Embedded Files
... and by "Portfolio", we mean Buffett's portfolio of work (i.e. writing), not his investment portfolio!
Here is a sampling of Warren Buffett's best quotes from his annual letters. We put them all on the same – albeit long – page to make it easier to search for particular topics.
Letter to shareholders of Berkshire Hathaway
Letter to shareholders of Berkshire Hathaway
As you will see, his teachings, sayings and jokes can be extremely insightful for investors of all types!
Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding. Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.
One of the lessons your management has learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds.
“Social inflation” [is] a broadening definition by society and juries of what is covered by insurance policies.
We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do1. […] In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.
Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price.
While there may be less excitement and prestige in sitting back and letting others do the work, we think that is all one loses by accepting a passive participation in excellent management. […] Direct ownership would offer no important advantages to us. While control would give us the opportunity - and the responsibility - to manage operations and corporate resources, we would not be able to provide management in either of those respects equal to that now in place. In effect, we can obtain a better management result through non-control than control. This is an unorthodox view, but one we believe to be sound2.
Even a “stopped clock” can look like a growth stock if the dividend payout ratio is low.
The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.
Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment. By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing. But the purchase was a mistake. While we labored mightily, new problems arose as fast as old problems were tamed. Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.
Much reinsurance business involves an exceptionally “long tail”, a characteristic that allows catastrophic current loss experience to fester undetected for many years.
A once-a-year report of stewardship should not be turned over to a staff specialist or public relations consultant who is unlikely to be in a position to talk frankly on a manager-to-owner basis.
Your company is run on the principle of centralization of financial decisions at the top (the very top, it might be added), and rather extreme delegation of operating authority to a number of key managers at the individual company or business unit level. […] This approach produces an occasional major mistake that might have been eliminated or minimized through closer operating controls. But it also eliminates large layers of costs and dramatically speeds decision-making. Because everyone has a great deal to do, a very great deal gets done. Most important of all, it enables us to attract and retain some extraordinarily talented individuals.
But it’s much easier to criticize than to improve […] accounting rules. The inherent problems are monumental. […] We would not like to have the job of designing a better system3.
Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.
GEICO may appear to be an exception [of other “turnaround” businesses], having been turned around from the very edge of bankruptcy in 1976. […] Its troubles in the mid-70s were not produced by any diminution or disappearance of this essential economic advantage. GEICO’s problems at that time put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true “turnaround” situation in which the managers expect - and need - to pull off a corporate Pygmalion.
A 100% interest of that kind gives the owner the options of leveraging the purchase, changing managements, directing cash flow, and selling the business. It may also provide some excitement around corporate headquarters (less frequently mentioned).
We believe that short-term forecasts of stock or bond prices are useless. The forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.
This ostrich-like behavior - selling the better assets and keeping the biggest losers - while less painful in the short term, is unlikely to be a winner in the long term.
Right behind having financial problems yourself, the next worst plight is to have a large group of competitors with financial problems that they can defer by a “sell-at-any-price” policy.
Initially, the morning mail brings lots of cash and few claims. This state of affairs can produce a blissful, almost euphoric, feeling akin to that experienced by an innocent upon receipt of his first credit card; [hence] transforming the reinsurance market into “amateur night”.
The most attractive opportunities may present themselves at a time when credit is extremely expensive - or even unavailable. At such a time we want to have plenty of financial firepower.
However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.
You learn a great deal about a person when you purchase a business from him and he then stays on to run it as an employee rather than as an owner. Before the purchase the seller knows the business intimately, whereas you start from scratch. The seller has dozens of opportunities to mislead the buyer - through omissions, ambiguities, and misdirection. After the check has changed hands, subtle (and not so subtle) changes of attitude can occur and implicit understandings can evaporate. As in the courtship-marriage sequence, disappointments are not infrequent.
While market values track business values quite well over long periods, in any given year the relationship can gyrate capriciously.
We suspect three motivations - usually unspoken - to be, singly or in combination, the important ones in most high-premium takeovers: 1) Leaders […] often relish increased activity and challenge. […] 2) Most organizations […] compensate their managers far more by the yardstick of size than by any other yardstick. […] 3) Many managements […] are certain their managerial kiss will do wonders for the profitability of [the target company]. Such optimism [in takeovers] is essential.
We neglected the Noah principle: predicting rain doesn’t count, building arks does.
Like virginity, a stable price level seems capable of maintenance, but not of restoration.
Inflation acts as a gigantic corporate tapeworm.
Other companies sell newly issued shares to Peter in order to pay dividends to Paul. Beware of “dividends” that can be paid out only if someone promises to replace the capital distributed.
Yardsticks seldom are discarded while yielding favorable readings. But when results deteriorate, most managers favor disposition of the yardstick rather than disposition of the manager.
A more flexible measurement system often suggests itself: just shoot the arrow of business performance into a blank canvas and then carefully draw the bullseye around the implanted arrow.
The thrill of the chase blinded the pursuers to the consequences of the catch.
In a given year, it is possible for an insurer to show almost any profit number it wishes, particularly if it (1) writes “long-tail” business (coverage where current costs can be only estimated, because claim payments are long delayed), (2) has been adequately reserved in the past, or (3) is growing very rapidly.
In insurance, as elsewhere, the reaction of weak managements to weak operations is often weak accounting.
The rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success.
What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal.
But in the insurance business [...] capacity can be instantly created by capital plus an underwriter’s willingness to sign his name.
Don’t ask the barber whether you need a haircut.
If the CEO is visibly panting over a prospective acquisition, subordinates and consultants will supply the requisite projections to rationalize any price.
In a trade, what you are giving is just as important as what you are getting.
If corporate pregnancy is going to be the consequence of corporate mating, the time to face that fact is before the moment of ecstasy.
A compact organization lets all of us spend our time managing the business rather than managing each other.
And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling - the advocates will be sincere - but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.)
Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style.
We also believe candor benefits us as managers: the CEO who misleads others in public may eventually mislead himself in private.
I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. […] Mrs. B was [once] hauled into court for violation of Fair Trade laws. She not only won all the cases, but received invaluable publicity. At the end of one case, after demonstrating to the court that she could profitably sell carpet at a huge discount from the prevailing price, she sold the judge $1400 worth of carpet.
We never take the one-year figure very seriously. After all, why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Instead, we recommend not less than a five-year test as a rough yardstick of economic performance.
Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out. An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.
You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject.
In stocks, price and value can differ; price is what you give, value is what you get.
The key to a rational stock price is rational shareholders, both current and prospective. […] Entering members of a shareholder “club” cannot be screened for intellectual capacity, emotional stability, moral sensitivity or acceptable dress.
Investors should understand that what is good for the croupier is not good for the customer.
Investment management fees [total] over $2 billion annually, [which are] sums paid for chair-changing advice. […] These expensive activities may decide who eats the pie, but they don’t enlarge it.
Our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy.
A business may be well liked, even loved, by most of its customers but possess no economic goodwill. […] And, regrettably, a business may be disliked by its customers but possess substantial, and growing, economic goodwill.
When a business is purchased, accounting principles require that the purchase price first be assigned to the fair value of the identifiable assets that are acquired. Frequently the sum of the fair values put on the assets (after the deduction of liabilities) is less than the total purchase price of the business. In that case, the difference is assigned to an asset account entitled "excess of cost over equity in net assets acquired". To avoid constant repetition of this mouthful, we will substitute "Goodwill".
A [strong] reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price.
When an overexcited management purchases a business at a silly price, […] the silliness ends up in the Goodwill account. Considering the lack of managerial discipline that created the account, under such circumstances it might better be labeled "No-Will".
No matter how often or how eloquently [the manager] mouths some public relations-inspired phrase such as “maximizing shareholder wealth” (this season’s favorite), the market correctly discounts assets lodged with him.
In all of our investments, we look to business performance, not market performance. If we are correct in expectations regarding the business, the market eventually will follow along.
Many of the losses that should be charged against the current year’s revenue are exceptionally difficult to estimate. Sometimes the extent of these losses, or even their existence, is not known for decades. […] The goal of the adjustments should be a loss-reserve total that has a 50-50 chance of being proved either slightly too high or slightly too low when all losses that occurred prior to the date of the financial statement are ultimately paid.
External auditors cannot effectively police the financial statements of property/casualty insurers. […] In other words, the corpse is supposed to file the death certificate. Under this “honor system” of mortality, the corpse sometimes gives itself the benefit of the doubt.
In most businesses, of course, insolvent companies run out of cash. Insurance is different: you can be broke but flush. Since cash comes in at the inception of an insurance policy and losses are paid much later, insolvent insurers don’t run out of cash until long after they have run out of net worth. In fact, these “walking dead” often redouble their efforts to write business, accepting almost any price or risk, simply to keep the cash flowing in. With an attitude like that of an embezzler who has gambled away his purloined funds, these companies hope that somehow they can get lucky on the next batch of business and thereby cover up earlier shortfalls. Even if they don’t get lucky, the penalty to managers is usually no greater for a $100 million shortfall than one of $10 million; in the meantime, while the losses mount, the managers keep their jobs and perquisites.
Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)
Billy Rose described the problem of over-diversification: “If you have a harem of forty women, you never get to know any of them very well.”
Outstanding businesses by definition generate large amounts of excess cash. […] Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners. [Instead they chose] to expand the corporate empire over which the managers rule. […] Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). […] The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team’s best-ball score will be respectable because of the dominating skills of the professional.
