statements diminishes as the number of economically diverse business operations lumped together increases, thereby limiting investors' ability to address the earlier posed three questions. So to answer the three questions more clearly, Buffett highlighted the need for segmental data to be reported. While Berkshire itself only reports consolidated numbers to meet outside requirements, he said he and Charlie Munger (Trades, Portfolio) constantly study the conglomerate's own segment data.
Buffett went on to note that some Berkshire investors might not need all the data it reports because these investors, for various reasons, trust he and Munger, calling this faith type investing. Other Berkshire investors prefer an "analysis" approach, which Berkshire tries to satisfy by supplying useful information. Buffett said the faith approach is not wrong in and of itself, but in Berkshire’s investment style is to align faith in company management backed up with fundamental analysis, hence Buffett’s need and focus on useful information over and above GAAP numbers.
This got me thinking because, in my own analysis, I have preferred to focus on GAAP or International Financial Reporting Standards numbers because I am often skeptical of adjusted numbers managements put out. Buffett is telling readers that accounting rules are not the be all and end all, and to answer his three questions we should probably think about free cash flow, asset-liability management (or balance sheet appropriateness) and fundamental operational performance at the segment level, or even better at the business level. If we have faith in management, then it follows that we can more likely have faith in non-GAAP reported numbers if they help us answer the important questions.
While Berkshire is a long-term investor, typically, some readers may be surprised to find that Buffett sometimes engages in arbitrage. Not arbitrage in its pure sense, but in the “risk arbitrage” sense. This is because sometimes Berkshire finds itself with too much cash, too little investment opportunity and some arbitrage opportunities offer better returns than Treasury bills. It also gives Buffett something interesting to do when there is nothing else to do, which Buffett indicated is preferable to relaxing his standards for long-term investments.
Buffett defined arbitrage here as:
"Pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock market. The major risk he usually faces instead is that the announced event won't happen."
Buffett described an “offbeat” situation early in his career when he was working at Graham-Newman Corp.
“For several weeks I busily bought shares, sold [cocoa] beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts. The profits were good and my only expense was subway tokens,” he wrote.
The 1980s, of course, was the era of corporate raiders and merger mania. Buffett noted, “With acquisition fever rampant, with anti-trust challenges almost non-existent, and with bids often ratcheting upward, arbitrageurs have prospered mightily.”
He also gave readers a quick primer on what they should look for:
"To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?"
However, he explains Berkshire is not an arbitrage specialist and participates in only a few, and usually very large, transactions each year. Buffett said he and Munger do not wish to live the life of a merger arbitrage trader, watching spreads and news flow incessantly. As such, Berkshire is much less diversified than the typical merger arbitrage shop, which Buffett explained will lead to potentially more profit and loss impact from the deals it does invest in. However, Buffett noted that they participate only in transactions that have been publicly announced and that they do not trade on rumors or try to guess takeover candidates. “We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities,” he wrote.
Buffett seemed to have a sixth sense of the markets, however, saying:
"Some extraordinary excesses have developed in the takeover field. As Dorothy says: 'Toto, I have a feeling we're not in Kansas any more.'"
By the end of the 1980s, merger mania had fizzled out with the collapse of Drexel Burnham Lambert. Buffett gave some classic sage advice:
"We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs."
He then went on to play down efficient market theory, saying academics having observed “correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient.”
Whilst in recent years Berkshire had performed well in arbitrage, over the longer term Buffett notes that for every arbitrage opportunity that was seized, “many more were foregone because they seemed properly-priced.”
Buffett concluded this section with some simple but very wise advice:
"An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better a strategy than selecting a portfolio by throwing darts."
What does this mean for readers then? In an age of information overload, and constant in-your-face narratives about this theme or that theme from the financial media, to differentiate the signal from the noise, we should go back to the financial statements of a company and ask ourselves the three questions Buffett says the reports should be helping us answer.