Two investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about 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 cover the 1993 letter.
Following the 1992 letter's discussion about discounted cash flow, early in the 1993 letter, Buffett reminds us that what is important is per-share intrinsic value, not book value. Book value is an accounting term that measures the capital, including retained earnings, that has been put into a business. Intrinsic value is a present-value estimate of the cash that can be taken out of a business during its remaining life.
Buffett notes that book value serves as a useful device for tracking intrinsic value, although they are not the same. In 1993, Buffett says each measure grew by roughly 14%, which indicates that Buffett does have a specific estimate for Berkshire’s intrinsic value. Berkshire’s market price grew much faster in 1993, but Buffett says, “Over time, of course, market price and intrinsic value will arrive at about the same destination.”
Just as Buffett emphasized the importance of long-term performance within insurance, given the volatility in its year-to-year results, Buffett says the true investor welcomes volatility.
"Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced "Mr. Market," an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly."
Corporate governance
Though the legal responsibility of directors is always the same, the ability for directors to effect change depends on the situation. Buffett writes a nice case study on what he sees are three fundamentally different manager/owner situations that exist in publicly-held companies, that didn’t get enough attention in the public debate about corporate governance. In my view this is an important discussion because boards of directors should work for shareholders to keep management in check.
No controlling shareholder
The first, and by far most common, board situation is one in which a company has no controlling shareholder. In that case, Buffett says directors should behave as if there is a single absentee owner, whose “long-term interest they should try to further in all proper ways.” The problem is "long-term" gives directors a lot of wiggle room.
"If they lack either integrity or the ability to think independently, directors can do great violence to shareholders while still claiming to be acting in their long-term interest."
If the board is functioning well and must deal with a mediocre or weak management team then directors have the responsibility for changing that management, “just as an intelligent owner would do” if they were present. On the other hand, if management is talented but greedy or where managers “over-reach and try to dip too deeply into the shareholders' pockets," it is again up to directors to act.
The board has the power to make appropriate changes. If, however, an unhappy director can't get other directors to agree with him, Buffett says the director should then feel free to make his views known to the absentee owners. Unfortunately, directors seldom do that. Buffett starts to sound a bit like Carl Icahn (Trades, Portfolio) here, saying the temperament of many directors is incompatible with this sort of critical behavior that is needed.
Buffett recommends that boards should have relatively few directors in number “say, 10 or less” and should come mostly from the outside. They should establish standards for the CEO's performance and should meet periodically, without the CEO being present, to evaluate CEO performance against those standards. Buffett also recommends board membership criterion should be business acumen, interest in the job and owner-orientation. Mistakes in selecting directors are particularly serious because appointments are so hard to undo. “The pleasant but vacuous director need never worry about job security.”
Where the controlling owner is also the manager
The second situation, which existed at Berkshire at the time, is where the controlling owner is also the manager. At some companies, this arrangement is facilitated by the existence of two classes of stock endowed with disproportionate voting power.
"In these situations, it's obvious that the board does not act as an agent between owners and management and that the directors cannot effect change except through persuasion. Therefore, if the owner/manager is mediocre or worse - or is over-reaching - there is little a director can do about it except object. If the directors having no connections to the owner/manager make a unified argument, it may well have some effect. More likely it will not. If change does not come, and the matter is sufficiently serious, the outside directors should resign. Their resignation will signal their doubts about management, and it will emphasize that no outsider is in a position to correct the owner/manager's shortcomings."
Where the controlling owner is not involved in management
The third governance scenario arises when there is a controlling owner who is not involved in management. This situation places the outside directors in a potentially advantageous position. If they become dissatisfied with either the competence or integrity of the manager, they can directly approach the owner (who may also be on the board) and express their dissatisfaction. This circumstance is ideal for an outside director since they need to present their case only to a single, presumably interested owner who can promptly effect change if the argument is persuasive. Nevertheless, the discontented director has only that solitary course of action. If they remain unsatisfied regarding a critical matter, resignation becomes their only choice.
Logically, says Buffett, the third case should be the most effective in ensuring first-class management. In the second case, the owner is not inclined to dismiss themselves, and in the first case, directors often encounter significant difficulty in dealing with mediocrity or slight overreaching. Unless the discontented directors can gain the support of a majority on the board - a socially and logistically challenging task, especially if management's behavior is objectionable but not flagrant - their hands are effectively tied. In practice, directors trapped in such situations often convince themselves that by remaining, they can at least make some positive impact. Meanwhile, management proceeds unrestricted.
In the third case, the owner neither judges themselves nor grapples with the burden of amassing a majority. They can also ensure the selection of outside directors who possess valuable qualities for the board. These directors, in turn, will know that the sound advice they provide will reach the appropriate ears, rather than being stifled by obstinate management. If the controlling owner is intelligent and self-assured, they will make meritocratic and pro-shareholder decisions regarding management. Moreover, and Buffett emphasizes the importance of this – the controlling owner can promptly rectify any mistakes they make.
Conclusion
The lesson I take from this is to look for sophisticated controlling owners who select independent board directors possessing valuable qualities such as business acumen, alongside an interest in the company and a shareholding in it.