These earnings may, with equal feasibility, be retained or distributed. […] If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.
Many annual meetings are a waste of time, both for shareholders and for management. Sometimes that is true because management is reluctant to open up on matters of business substance. More often a nonproductive session is the fault of shareholder participants who are more concerned about their own moment on stage than they are about the affairs of the corporation. […] The deal is irresistible: for the price of one share you get to tell a captive audience your ideas as to how the world should be run. Under such circumstances, the quality of the meeting often deteriorates from year to year as the antics of those interested in themselves discourage attendance by those interested in the business.
We cannot, however, respond to written or phoned questions at other times of the year; one-person-at-a time reporting is a poor use of management time in a company with 3000 shareholders.
Managers usually gave them a we-can’t-tell-you-what-is- going-on-because-it-would-hurt-the-company answer4. […] The only business matters that are off limits at the annual meeting are those about which candor might cost our company real money.
Long periods of substantial undervaluation and/or overvaluation will cause the gains of the business to be inequitably distributed among various owners, with the investment result of any given owner largely depending upon how lucky, shrewd, or foolish he happens to be.
You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not: stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued.
In selecting common stocks, we devote our attention to attractive purchases, not to the possibility of attractive sales.
I won’t close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable.
A horse that can count to ten is a remarkable horse - not a remarkable mathematician. Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company - but not a remarkable business.
A good managerial record […] is far more a function of what business boat you get into than it is of how effectively you row. […] Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.
Managers actually apply a double standard to options. […] I can’t resist commenting on one long-term option given an “outsider”: that granted the U.S. Government on Chrysler shares as partial consideration for the government’s guarantee of some lifesaving loans. When these options worked out well for the government, Chrysler sought to modify the payoff, arguing that the rewards to the government were both far greater than intended and outsize in relation to its contribution to Chrysler’s recovery. […] To my knowledge, no managers - anywhere - have been similarly offended by unwarranted payoffs arising from options granted to themselves or their colleagues.
An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I’ll be happy to accept a lottery ticket as a gift - but I’ll never buy one.)
Managers with limited areas of responsibility should have incentives that pay off in relation to results under their control. The .350 hitter expects, and also deserves, a big payoff for his performance - even if he plays for a cellar- dwelling team. And the .150 hitter should get no reward - even if he plays for a pennant winner. Only those with overall responsibility for the team should have their rewards tied to its results. […] We believe good unit performance should be rewarded whether Berkshire stock rises, falls, or stays even.
At our various business units, top managers sometimes receive incentive bonuses of five times their base salary, or more, and it would appear possible that one manager’s bonus could top $2 million in 1986. (I hope so.) We do not put a cap on bonuses.
The dynamics of capitalism cause each insurer to make decisions that for itself appear sensible, but that collectively slash profitability.
Every year his managers told him that “except for the Florida hurricane” or “except for Midwestern tornadoes”, they would have had a terrific year. Finally he called the group together and suggested that they form a new operation - the Except-For Insurance Company - in which they would henceforth place all of the business that they later wouldn’t want to count. In any business, insurance or otherwise, “except for” should be excised from the lexicon. If you are going to play the game, you must count the runs scored against you in all nine innings. Any manager who consistently says “except for” and then reports on the lessons he has learned from his mistakes may be missing the only important lesson - namely, that the real mistake is not the act, but the actor. [...] “Except for” losses will forever be part of the insurance business, and they will forever be paid with shareholders’ money6.
No matter how great the talent or effort, some things just take time: you can’t produce a baby in one month by getting nine women pregnant.
If my job were to manage a golf team - and if Jack Nicklaus or Arnold Palmer were willing to play for me - neither would get a lot of directives from me about how to swing.
When you have able managers of high character running businesses about which they are passionate, you can have a dozen or more reporting to you and still have time for an afternoon nap. Conversely, if you have even one person reporting to you who is deceitful, inept or uninterested, you will find yourself with more than you can handle.
If our success were to depend upon insights we developed through plant inspections, Berkshire would be in big trouble.
We don’t engage in layoffs when we experience a cyclical slowdown at one of our generally-profitable insurance operations. This no-layoff practice is in our self- interest. Employees who fear that large layoffs will accompany sizable reductions in premium volume will understandably produce scads of business through thick and thin (mostly thin).
What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
[Beware of] a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Unfortunately, however, stocks can’t outperform businesses indefinitely.
The term "institutional investor" is becoming one of those self-contradictions called an oxymoron, comparable to "jumbo shrimp," "lady mudwrestler" and "inexpensive lawyer."
We agree with Keynes's observation: "I would rather be vaguely right than precisely wrong."
To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment - or the business decays.
Though dentists correctly claim that if you ignore your teeth they'll go away, the same is not true for [CAPEX].
In many cases, a corporation's book value and business value are almost totally unrelated. [For example], Belridge Oil was sold to Shell in 1979 for $3.6 billion although its book value was only $177 million.
CEOs seldom tell their shareholders that they have assembled a bunch of turkeys to run things. Their reluctance to do so makes for some strange annual reports. Oftentimes, in his shareholders' letter, a CEO will go on for pages detailing corporate performance that is woefully inadequate. He will nonetheless end with a warm paragraph describing his managerial comrades as "our most precious asset." Such comments sometimes make you wonder what the other assets can possibly be.
There's not a lot new to report about these businesses - and that's good, not bad. […] Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today's business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be. Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.
Our managers have produced extraordinary results by doing rather ordinary things - but doing them exceptionally well.
Really good businesses usually don't need to borrow.
We neither understand the adding of unneeded people or activities because profits are booming, nor the cutting of essential people or activities because profitability is shrinking.
We want to emphasize that we are not faulting auditors for their inability to accurately assess loss reserves (and therefore earnings). We fault them only for failing to publicly acknowledge that they can't do this job.
When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts.
As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."
After all, what witch doctor has ever achieved fame and fortune by simply advising "Take two aspirins"?
In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.
We do not sell holdings just because they have appreciated or because we have held them for a long time.
It must be noted that your Chairman, always a quick study, required only 20 years to recognize how important it was to buy good businesses. In the interim, I searched for "bargains" - and had the misfortune to find some. My punishment was an education in the economics of short-line farm implement manufacturers, third-place department stores, and New England textile manufacturers.
Management changes, like marital changes, are painful, time- consuming and chancy.
During 1987 the stock market was an area of much excitement but little net movement: The Dow advanced 2.3% for the year. You are aware, of course, of the roller coaster ride that produced this minor change. Mr. Market was on a manic rampage until October and then experienced a sudden, massive seizure. […] We have "professional" investors, those who manage many billions, to thank for most of this turmoil. Instead of focusing on what businesses will do in the years ahead, many prestigious money managers now focus on what they expect other money managers to do in the days ahead. For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly.
Portfolio insurance [is] a money-management strategy that many leading investment advisors embraced in 1986-1987. […] According to the Brady Report, $60 billion to $90 billion of equities were poised on this hair trigger in mid- October of 1987. If you've thought that investment advisors were hired to invest, you may be bewildered by this technique. After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price?
Bonds are no better than the currency in which they are denominated. […] For the debtor government, the weapon of inflation is the economic equivalent of the "H" bomb, and that is why very few countries have been allowed to swamp the world with debt denominated in their own currency.
Interestingly, there has been no correlation between the size and prestige of the publication and the accuracy of the report. […] (In not naming names, I am observing the old warning that it's not wise to pick fights with people who buy ink by the barrel.)
Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky.
Berkshire’s past rates of gain in both book value and business value were achieved under circumstances far different from those that now exist. Anyone ignoring these differences makes the same mistake that a baseball manager would were he to judge the future prospects of a 42-year-old center fielder on the basis of his lifetime batting average.
“How much,” says the client, “is two plus two?” Replies the cooperative accountant, “What number did you have in mind?”
Both the smoothing of earnings and the “big bath” quarter are “white lie” techniques employed by otherwise upright managements.
Few of the perpetrators [of accounting-based frauds] have been punished; many have not even been censured. It has been far safer to steal large sums with a pen than small sums with a gun.
If you want to be loved, it’s clearly better to sell high-priced corn flakes than low-priced auto insurance.
The supreme irony of business management is that it is far easier for an inadequate CEO to keep his job than it is for an inadequate subordinate. If a secretary, say, is hired for a job that requires typing ability of at least 80 words a minute and turns out to be capable of only 50 words a minute, she will lose her job in no time. There is a logical standard for this job; performance is easily measured; and if you can’t make the grade, you’re out. […] One reason is that performance standards for [the CEO’s] job seldom exist. When they do, they are often fuzzy or they may be waived or explained away, even when the performance shortfalls are major and repeated. At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands.
Relations between the Board and the CEO are expected to be congenial. At board meetings, criticism of the CEO’s performance is often viewed as the social equivalent of belching. No such inhibitions restrain the office manager from critically evaluating the substandard typist.
When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.
[Don’t] hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.
The goal was to exploit tiny price differentials that might exist between, say, Royal Dutch stock trading in guilders in Amsterdam, pounds in London, and dollars in New York. Some people might call this scalping; it won’t surprise you that practitioners opted for the French term, arbitrage.
Its [takeover] offer was contingent upon its obtaining “satisfactory financing.” A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage.
He lied like a finance minister on the eve of devaluation.
With that many irons in the fire, [arbitrage investors] must spend most of their time monitoring both the progress of deals and the market movements of the related stocks. This is not how Charlie nor I wish to spend our lives. (What’s the sense in getting rich just to stare at a ticker tape all day?)
