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 1994 letter.
The 1994 letter discusses Buffett’s views on forecasts, intrinsic value and capital allocation.
Forecasts
Buffett and Charlie Munger (Trades, Portfolio) make few predictions, yet Buffett wrote he still believed the Berkshire formula - the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people – would continue to produce good results. Berkshire’s size makes it harder to make investments that move the needle and, recognizing this, the guru said they will try not to relax their investment standards. He used a quote from baseball legend Ted Williams’ book, "The Story of My Life," to explain why:
"My argument is, to be a good hitter, you've got to get a good ball to hit. It's the first rule in the book. If I have to bite at stuff that is out of my happy zone, I'm not a .344 hitter. I might only be a .250 hitter."
Buffett noted that his job is to simply wait for opportunities that are well within Berkshire’s own "happy zone."
Regarding political and economic forecasts, the investor said he would continue to avoid making them, calling them “an expensive distraction for many investors and businessmen.”
He continued:
"Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%."
These big events did not influence Benjamin Graham's investment principles. These types of big events did not “render unsound the negotiated purchases of fine businesses at sensible prices.” Buffett said if the “fear of unknowns” caused Berkshire to defer or alter the deployment of capital, it would have suffered greatly. In fact, Buffett wrote, “We have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.” In earlier writings, Buffett warned us not to be contrarian for the sake of being contrarian, but when there is excess fear in the market, that can be a time to find bargains, if and only if stocks are trading at bargains.
Going forward, Buffett said there will be a different set of major shocks in the next 30 years (he was correct about that), but that Berkshire “will neither try to predict these nor to profit from them.” The disciplined indemnification of opportunities following Berkshire’s criterion, Buffett predicted, means that external surprises would have little effect on its long-term results. Writing this in 2023, we can say that Buffett was exactly right about that.
Intrinsic value and capital allocation
Understanding intrinsic value is as important for managers as it is for investors. One thing I have learned from Buffett’s writings and philosophies is that good investors need to think like good corporate managers, and good corporate investors need to think like good investors. Buffett wrote it is vital that managers “act in ways that increase per-share intrinsic value and avoid moves that decrease it.”
While this principle may seem obvious, it is constantly violated. Buffett then looked at a very common technique when appraising mergers and acquisitions – the focus on whether the transaction is immediately dilutive or anti-dilutive to earnings per share. Buffett warned that an emphasis of this sort carries great dangers.
In corporate transactions, Buffett wrote"
"[It is] silly for the would-be purchaser to focus on current earnings when the prospective acquiree has either different prospects, different amounts of non-operating assets, or a different capital structure. At Berkshire, we have rejected many merger and purchase opportunities that would have boosted current and near-term earnings but that would have reduced per-share intrinsic value. Our approach, rather, has been to follow Wayne Gretzky's advice: 'Go to where the puck is going to be, not to where it is.' As a result, our shareholders are now many billions of dollars richer than they would have been if we had used the standard catechism.
Unfortunately, many major acquisitions increase the income and status of the acquirer's management; and they are a “honey pot” for the investment bankers and other professionals on both sides. But, alas, Buffett said:
"They usually reduce the wealth of the acquirer's shareholders, often to a substantial extent. That happens because the acquirer typically gives up more intrinsic value than it receives."
Over time, the skill with which a company's managers allocate capital has an enormous impact on an enterprise's value. Almost by definition, a good business generates far more money (at least after its early years) than it can use internally. Then, Buffett suggested, a company could distribute the money to shareholders by way of dividends or share repurchases. Instead, CEOs often ask strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense and the result is “like asking your interior decorator whether you need a $50,000 rug.” Ha!
Buffett said the problem is often compounded by a “biological bias.” CEOs get to where they are through a combination of ego and animal spirits. So when a CEO’s advisors encourage dealmaking, it is quite likely they do not need too much pushing. Buffett acknowledged that an abundance of animal spirits and ego sometimes have their advantages, but not when it comes to dealmaking. Buffett sums this up with a short story that makes the point clearly. He wrote:
"Some years back, a CEO friend of mine - in jest, it must be said - unintentionally described the pathology of many big deals. This friend, who ran a property-casualty insurer, was explaining to his directors why he wanted to acquire a certain life insurance company. After droning rather unpersuasively through the economics and strategic rationale for the acquisition, he abruptly abandoned the script. With an impish look, he simply said: 'Aw, fellas, all the other kids have one.'"
Conclusion
I am not going to argue with this analysis, but at the same time we must not forget that not all M&A is bad. My review of the book, "Deals from Hell" demonstrates the risks and rewards to M&A.
Buffett’s point, however, is that corporate managers need to treat M&A like an investor would, rationally assessing if any given transaction increases per-share intrinsic value.
