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 1989 letter.
It is the real thing
In the 1989 letter, Buffett admitted it took him 52 years to recognize Coca-Cola Co. (KO, Financial) as a good investment, having first come across the drink in 1935 or 1936 and even selling bottles as a child.
What Buffett realized was “both clear and fascinating.” After drifting a bit in the 1970s, he noticed something about Coca-Cola, noting it:
"…had in 1981 become a new company with the move of Roberto Goizueta to CEO. Roberto, along with Don Keough, once my across-the-street neighbor in Omaha, first rethought and focused the company's policies and then energetically carried them out. What was already the world's most ubiquitous product gained new momentum, with sales overseas virtually exploding.
Through a truly rare blend of marketing and financial skills, Roberto has maximized both the growth of his product and the rewards that this growth brings to shareholders. Normally, the CEO of a consumer products company, drawing on his natural inclinations or experience, will cause either marketing or finance to dominate the business at the expense of the other discipline. With Roberto, the mesh of marketing and finance is perfect and the result is a shareholder's dream."
This domination of one side of a company is true not just at consumer companies; I find that many industrial companies get dominated by engineers who want to solve problems and CEOs with opportunities to build large projects often become like children with toys. On the other side, at companies run by accountants, every expense is seen as a cost ripe for cutting, and creativity, innovation and growth opportunities can fall by the wayside. So looking for that rare combination is a good tip from Buffett. Coke turned out to be a pretty good investment!
Fools rush in where angels fear to trade
Buffett’s prediction the year prior that Berkshire probably would not do much arbitrage in 1989 turned out to be correct.
"Arbitrage positions are a substitute for short-term cash equivalents, and during part of the year we held relatively low levels of cash. In the rest of the year we had a fairly good-sized cash position and even so chose not to engage in arbitrage. The main reason was corporate transactions that made no economic sense to us; arbitraging such deals comes too close to playing the greater-fool game. (As Wall Streeter Ray DeVoe says: 'Fools rush in where angels fear to trade.') We will engage in arbitrage from time to time - sometimes on a large scale - but only when we like the odds."
In September 1989, Berkshire issued a $902.6 million principal amount of zero-coupon convertible subordinated debentures. Buffett went on to explain the mechanics of Berkshire’s zero-coupon bond, but was critical of a great bulk of zero-coupon bonds that have been issued. He said, “Such bonds have often been used in the most deceptive of ways and with deadly consequences to investors.”
Buffett briefly explained the evolution of the market, including the stripping of government bonds, which he said were well suited to many investor needs. He continued:
"But as happens in Wall Street all too often, what the wise do in the beginning, fools do in the end. In the last few years zero-coupon bonds (and their functional equivalent, pay-in-kind bonds, which distribute additional PIK bonds semi-annually as interest instead of paying cash) have been issued in enormous quantities by ever-junkier credits."
Debt now became something to be refinanced rather than repaid and credit standards weakened more and more, driving the leveraged buyout craze. Interest cover, traditionally, conservatively estimated free cash flow - that is, operating earnings plus depreciation and amortization less normalized capital expenditures was replaced by “an abomination” Ebdit - earnings before depreciation, interest and taxes - as the test of a company's ability to pay interest.
"You might think that waving away a major expense such as depreciation in an attempt to make a terrible deal look like a good one hits the limits of Wall Street's ingenuity. If so, you haven't been paying attention during the past few years. Promoters needed to find a way to justify even pricier acquisitions. Otherwise, they risked - heaven forbid! - losing deals to other promoters with more 'imagination.'
So, stepping through the Looking Glass, promoters and their investment bankers proclaimed that EBDIT should now be measured against cash interest only, which meant that interest accruing on zero-coupon or PIK bonds could be ignored when the financial feasibility of a transaction was being assessed. This approach not only relegated depreciation expense to the let's-ignore-it corner, but gave similar treatment to what was usually a significant portion of interest expense. To their shame, many professional investment managers went along with this nonsense, though they usually were careful to do so only with clients' money, not their own."
Buffett credited Ken Galbraith’s witty and insightful book, "The Great Crash," for a new economic term: "the bezzle," which is defined as the current amount of undiscovered embezzlement. Embezzlers get richer by the amount of the bezzle, while the “embezzles” do not yet feel poorer. He wrote:
"Galbraith astutely pointed out that this sum should be added to the National Wealth so that we might know the Psychic National Wealth. Logically, a society that wanted to feel enormously prosperous would both encourage its citizens to embezzle and try not to detect the crime. By this means, 'wealth' would balloon though not an erg of productive work had been done. The satirical nonsense of the bezzle is dwarfed by the real-world nonsense of the zero-coupon bond. With zeros, one party to a contract can experience 'income' without his opposite experiencing the pain of expenditure. In our illustration, a company capable of earning only $100 million dollars annually - and therefore capable of paying only that much in interest - magically creates 'earnings' for bondholders of $150 million. As long as major investors willingly don their Peter Pan wings and repeatedly say 'I believe,' there is no limit to how much 'income' can be created by the zero-coupon bond."
Buffett noted that Wall Street loved this new invention as here, finally, was “an instrument that would let the Street make deals at prices no longer limited by actual earning power.” The result, obviously, would be more transactions as silly prices will always attract sellers. After all, deals are the lifeblood of Wall Street. The guru said that zero-coupon and PIK bonds allow a kind of extend-and-pretend mentality to kick in, allowing investment banks to rake in more fees “before any chickens come home to roost from their earlier ventures.”
As Buffett wrapped up the discussion, he said:
"But in the end, alchemy, whether it is metallurgical or financial, fails. A base business can not be transformed into a golden business by tricks of accounting or capital structure. The man claiming to be a financial alchemist may become rich. But gullible investors rather than business achievements will usually be the source of his wealth.
Whatever their weaknesses, we should add, many zero-coupon and PIK bonds will not default. We have in fact owned some and may buy more if their market becomes sufficiently distressed. (We've not, however, even considered buying a new issue from a weak credit.) No financial instrument is evil per se; it's just that some variations have far more potential for mischief than others."
Buffett dishes out some good corporate finance advice “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” then in return offer “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.”
There are two reasons to read Buffett’s letters; to learn about investing and to have a laugh!