We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be a year from now.
“Efficient market theory” (EMT) […] became highly fashionable - indeed, almost holy scripture in academic circles during the 1970s. […] Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.
Charlie and I are bothered as much by significant overvaluation as significant undervaluation.
In a finite world, high growth rates must self-destruct. […] This phenomenon [is like] the destiny of bacteria that reproduce by dividing into two every 15 minutes. Says Sagan: "That means four doublings an hour, and 96 doublings a day. Although a bacterium weighs only about a trillionth of a gram, its descendants, after a day of wild asexual abandon, will collectively weigh as much as a mountain...in two days, more than the sun - and before very long, everything in the universe will be made of bacteria." Not to worry, says Sagan: Some obstacle always impedes this kind of exponential growth.
In most industries, capacity is described in physical terms. In the insurance world, […] the amount of industry capacity at any particular moment primarily depends on the mental state of insurance managers.
We are willing to look foolish as long as we don't feel we have acted foolishly.
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.
But as happens in Wall Street all too often, what the wise do in the beginning, fools do in the end.
To these issuers, zero (or PIK) bonds offer one overwhelming advantage: It is impossible to default on a promise to pay nothing. […] With zeros, one party to a contract can experience "income" without his opposite experiencing the pain of expenditure.
At 95% of American businesses, capital expenditures that over time roughly approximate depreciation are a necessity and are every bit as real an expense as labor or utility costs.
Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and- stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet.
When they make these offerings, investment bankers display their humorous side: They dispense income and balance sheet projections extending five or more years into the future for companies they barely had heard of a few months earlier.
But in the end, alchemy, whether it is metallurgical or financial, fails.
Whenever an investment banker starts talking about EBDIT […] zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero- coupon fees.
Promoters, after all, have throughout time exercised the same judgment and restraint in accepting money that alcoholics have exercised in accepting liquor. At a minimum, therefore, the banker's conduct should rise to that of a responsible bartender who, when necessary, refuses the profit from the next drink to avoid sending a drunk out on the highway. In recent years, unfortunately, many leading investment firms have found bartender morality to be an intolerably restrictive standard.
Lately, those who have traveled the high road in Wall Street have not encountered heavy traffic.
Never is there just one cockroach in the kitchen.
Time is the friend of the wonderful business, the enemy of the mediocre.
As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction.
Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds.
Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.
We've never succeeded in making a good deal with a bad person.
It's no sin to miss a great opportunity outside one's area of competence.
Last summer we sold the corporate jet that we purchased for $850,000 three years ago and bought another used jet for $6.7 million. […] Naming the plane […] we finally settled on "The Indefensible."
Berkshire's intrinsic value continues to exceed book value by a substantial margin. We can't tell you the exact differential because intrinsic value is necessarily an estimate; Charlie and I might, in fact, differ by 10% in our appraisals.
The term "earnings" has a precise ring to it. And when an earnings figure is accompanied by an unqualified auditor's certificate, a naive reader might think it comparable in certitude to pi, calculated to dozens of decimal places. In reality, however, earnings can be as pliable as putty when a charlatan heads the company reporting them.
When Coca-Cola uses retained earnings to repurchase its shares, the company increases our percentage ownership. […] Instead of repurchasing stock, Coca-Cola could pay those funds to us in dividends, which we could then use to purchase more Coke shares. That would be a less efficient scenario: Because of taxes we would pay on dividend income, we would not be able to increase our proportionate ownership to the degree that Coke can, acting for us. If this less efficient procedure were followed, however, Berkshire would report far greater "earnings."
I have long scorned the boasts of corporate executives about synergy, deriding such claims as the last refuge of scoundrels defending foolish acquisitions.
Cutting product quality is not a proper response to adversity.
The most important thing to do when you find yourself in a hole is to stop digging.
Most corporate managements believe that their shareholders dislike volatility in results. […] Charlie and I always have preferred a lumpy 15% return to a smooth 12%.
Insurance offers a host of opportunities for error, and when opportunity knocked, too often I answered. Many years later, the bills keep arriving for these mistakes: In the insurance business, there is no statute of limitations on stupidity.
Lethargy bordering on sloth remains the cornerstone of our investment style.
Many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases.
We will be buying businesses - or small parts of businesses, called stocks - year in, year out as long as I live (and longer, if Berkshire's directors attend the seances I have scheduled).
Optimism that is the enemy of the rational buyer.
What's required is thinking rather than polling.
Woody Allen, in another context, pointed out the advantage of open-mindedness: "I can't understand why more people aren't bi-sexual because it doubles your chances for a date on Saturday night."
Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care.
Dagger-selling investment bankers pointed to the "scholarly" research of academics, which reported that over the years the higher interest rates received from low-grade bonds had more than compensated for their higher rate of default. […] There was a flaw in the salesmen's logic - one that a first- year student in statistics is taught to recognize. An assumption was being made that the universe of newly-minted junk bonds was identical to the universe of low-grade fallen angels and that, therefore, the default experience of the latter group was meaningful in predicting the default experience of the new issues. (That was an error similar to checking the historical death rate from Kool-Aid before drinking the version served at Jonestown.)
Beware of past-performance "proofs" in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.
Behaving much as a heroin user might, [the junk-bond-issuing financiopath] devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix.
As usual, the Street's enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce. Mountains of junk bonds were sold by those who didn't care to those who didn't think - and there was no shortage of either.
We have never bought a new issue of a junk bond. (The only time to buy these is on a day with no "y" in it.)
Almost all airline mergers have been followed by operational turmoil.
Any good ad salesman will tell you that trying to sell something without advertising is like winking at a girl in the dark.
We've found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels.
Were I to die tomorrow, you could be sure of three things: (1) None of my stock would have to be sold; (2) Both a controlling shareholder and a manager with philosophies similar to mine would follow me; and (3) Berkshire's earnings would increase by $1 million annually, since Charlie would immediately sell our corporate jet, The Indefensible (ignoring my wish that it be buried with me).
In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard.
In the business world, unfortunately, the rear-view mirror is always clearer than the windshield.
Most managers […] employ compensation systems that are long on carrots but short on sticks (and that almost invariably treat equity capital as if it were cost-free).
Eventually, managements of this kind achieve the same result as the seriously-ill patient who tells his doctor: "I can't afford the operation, but would you accept a small payment to touch up the x-rays?"
In any given year, however, we are likely to appear either enormously profitable or enormously unprofitable. That is true in part because GAAP accounting does not allow us to set up reserves in the catastrophe- free years for losses that are certain to be experienced in other years.
We believe that according the name "investors" to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic.
Our motto is: "If at first you do succeed, quit trying."
This burn-the- furniture-to-provide-firewood approach to fare-setting by bankrupt carriers contributes to the toppling of previously-marginal carriers, creating a domino effect that is perfectly designed to bring the industry to its knees.
We've long felt that the only value of stock forecasters is to make fortune tellers look good.
A tolerance for short-term swings improves our long-term prospects.
In the search [for acquisitions], we adopt the same attitude one might find appropriate in looking for a spouse: It pays to be active, interested and open-minded, but it does not pay to be in a hurry.
Just as you should be suspicious of managers who pump up short-term earnings by accounting maneuvers, asset sales and the like, so also should you be suspicious of those managers who fail to deliver for extended periods and blame it on their long-term focus.
It's only when the tide goes out that you learn who's been swimming naked.
The saying, "a fool and his money are soon invited everywhere," applies in spades in reinsurance, and we actually reject more than 98% of the business we are offered.
Catastrophe insurers can't simply extrapolate past experience. If there is truly "global warming," for example, the odds would shift, since tiny changes in atmospheric conditions can produce momentous changes in weather patterns.
Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross- dressing.
We think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).
What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know.
In health-care, open-ended promises have created open-ended liabilities that in a few cases loom so large as to threaten the global competitiveness of major American industries. […] In effect, the attitude of both managements and their accountants toward these liabilities was "out-of-sight, out-of-mind." Ironically, some of these same managers would be quick to criticize Congress for employing "cash- basis" thinking in respect to Social Security promises or other programs creating future liabilities of size.
Managers thinking about accounting issues should never forget one of Abraham Lincoln's favorite riddles: "How many legs does a dog have if you call his tail a leg?" The answer: "Four, because calling a tail a leg does not make it a leg." It behooves managers to remember that Abe's right even if an auditor is willing to certify that the tail is a leg.
So if you're a CEO and subscribe to this "no cash-no cost" theory of accounting, I'll make you an offer you can't refuse: Give us a call at Berkshire and we will happily sell you insurance in exchange for a bundle of long- term options on your company's stock.
It is both silly and cynical to say that an important item of cost should not be recognized simply because it can't be quantified with pinpoint precision. Right now, accounting abounds with imprecision. After all, no manager or auditor knows how long a 747 is going to last, which means he also does not know what the yearly depreciation charge for the plane should be.
If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?
We have no legal, personnel, public relations, investor relations, or strategic planning departments. In turn this means we don't need support personnel such as guards, drivers, messengers, etc. […] At some companies, corporate expense runs 10% or more of operating earnings. […] Charlie and I have observed no correlation between high corporate costs and good corporate performance. In fact, we see the simpler, low-cost operation as more likely to operate effectively than its bureaucratic brethren. We're admirers of the Wal-Mart, Nucor, Dover, GEICO, Golden West Financial and Price Co. models.
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. At most companies, the two values are unrelated. […] Over time, of course, market price and intrinsic value will arrive at about the same destination.
Coke went public in 1919 at $40 per share. By the end of 1920 the market, coldly reevaluating Coke's future prospects, had battered the stock down by more than 50%, to $19.50. At yearend 1993, that single share, with dividends reinvested, was worth more than $2.1 million.
At Berkshire, we do not tell .400 hitters how to swing.
Charlie and I have absolutely no complaint about [corporate] taxes. We know we work in a market-based economy that rewards our efforts far more bountifully than it does the efforts of others whose output is of equal or greater benefit to society.
In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury." Academics, however, like to define investment "risk" differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the "beta" of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong. For owners of a business - and that's the way we think of shareholders - the academics' definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price.
In fact, 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.
After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don't need a daily quote […] to validate our well-being.
As Peter Lynch says, stocks of companies selling commodity-like products should come with a warning label: "Competition may prove hazardous to human wealth."
The competitive strengths of a Coke or Gillette are obvious to even the casual observer of business. Yet the beta of their stocks is similar to that of a great many run-of-the-mill companies who possess little or no competitive advantage. […] The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles.
The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy company selling pet rocks or hula hoops from that of another toy company whose sole product is Monopoly or Barbie.
Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.
If you are a know-something investor, able to understand business economics and to find five to ten sensibly- priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential.
Too often, directors are selected simply because they are prominent or add diversity to the board. That practice is a mistake. Furthermore, 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.
Our formula - the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people - is certain to produce reasonable success.
We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. 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%. […] A different set of major shocks is sure to occur in the next 30 years.
Fear is the foe of the faddist, but the friend of the fundamentalist.
It's far better to own a significant portion of the Hope diamond than 100% of a rhinestone.
Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move.
What a manager must do is handle the basics well and not get diverted.
To follow Wayne Gretzky's advice: "Go to where the puck is going to be, not to where it is."
The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholders of the acquiree; they 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, they usually reduce the wealth of the acquirer's shareholders, often to a substantial extent.
Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally. The company could, of course, distribute the money to shareholders by way of dividends or share repurchases. But often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense. That's like asking your interior decorator whether you need a $50,000 rug.
The acquisition problem is often compounded by a biological bias: Many CEO's attain their positions in part because they possess an abundance of animal spirits and ego. If an executive is heavily endowed with these qualities - which, it should be acknowledged, sometimes have their advantages - they won't disappear when he reaches the top. When such a CEO is encouraged by his advisors to make deals, he responds much as would a teenage boy who is encouraged by his father to have a normal sex life. It's not a push he needs.
Many "alignment" [CEO compensation] plans flunk this basic test, being artful forms of "heads I win, tails you lose."
Super-cat policies are small in number, large in size and non- standardized. Therefore, the underwriting of this business requires far more judgment than, say, the underwriting of auto policies, for which a mass of data is available. […] At Berkshire, on the other hand, we will quote prices for coverage as great as $500 million on the same day that we are asked to bid. No one else in the industry will do the same.
Carriers having benefitted from "fresh-start" costs that came out of bankruptcy proceedings. (As Herb Kelleher, CEO of Southwest Airlines, has said: "Bankruptcy court for airlines has become a health spa.")
Sellers and their representatives invariably present financial projections having more entertainment value than educational value. In the production of rosy scenarios, Wall Street can hold its own against Washington. […] In any case, why potential buyers even look at projections prepared by sellers baffles me.
Keep in mind the story of the man with an ailing horse. Visiting the vet, he said: "Can you help me? Sometimes my horse walks just fine and sometimes he limps." The vet's reply was pointed: "No problem - when he's walking fine, sell him." […] We face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale - a time when the business is likely to be walking "just fine."
Dealmaking is romantic, sexy. That's why you have deals that make no sense.
Buying a retailer without good management is like buying the Eiffel Tower without an elevator.
Retailing is a tough business. […] If you were smart enough to buy a network TV station very early in the game, you could put in a shiftless and backward nephew to run things, and the business would still do well for decades. […] For a retailer, hiring that nephew would be an express ticket to bankruptcy.
I'm sometimes asked how many people I can handle reporting to me. My answer to that is simple: If I have one person reporting to me and he is a lemon, that's one too many, and if I have managers like those we now have, the number can be almost unlimited.
I sold my entire GEICO position in 1952 for $15,259, […] but in the next 20 years, the GEICO stock I sold grew in value to about $1.3 million.
We insured: (1) The life of Mike Tyson for a sum that is large initially and that, fight-by-fight, gradually declines to zero over the next few years; (2) Lloyd's against more than 225 of its "names" dying during the year; and (3) The launch, and a year of orbit, of two Chinese satellites. Happily, both satellites are orbiting, the Lloyd's folk avoided abnormal mortality, and if Mike Tyson looked any healthier, no one would get in the ring with him.
A bad reinsurance contract is like hell: easy to enter and impossible to exit.
At Berkshire, we believe in Charlie's dictum - "Just tell me the bad news; the good news will take care of itself" - and that is the behavior we expect of our managers when they are reporting to us.
Buffett Partnership Ltd. bought a significant amount of Disney stock at a split-adjusted price of 31c per share. That decision may appear brilliant, given that the stock now sells for $66. But your Chairman was up to the task of nullifying it: In 1967 I sold out at 48c per share.
Berkshire is selling at a price at which Charlie and I would not consider buying it.
We are here to make money with you, not off you.
Selling fine businesses on "scary" news is usually a bad decision.
After all, our earnings swing wildly on a daily and weekly basis - why should we demand that smoothness accompany each orbit that the earth makes of the sun?
So what are the true odds of our having to make a payout during the policy's term? We don't know - nor do we think computer models will help us, since we believe the precision they project is a chimera. In fact, such models can lull decision-makers into a false sense of security and thereby increase their chances of making a really huge mistake. […] Even if perfection in assessing risks is unattainable, insurers can underwrite sensibly. After all, you need not know a man's precise age to know that he is old enough to vote nor know his exact weight to recognize his need to diet.
Witness "portfolio insurance," whose destructive effects in the 1987 market crash led one wag to observe that it was the computers that should have been jumping out of windows.
In insurance, it is essential to remember that virtually all surprises are unpleasant.
Try singing country western songs backwards and you will quickly regain your house, your car and your wife.
At Berkshire, we never greet good work by raising the bar. If GEICO's performance continues to improve, we will happily keep on making larger charts.
We continue to make more money when snoring than when active.
As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride.
I would rather be certain of a good result than hopeful of a great one.
Leadership alone provides no certainties: Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility.
Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette? Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding.
Intelligent investing is not complex, though that is far from saying that it is easy.
To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects.
When Richard Branson, the wealthy owner of Virgin Atlantic Airways, was asked how to become a millionaire, he had a quick answer: "There's really nothing to it. Start as a billionaire and then buy an airline."
Come by at any time this year [to our Berkshire Annual Meeting] and let Susan Jacques, Borsheim's CEO, and her skilled associates perform a painless walletectomy on you.
[Some companies] ask you to adopt the philosophy of the Chicago Cubs fan who reacted to a string of lackluster seasons by saying, "Why get upset? Everyone has a bad century now and then."
A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? […] Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
Estimating errors, usually innocent but sometimes not, can be huge. The consequences of these miscalculations flow directly into earnings. An experienced observer can usually detect large-scale errors in reserving, but the general public can typically do no more than accept what's presented, and at times I have been amazed by the numbers that big-name auditors have implicitly blessed.
Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.
Truly outsized risks will exist in these contracts if they are not properly priced. A pernicious aspect of catastrophe insurance, however, makes it likely that mispricing, even of a severe variety, will not be discovered for a very long time. Consider, for example, the odds of throwing a 12 with a pair of dice -- 1 out of 36. Now assume that the dice will be thrown once a year; that you, the "bond-buyer," agree to pay $50 million if a 12 appears; and that for "insuring" this risk you take in an annual "premium" of $1 million. That would mean you had significantly underpriced the risk. Nevertheless, you could go along for years thinking you were making money -- indeed, easy money. There is actually a 75.4% probability that you would go for a decade without paying out a dime. Eventually, however, you would go broke. […] When the stakes are high, an expert can invariably be found who will affirm -- to return to our example -- that the chance of rolling a 12 is not 1 in 36, but more like 1 in 100. (In fairness, we should add that the expert will probably believe that his odds are correct, a fact that makes him less reprehensible -- but more dangerous.)
For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event – except when the team must trade a .380 hitter to make the deal.
If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told that they are naked.
Writing checks to the IRS that include strings of zeros does not bother Charlie or me. Berkshire as a corporation, and we as individuals, have prospered in America as we would have in no other country. Indeed, if we lived in some other part of the world and completely escaped taxes, I'm sure we would be worse off financially (and in many other ways as well). Overall, we feel extraordinarily lucky to have been dealt a hand in life that enables us to write large checks to the government rather than one requiring the government to regularly write checks to us -- say, because we are disabled or unemployed.
We tell [our managers that] they should not let any of their decisions be affected even slightly by accounting considerations. We want our managers to think about what counts, not how it will be counted.
[A manager working for Berkshire] does not have to devote his time or energy to board meetings, press interviews, presentations by investment bankers or talks with financial analysts. Furthermore, he need never spend a moment thinking about financing, credit ratings or "Street" expectations for earnings per share.
In allocating capital, activity does not correlate with achievement.
Cash never makes us happy. But it's better to have the money burning a hole in Berkshire's pocket than resting comfortably in someone else's.
Our never-comment-even-if-untrue policy in regard to investments may disappoint "piggybackers" but will benefit owners.
Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers – CEOs you would be happy to have as spouses for your children or as trustees under your will – have come to the view that it's okay to manipulate earnings to satisfy what they believe are Wall Street's desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty. These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree).
The distortion du jour is the "restructuring charge," an accounting entry that can, of course, be legitimate but that too often is a device for manipulating earnings. In this bit of legerdemain, a large chunk of costs that should properly be attributed to a number of years is dumped into a single quarter, typically one already fated to disappoint investors. In some cases, the purpose of the charge is to clean up earnings misrepresentations of the past, and in others it is to prepare the ground for future misrepresentations. In either case, the size and timing of these charges is dictated by the cynical proposition that Wall Street will not mind if earnings fall short by $5 per share in a given quarter, just as long as this deficiency ensures that quarterly earnings in the future will consistently exceed expectations by five cents per share.
This dump-everything-into-one-quarter behavior suggests a corresponding "bold, imaginative" approach to – golf scores. […] As he takes his new swing onto the course, he should count his good holes, but not the bad ones. […] After all, it's easier to fiddle with the scorecard than to spend hours on the practice tee.
A preliminary tally by R. G. Associates, of Baltimore, of special charges taken or announced during 1998 -- that is, charges for restructuring, in-process R&D, merger-related items, and write-downs – identified no less than 1,369 of these, totaling $72.1 billion. That is a staggering amount as evidenced by this bit of perspective: The 1997 earnings of the 500 companies in Fortune's famous list totaled $324 billion.
At other companies, executives may devote themselves to pursuing acquisition possibilities with investment bankers. […] In this exercise the bankers prepare a "book" that makes me think of the Superman comics of my youth. In the Wall Street version, a formerly mild-mannered company emerges from the investment banker's phone booth able to leap over competitors in a single bound and with earnings moving faster than a speeding bullet. […] What's particularly entertaining in these books is the precision with which earnings are projected for many years ahead.
As an example, depreciation charges can't with precision calibrate the decline in value that physical assets suffer, but these charges do at least describe something that is truly occurring: Physical assets invariably deteriorate. Correspondingly, obsolescence charges for inventories, bad debt charges for receivables and accruals for warranties are among the charges that reflect true costs. The annual charges for these expenses can't be exactly measured, but the necessity for estimating them is obvious.
The reality of merging is usually far different: There is indisputably an acquirer and an acquiree, and the latter has been "purchased," no matter how the deal has been structured. If you think otherwise, just ask employees severed from their jobs which company was the conqueror and which was the conquered.
If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter.
If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price.
Equity investors currently seem wildly optimistic in their expectations about future returns. […] The market adjustment is apt to be severe, particularly in sectors in which speculation has been concentrated.
Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. […] The continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.
I will tell you now that we have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint. Try to control your excitement.
Charlie and I went soft last year and added one more person at headquarters. (Charlie, bless him, never lets me forget Ben Franklin’s advice: "A small leak can sink a great ship.") Now we have 13.8 people.
Only in the sales presentations of investment banks do earnings move forever upward.
[We] wrote a large policy protecting the Texas Rangers from the possibility that Alex Rodriguez will become permanently disabled. As sports fans know, "A-Rod" was signed for $252 million, a record, and we think that our policy probably also set a record for disability insurance.
Agonizing over errors is a mistake. But acknowledging and analyzing them can be useful, though that practice is rare in corporate boardrooms. […] Elsewhere, triumphs are trumpeted, but dumb decisions either get no follow-up or are rationalized. The financial consequences of these boners are regularly dumped into massive restructuring charges or write-offs that are casually waved off as "nonrecurring." Managements just love these. Indeed, in recent years it has seemed that no earnings statement is complete without them.
The formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. [whose] investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of the birds you now possess that should be offered for it.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota – nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe. Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.
Alas, though Aesop’s proposition and the third variable – that is, interest rates – are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value.
Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value equation. […] Growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs.
Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was an irrational expectation.
Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them. This surreal scene was accompanied by much loose talk about "value creation."
By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the "business model" for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street – a community in which quality control is not prized – will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.
When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. […] And we don’t want to read messages that a public relations department or consultant has turned out.
References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures?
More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.
On the front page (and above the fold, as they say) The Wall Street Journal published a news brief that said, in unequivocal terms, that we were buying bonds of Conseco [as] disclosed by "people familiar with the matter." […] But to this day neither Berkshire nor I have ever bought a share of stock or a bond of Conseco. […] During all of the story’s iterations, I never heard or read the word "rumor." Apparently reporters and editors, who generally pride themselves on their careful use of language, just can’t bring themselves to attach this word to their accounts. But what description would fit more precisely? Certainly not the usual "sources say" or "it has been reported." […] But rumors are what these organizations often publish and broadcast, whatever euphemism they duck behind.
You can’t eat relative performance.
A gorgeous woman slinks up to a CEO at a party and through moist lips purrs, "I’ll do anything – anything – you want. Just tell me what you would like." With no hesitation, he replies, "Reprice my options."
In pricing property coverages, for example, we had looked to the past and taken into account only costs we might expect to incur from windstorm, fire, explosion and earthquake. But what will be the largest insured property loss in history (after adding related business-interruption claims) originated from none of these forces. In short, all of us in the industry made a fundamental underwriting mistake by focusing on experience, rather than exposure, thereby assuming a huge terrorism risk for which we received no premium. […] Insurers have always found it costly to ignore new exposures. Doing that in the case of terrorism, however, could literally bankrupt the industry. […] We are perfectly willing to lose $2 billion to $2½ billion in a single event (as we did on September 11th) if we have been paid properly for assuming the risk that caused the loss (which on that occasion we weren't).
Late in a bull market, for example, large losses from directors and officers liability insurance ("D&O") are likely to be relatively rare. When stocks are rising, there are a scarcity of targets to sue, and both questionable accounting and management chicanery often go undetected. […] But that's just when exposure is likely to be exploding, by way of ridiculous public offerings, earnings manipulation, chain-letter-like stock promotions and a potpourri of other unsavory activities. When stocks fall, these sins surface.
Fear may recede with time, but the danger won't – the war against terrorism can never be won. The best the nation can achieve is a long succession of stalemates. There can be no checkmate against hydra-headed foes.
"No" must be an important part of any underwriter's vocabulary.
When companies or investment professionals use terms such as "EBITDA" and "pro forma," they want you to unthinkingly accept concepts that are dangerously flawed. (In golf, my score is frequently below par on a pro forma basis: I have firm plans to "restructure" my putting stroke and therefore only count the swings I take before reaching the green.)
In effect, insurance accounting is a self-graded exam, in that the insurer gives some figures to its auditing firm and generally doesn't get an argument. (What the auditor gets, however, is a letter from management that is designed to take his firm off the hook if the numbers later look silly.) A company experiencing financial difficulties – of a kind that, if truly faced, could put it out of business – seldom proves to be a tough grader. Who, after all, wants to prepare his own execution papers?
Even when companies have the best of intentions, it's not easy to reserve properly. I've told the story in the past about the fellow traveling abroad whose sister called to tell him that their dad had died. The brother replied that it was impossible for him to get home for the funeral; he volunteered, however, to shoulder its cost. Upon returning, the brother received a bill from the mortuary for $4,500, which he promptly paid. A month later, and a month after that also, he paid $10 pursuant to an add-on invoice. When a third $10 invoice came, he called his sister for an explanation. "Oh," she replied, "I forgot to tell you. We buried dad in a rented suit." […] There are a lot of "rented suits" buried in the past operations of insurance companies.
When a claims manager walks into the CEO's office and says "Guess what just happened," his boss, if a veteran, does not expect to hear it's good news.
A market that no more than parallels business progress, however, is likely to leave many investors disappointed.
Here's one for those who enjoy an odd coincidence: The Great Bubble ended on March 10, 2000 (though we didn't realize that fact until some months later). On that day, the NASDAQ (recently 1,731) hit its all-time high of 5,132. That same day, Berkshire shares traded at $40,800, their lowest price since mid-1997.
We have never purchased a newly-issued junk bond, which is the only kind most investors are urged to buy. [But] occasionally, a purchase of distressed bonds leads us into something bigger. Early in the Fruit of the Loom bankruptcy, we purchased the company's public and bank debt at about 50% of face value. This was an unusual bankruptcy in that interest payments on senior debt were continued without interruption, which meant we earned about a 15% current return. Our holdings grew to 10% of Fruit's senior debt, which will probably end up returning us about 70% of face value.
In neither the purchase of goods nor the hiring of personnel, do we ever consider the religious views, the gender, the race or the sexual orientation of the persons we are dealing with. It would not only be wrong to do so, it would be idiotic. We need all of the talent we can find, and we have learned that able and trustworthy managers, employees and suppliers come from a very wide spectrum of humanity.
At headquarters we added one employee and now have 14.8. (I've tried in vain to get JoEllen Rieck to change her workweek from four days to five; I think she likes the national recognition she gains by being .8.)
Unlike LBO operators and private equity firms, we have no “exit” strategy – we buy to keep.
You’ve seen a flood of “pro-forma” earnings statements – tabulations in which managers invariably show “earnings” far in excess of those allowed by their auditors. In these presentations, the CEO tells his owners “don’t count this, don’t count that – just count what makes earnings fat.” Often, a forget-all-this-bad-stuff message is delivered year after year without management so much as blushing.
My managerial model is Eddie Bennett, who was a batboy. In 1919, at age 19, Eddie began his work with the Chicago White Sox, who that year went to the World Series. The next year, Eddie switched to the Brooklyn Dodgers, and they, too, won their league title. Our hero, however, smelled trouble. Changing boroughs, he joined the Yankees in 1921, and they promptly won their first pennant in history. Now Eddie settled in, shrewdly seeing what was coming. In the next seven years, the Yankees won five American League titles. […] What does this have to do with management? It’s simple – to be a winner, work with winners.
From its beginnings in the 1930s, Northern Natural was one of Omaha’s premier businesses, run by CEOs who regularly distinguished themselves as community leaders. Then, in July, 1985, the company – which in 1980 had been renamed InterNorth – merged with Houston Natural Gas, a business less than half its size. The companies announced that the enlarged operation would be headquartered in Omaha, with InterNorth’s CEO continuing in that job. Within a year, those promises were broken. By then, the former CEO of Houston Natural had taken over the top job at InterNorth, the company had been renamed, and the headquarters had been moved to Houston. These switches were orchestrated by the new CEO – Ken Lay – and the name he chose was Enron.
At merger time, I detected no slippage in Gen Re’s standards. I was dead wrong. Gen Re’s culture and practices had substantially changed and unbeknownst to management – and to me – the company was grossly mispricing its current business. […] When the WTC disaster occurred, it exposed weaknesses in Gen Re’s operations that I should have detected earlier. […] When I review the reserving errors that have been uncovered at General Re, a line from a country song seems apt: “I wish I didn’t know now what I didn’t know then.”
Here’s one footnote to GEICO’s 2002 earnings that underscores the need for insurers to do business with only the strongest of reinsurers. In 1981-1983, the managers then running GEICO decided to try their hand at writing commercial umbrella and product liability insurance. The risks seemed modest: the company took in only $3,051,000 from this line and used almost all of it – $2,979,000 – to buy reinsurance in order to limit its losses. GEICO was left with a paltry $72,000 as compensation for the minor portion of the risk that it retained. But this small bite of the apple was more than enough to make the experience memorable. GEICO’s losses from this venture now total a breathtaking $94.1 million or about 130,000% of the net premium it received. […] “Cheap” reinsurance is a fool’s bargain.
We cherish cost-consciousness at Berkshire. Our model is the widow who went to the local newspaper to place an obituary notice. Told there was a 25-cents-a-word charge, she requested “Fred Brown died.” She was then informed there was a seven-word minimum. “Okay” the bereaved woman replied, “make it ‘Fred Brown died, golf clubs for sale’.”
Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them.
Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years. Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market […] and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. […] In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.
Of course, both internal and outside auditors review the numbers, but that’s no easy job. […] The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash.
I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.
Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.
History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.
In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives.
Even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.
The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. […] Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. […] In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.
Accountability and stewardship withered in the last decade, becoming qualities deemed of little importance by those caught up in the Great Bubble. As stock prices went up, the behavioral norms of managers went down. […] Too many of these people, however, have in recent years behaved badly at the office, fudging numbers and drawing obscene pay for mediocre business achievements.
In theory, corporate boards should have prevented this deterioration of conduct. […] Directors must get rid of a manager who is mediocre or worse, no matter how likable he may be. Directors must react as did the chorus-girl bride of an 85-yearold multimillionaire when he asked whether she would love him if he lost his money. “Of course,” the young beauty replied, “I would miss you, but I would still love you.”
Why have intelligent and decent directors failed so miserably? The answer lies not in inadequate laws – it’s always been clear that directors are obligated to represent the interests of shareholders – but rather in what I’d call “boardroom atmosphere.” It’s almost impossible, for example, in a boardroom populated by well-mannered people, to raise the question of whether the CEO should be replaced. It’s equally awkward to question a proposed acquisition that has been endorsed by the CEO, particularly when his inside staff and outside advisors are present and unanimously support his decision. (They wouldn’t be in the room if they didn’t.) […] These “social” difficulties argue for outside directors regularly meeting without the CEO – a reform that is being instituted and that I enthusiastically endorse.
The current cry is for “independent” directors. It is certainly true that it is desirable to have directors who think and speak independently – but they must also be business-savvy. […] Over a span of 40 years, I have been on 19 public-company boards (excluding Berkshire’s) and have interacted with perhaps 250 directors. Most of them were “independent” as defined by today’s rules [and yet] their contribution to shareholder well-being was minimal at best and, too often, negative. […] In those cases, collegiality trumped independence.
Year after year the directors of Fund A select manager A, Fund B directors select manager B, etc. … in a zombie-like process that makes a mockery of stewardship. Very occasionally, a board will revolt. But for the most part, a monkey will type out a Shakespeare play before an “independent” mutual-fund director will suggest that his fund look at other managers, even if the incumbent manager has persistently delivered substandard performance. When they are handling their own money, of course, directors will look to alternative advisors – but it never enters their minds to do so when they are acting as fiduciaries for others.
Investment company directors have failed as well in negotiating management fees. […] Believe me, if directors were promised a portion of any fee savings they realized, the skies would be filled with falling fees. Under the current system, though, reductions mean nothing to “independent” directors while meaning everything to managers. So guess who wins?
The ownership of stock has grown increasingly concentrated in recent decades, and today it would be easy for institutional managers to exert their will on problem situations. Twenty, or even fewer, of the largest institutions, acting together, could effectively reform corporate governance at a given company. […] Unfortunately, certain major investing institutions have “glass house” problems in arguing for better governance elsewhere; they would shudder, for example, at the thought of their own performance and fees being closely inspected by their own boards.
Audit committees can’t audit. Only a company’s outside auditor can determine whether the earnings that a management purports to have made are suspect. […] Far too many managers have fudged their company’s numbers in recent years, using both accounting and operational techniques that are typically legal but that nevertheless materially mislead investors. Frequently, auditors knew about these deceptions. Too often, however, they remained silent. The key job of the audit committee is simply to get the auditors to divulge what they know. To do this job, the committee must make sure that the auditors worry more about misleading its members than about offending management. In recent years auditors have not felt that way. They have instead generally viewed the CEO, rather than the shareholders or directors, as their client. That has been a natural result of day-to-day working relationships and also of the auditors’ understanding that, no matter what the book says, the CEO and CFO pay their fees and determine whether they are retained for both auditing and other work.
If an earnings release is imminent when the auditors and committee interact – the committee will feel pressure to rubberstamp the prepared figures. Haste is the enemy of accuracy. My thinking, in fact, is that the SEC’s recent shortening of reporting deadlines will hurt the quality of information that shareholders receive.
Within [Arthur Andersen], an elite Professional Standards Group (PSG) insisted on honest reporting, no matter what pressures were applied by the client. […] The PSG’s position was reversed, however, by the “rainmaking” partners of Andersen who knew what their clients wanted – higher reported earnings no matter what the reality.
Soon after the Andersen [scandal], the independent accounting standards board (FASB) voted 7-0 for expensing options. Predictably, the major auditing firms and an army of CEOs stormed Washington to pressure the Senate – what better institution to decide accounting questions? – into castrating the FASB. The voices of the protesters were amplified by their large political contributions, usually made with corporate money belonging to the very owners about to be bamboozled. It was not a sight for a civics class. To its shame, the Senate voted 88-9 against expensing. Several prominent Senators even called for the demise of the FASB if it didn’t abandon its position. (So much for independence.) […] After being threatened by the Senate, FASB backed off its original position and adopted an “honor system” approach. […] The disheartening result: Of the 500 companies in the S&P, 498 adopted the method deemed less desirable, which of course let them report higher “earnings.”
Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?
Unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.
Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).
Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.
Investment managers often profit far more from piling up assets than from handling those assets well. So when one tells you that increased funds won’t hurt his investment performance, step back: His nose is about to grow.
Growth-rate presentations can be significantly distorted by a calculated selection of either initial or terminal dates.
Our capital is underutilized now, but that will happen periodically. It’s a painful condition to be in – but not as painful as doing something stupid. (I speak from experience.)
When “securitization” then became popular in the 1990s, further distancing the supplier of funds from the lending transaction, the industry’s conduct went from bad to worse. Much of its volume a few years back came from buyers who shouldn’t have bought, financed by lenders who shouldn’t have lent. The consequence has been huge numbers of repossessions and pitifully low recoveries on the units repossessed. […] A different business model is required [in the housing market], one that eliminates the ability of the retailer and salesman to pocket substantial money up front by making sales financed by loans that are destined to default.
Our federal tax return for 2002 […] covered a mere 8,905 pages. As is required, we dutifully filed two copies of this return, creating a pile of paper seven feet Tall. [Ed: in 2013 it was 23,000 pages].
If class warfare is being waged in America, my class is clearly winning.
In judging whether Corporate America is serious about reforming itself, CEO pay remains the acid test. To date, the results aren’t encouraging. […] When management hires employees, or when companies bargain with a vendor, the intensity of interest is equal on both sides of the table. One party’s gain is the other party’s loss, and the money involved has real meaning to both. […] But when CEOs (or their representatives) have met with compensation committees, […] the negotiation often has a “play-money” quality. […] But sadly, “boardroom atmosphere” almost invariably sedates their fiduciary genes.
As one compensation consultant commented: “There are two classes of clients you don’t want to offend – actual and potential.”
After all, whoever washes a rental car?
Many people who are smart, articulate and admired have no real understanding of business. That’s no sin; they may shine elsewhere. But they don’t belong on corporate boards. Similarly, I would be useless on a medical or scientific board (though I would likely be welcomed by a chairman who wanted to run things his way). My name would dress up the list of directors, but I wouldn’t know enough to critically evaluate proposals. Moreover, to cloak my ignorance, I would keep my mouth shut (if you can imagine that). In effect, I could be replaced, without loss, by a potted plant.
Last year, for example, PepsiCo promoted a drawing that offered participants a chance to win a $1 billion prize. Understandably, Pepsi wished to lay off this risk, and we were the logical party to assume it. So we wrote a $1 billion policy, retaining the risk entirely for our own account.
The shrinking of [Gen Re’s derivative] business has been costly. We’ve had pre-tax losses of $173 million in 2002 and $99 million in 2003. These losses, it should be noted, came from a portfolio of contracts that – in full compliance with GAAP – had been regularly marked-to-market with standard allowances for future credit-loss and administrative costs. Moreover, our liquidation has taken place both in a benign market – we’ve had no credit losses of significance – and in an orderly manner. This is just the opposite of what might be expected if a financial crisis forced a number of derivatives dealers to cease operations simultaneously. If our derivatives experience […] no matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you.
You may wonder why we borrow money while sitting on a mountain of cash. It’s because of our “every tub on its own bottom” philosophy. We believe that any subsidiary lending money should pay an appropriate rate for the funds needed to carry its receivables and should not be subsidized by its parent. Otherwise, having a rich daddy can lead to sloppy decisions.
If you have the lowest price, customers will find you at the bottom of a river.
During 2002 we entered the foreign currency market for the first time in my life, and in 2003 we enlarged our position, as I became increasingly bearish on the dollar. I should note that the cemetery for seers has a huge section set aside for macro forecasters.
When we can’t find anything exciting in which to invest, our “default” position is U.S. Treasuries, both bills and repos. No matter how low the yields on these instruments go, we never “reach” for a little more income by dropping our credit standards or by extending maturities. Charlie and I detest taking even small risks unless we feel we are being adequately compensated for doing so. About as far as we will go down that path is to occasionally eat cottage cheese a day after the expiration date on the carton.
My message to [our managers] is simple: Run your business as if it were the only asset your family will own over the next hundred years.
Investors should remember that excitement and expenses are their enemies.
Customers by the millions say “I need some Gillette blades” or “I’ll have a Coke” but we wait in vain for “I’d like a National Indemnity policy, please.” Consequently, price competition in insurance is usually fierce. Think airline seats.
[If] there is a fear factor at work, in that a shrinking business usually leads to layoffs. To avoid pink slips, employees will rationalize inadequate pricing. […] To combat employees’ natural tendency to save their own skins, we have always promised NICO’s workforce that no one will be fired because of declining volume, however severe the contraction. (This is not Donald Trump’s sort of place.) NICO is not labor-intensive, and, as the table suggests, can live with excess overhead.
Naturally, a business that follows a no-layoff policy must be especially careful to avoid overstaffing when times are good. [Like] an employee who asked his boss for permission to hire an assistant. The employee assumed that adding $20,000 to the annual payroll would be inconsequential. But his boss told him the proposal should be evaluated as a $3 million decision, given that an additional person would probably cost at least that amount over his lifetime, factoring in raises, benefits and other expenses (more people, more toilet paper). And unless the company fell on very hard times, the employee added would be unlikely to be dismissed, however marginal his contribution to the business.
Our experience tells us that extraordinary business ability is largely innate.
At bottom, any insurance policy is simply a promise, and as everyone knows, promises vary enormously in their quality. […] When “the day after” arrives, Berkshire’s checks will clear.
Derivative contracts have always been required to be marked to market, and I believe the company’s management conscientiously tried to make realistic “marks.” […] In the interim the marks influence the managerial and trading bonuses that are paid annually. It’s small wonder that phantom profits are often recorded.
I viewed the selection of a flight provider as akin to picking a brain surgeon: you simply want the best. (Let someone else experiment with the low bidder.)
If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.
John Maynard Keynes said in his masterful The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
The “whistleblower line,” [is a reform] arrangement through which employees can send information to me and the board’s audit committee without fear of reprisal. Berkshire’s extreme decentralization makes this system particularly valuable both to me and the committee. (In a sprawling “city” of 180,000 – Berkshire’s current employee count – not every sparrow that falls will be noticed at headquarters.) Most of the complaints we have received are of “the guy next to me has bad breath” variety, but on occasion I have learned of important problems at our subsidiaries that I otherwise would have missed.
Independence is defined in Webster’s as “not subject to control by others.” I’m puzzled how anyone could conclude that our Coke purchases would “control” my decision-making when the counterweight is the wellbeing of $8 billion of Coke stock held by Berkshire. Assuming I’m even marginally rational, elementary arithmetic should make it clear that my heart and mind belong to the owners of Coke, not to its management.
In our view, based on our considerable boardroom experience, the least independent directors are likely to be those who receive an important fraction of their annual income from the fees they receive for board service (and who hope as well to be recommended for election to other boards and thereby to boost their income further). […] Most directors of this type are decent people and do a first-class job. But they wouldn’t be human if they weren’t tempted to thwart actions that would threaten their livelihood.
[An business owner characterised] Berkshire’s unusual acquisition and managerial practices [this way:] “It was easier to sell my business than to renew my driver’s license.”
If you have a business that fits, give me a call. Like a hopeful teenage girl, I’ll be waiting by the phone.
One of the [derivatives] contracts we liquidated in 2005 had a term of 100 years! It’s difficult to imagine what “need” such a contract could fulfill except, perhaps, the need of a compensation-conscious trader to have a long-dated contract on his books […] and provide the most opportunity for “imagination” when traders are estimating their value.
A given contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.
CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options.
Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets.
Comp committees have become slaves to comparative data. […] In this manner, outlandish “goodies” are showered upon CEOs simply because of a corporate version of the argument we all used when children: “But, Mom, all the other kids have one.” When comp committees follow this “logic,” yesterday’s most egregious excess becomes today’s baseline.
The most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. […] For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.
Sir Isaac Newton’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
Alternatively, we could “securitize” – that is, sell – these receivables, but retain the servicing of them. If we followed this procedure, which is common in the industry, we would not show the debt that we do on our balance sheet, and we would also accelerate the earnings we report. In the end, however, we would earn less money. […] We prefer better profits to better cosmetics.
I know I wouldn’t enjoy many of the duties that come with [most CEO] positions – meetings, speeches, foreign travel, the charity circuit and governmental relations.
Our exemplar is the older man who crashed his grocery cart into that of a much younger fellow while both were shopping. The elderly man explained apologetically that he had lost track of his wife and was preoccupied searching for her. His new acquaintance said that by coincidence his wife had also wandered off and suggested that it might be more efficient if they jointly looked for the two women. Agreeing, the older man asked his new companion what his wife looked like. “She’s a gorgeous blonde,” the fellow answered, “with a body that would cause a bishop to go through a stained glass window, and she’s wearing tight white shorts. How about yours?” The senior citizen wasted no words: “Forget her, we’ll look for yours.”
[In the past] no paper in a one-paper city, however bad the product or however inept the management, could avoid gushing profits. […] The great majority of families therefore felt the need for a paper every day, but understandably most didn’t wish to pay for two. Advertisers preferred the paper with the most circulation, and readers tended to want the paper with the most ads and news pages. This circularity led to a law of the newspaper jungle: Survival of the Fattest. Thus, when two or more papers existed in a major city (which was almost universally the case a century ago), the one that pulled ahead usually emerged as the stand-alone winner. After competition disappeared, the paper’s pricing power in both advertising and circulation was unleashed. Typically, rates for both advertisers and readers would be raised annually – and the profits rolled in. […] However, the economic potential of a newspaper internet site – given the many alternative sources of information and entertainment that are free and only a click away – is at best a small fraction of that existing in the past for a print newspaper facing no competition. […] Fixed costs are high in the newspaper business, and that’s bad news when unit volume heads south.
The slowdown in residential real estate activity stems in part from the weakened lending practices of recent years. The “optional” contracts and “teaser” rates that have been popular have allowed borrowers to make payments in the early years of their mortgages that fall far short of covering normal interest costs. […] Consequently there is a huge overhang of offerings in several [U.S.] markets.
Derivatives, just like stocks and bonds, are sometimes wildly mispriced.
Temperament is also important [in our search for CEO]. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues. Finally, we have a special problem to consider: our ability to keep the person we hire. Being able to list Berkshire on a resume would materially enhance the marketability of an investment manager. We will need, therefore, to be sure we can retain our choice, even though he or she could leave and make much more money elsewhere. […] How many CEOs have voluntarily left us for other jobs in our 42-year history? Precisely none.
Corporate bigwigs often complain about government spending, criticizing bureaucrats who they say spend taxpayers’ money differently from how they would if it were their own. But sometimes the financial behavior of executives will also vary based on whose wallet is getting depleted. Here’s an illustrative tale from my days at Salomon. In the 1980s the company had a barber, Jimmy by name, who came in weekly to give free haircuts to the top brass. A manicurist was also on tap. Then, because of a cost-cutting drive, patrons were told to pay their own way. One top executive (not the CEO) who had previously visited Jimmy weekly went immediately to a once-every-three-weeks schedule.
[Managers may] harbor unrealistic expectations about obtainable returns. Sometimes these delusions are self-serving. For example, private pension plans can temporarily overstate their earnings, and public pension plans can defer the need for increased taxes, by using investment assumptions that are likely to be out of reach.
When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.
Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.
Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was “right” […] After all, if you are in the shipping business, it’s helpful to have all of your potential competitors be taught that the earth is flat.
Charlie and I are extraordinarily lucky. We were born in America; had terrific parents who saw that we got good educations; have enjoyed wonderful families and great health; and came equipped with a “business” gene that allows us to prosper in a manner hugely disproportionate to other people who contribute as much or more to our society’s well-being. Moreover, we have long had jobs that we love, in which we are helped every day in countless ways by talented and cheerful associates. No wonder we tap-dance to work.
You may recall a 2003 Silicon Valley bumper sticker that implored, “Please, God, Just One More Bubble.” Unfortunately, this wish was promptly granted, as just about all Americans came to believe that house prices would forever rise. That conviction made a borrower’s income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA – house price appreciation – would cure all problems. Today, our country is experiencing widespread pain because of that erroneous belief. As house prices fall, a huge amount of financial folly is being exposed.
[Our] managers is that they have exactly the job they want for the rest of their working years. At almost any other company, key managers below the top aspire to keep climbing the pyramid. For them, the subsidiary or division they manage today is a way station – or so they hope. Indeed, if they are in their present positions five years from now, they may well feel like failures. […] Their decisions flow from a here-today, here-forever mindset.
The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success.
Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google. […] Just as Adam and Eve kick-started an activity that led to six billion humans.
The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
[We] poured money into a bottomless pit. […] In the decade following our sale [of U.S. Air], the company went bankrupt. Twice.
[TV Stations] were simple to run and showered cash on their owners. […] Its total earnings since I turned down the deal [are] at least $1 billion. […] Why did I say “no”? The only explanation is that my brain had gone on vacation and forgot to notify me. (My behavior resembled that of a politician Molly Ivins once described: “If his I.Q. was any lower, you would have to water him twice a day.”)
To date, Dexter is the worst deal that I’ve made. […] In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion– to buy a worthless business. […] A line from Bobby Bare’s country song explains what too often happens with acquisitions: “I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.”
We agreed to purchase […] MidAmerican at $35.05 per share in 1999. […] Why the odd figure of $35.05? I originally decided the business was worth $35.00 per share to Berkshire. […] For several days the investment bankers representing MidAmerican had no luck in getting me to increase Berkshire’s offer. But, finally, they caught me in a moment of weakness, and I caved, telling them I would go to $35.05. With that, I explained, they could tell their client they had wrung the last nickel out of me. At the time, it hurt. […] And yes, I’m glad I wilted and offered the extra nickel.
[We] are not big fans of resumes. Instead, we focus on brains, passion and integrity.
[An] aspects of our derivative contracts [that is] particularly important: […] in all cases we hold the money, which means that we have no counter party risk.
Americans like buying products made elsewhere more than the rest of the world likes buying products made in the U.S. Inevitably, that causes America to ship about $2 billion of IOUs and assets daily to the rest of the world. […] When we force-feed $2 billion daily to the rest of the world, they must invest in something here.
During the past century five versions of Brazilian currency have, in effect, turned into confetti.
At the time, Amazon bonds were priced as “junk” credits, though they were anything but. […] You can occasionally find markets that are ridiculously inefficient – or at least you can find them anywhere except at the finance departments of some leading business schools.
America’s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever growing prosperity for its citizens.
To avoid that bothersome [FASB] rule, a number of companies surreptitiously backdated options to falsely indicate that they were granted at current market prices, when in fact they were dished out at prices well below market.
Other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. […] For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved. The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss. This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been. How realistic is this expectation? […]During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. […] It was a wonderful century. […] For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099.
Naturally, everyone expects to be above average.
Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.
Some companies have pension plans in Europe as well as in the U.S. and, in their accounting, almost all assume that the U.S. plans will earn more than the non-U.S. plans. This discrepancy is puzzling: Why should these companies not put their U.S. managers in charge of the non-U.S. pension assets and let them work their magic on these assets as well? I’ve never seen this puzzle explained. But the auditors and actuaries who are charged with vetting the return assumptions seem to have no problem with it. What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire.
If you decide to leave during the day’s question periods, please do so while Charlie is talking.
By yearend, investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game.
The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear
In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. […] Weaning these entities from the public teat will be a political challenge.
In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21 1⁄2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so.
When investing, pessimism is your friend, euphoria the enemy.
Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.
Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. […] Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. […] The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.
To begin with, the need for meaningful down payments was frequently ignored. Sometimes fakery was involved. (“That certainly looks like a $2,000 cat to me” says the salesman who will receive a $3,000 commission if the loan goes through.) […] Indeed, no purchaser of the mortgages it originated and then securitized has ever lost a dime of principal or interest.
My family and I have enjoyed my present home for 50 years, with more to come. But enjoyment and utility should be the primary motives for purchase, not profit or refi possibilities. And the home purchased ought to fit the income of the purchaser.
Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition.
Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.
Let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. […] Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt-tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. […] What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?
Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.
During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss.
Beware the investment activity that produces applause; the great moves are usually greeted by yawns.
So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight of these two institutions, totally missed their cooking of the books.
Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them.
[Derivative] participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with.
I believe the BlackScholes formula, even though it is the standard for establishing the dollar liability for options, produces strange results when the long-term variety are being valued. […] Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options, its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the BlackScholes formula now place on our long-term put options overstate our liability, though the overstatement will diminish as the contracts approach maturity.
The Black-Scholes formula has approached the status of holy writ in finance. […] If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula.
In 2008 we began to write “credit default swaps” on individual companies. This is simply credit insurance, similar to what we write in BHAC, except that here we bear the credit risk of corporations rather than of tax-exempt issuers. […] For the typical contract, we receive quarterly payments for five years. […] At yearend, however, mark-to-market accounting required us to record a loss of $631 million on these derivatives contracts. Had we instead insured the same bonds at the same price in BHAC, and used the accrual accounting required at insurance companies, we would have recorded a small profit for the year.
Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. […] Even the survivors tended to come away bleeding.
We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that both operating and capital decisions are occasionally made with which Charlie and I would have disagreed had we been consulted. […] We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly – or not at all – because of a stifling bureaucracy. […] But we will never allow Berkshire to become some monolith that is overrun with committees, budget presentations and multiple layers of management.
Last year we saw, in one instance, how sound-bite reporting can go wrong. Among the 12,830 words in the annual letter was this sentence: “We are certain, for example, that the economy will be in shambles throughout 2009 – and probably well beyond – but that conclusion does not tell us whether the market will rise or fall.” Many news organizations reported – indeed, blared – the first part of the sentence while making no mention whatsoever of its ending. I regard this as terrible journalism.
If Charlie, I and Ajit are ever in a sinking boat – and you can only save one of us – swim to Ajit. […] Throughout the world, he is known as the man to call when something both very large and unusual needs to be insured.
The supply side of the [housing] picture – were running about two million annually. But household formations – the demand side – only amounted to about 1.2 million. After a few years of such imbalances, the country unsurprisingly ended up with far too many houses. There were three ways to cure this overhang: (1) blow up a lot of houses, a tactic similar to the destruction of autos that occurred with the “cash-for-clunkers” program; (2) speed up household formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers or; (3) reduce new housing starts to a number far below the rate of household formations.
Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.
Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy.
You simply can’t exchange an undervalued stock for a fully-valued one without hurting your shareholders. [However] if an acquirer’s stock is overvalued, it’s a different story: […] they can afford to overpay because they are, in effect, using counterfeit money.
Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through.
[Leading up to the financial crisis, bank] managers – fine people and able bankers – not unexpectedly began to behave like teenage boys who had just discovered girls.
Besides, it’s only a small deal,” they said […] agreeing to this value-destroying deal. […] Charlie’s reaction at the time: “Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?”s
Our best guess is that 35,000 people attended the annual meeting last year (up from 12 – no zeros omitted – in 1981).
Think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.
Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills. […] A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.
At Berkshire, managers can focus on running their businesses: They are not subjected to meetings at headquarters nor financing worries nor Wall Street harassment. They simply get a letter from me every two years and call me when they wish. […] A “hire well, manage little” code suits both them and me.
Our [competitive] advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.
Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior.
At Berkshire’s “World Headquarters” our annual rent is $270,212. Moreover, the home-office investment in furniture, art, Coke dispenser, lunch room, high-tech equipment – you name it – totals $301,363.
I try to look out ten or twenty years when making an acquisition, but sometimes my eyesight has been poor.
Even though NetJets was consistently a runaway winner with customers, our financial results, since its acquisition in 1998, were a failure. […] Borrowing costs at NetJets were heavily subsidized by its free use of Berkshire’s credit.
All things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks. (The two best investments were wedding rings.) For the $31,500 I paid for our house, my family and I gained 52 years of terrific memories with more to come. But a house can be a nightmare if the buyer’s eyes are bigger than his wallet and if a lender – often protected by a government guarantee – facilitates his fantasy.
To update Aesop, a girl in a convertible is worth five in the phone book.
The hedge-fund world has witnessed some terrible behavior by general partners who have received huge payouts on the upside and who then, when bad results occurred, have walked away rich, with their limited partners losing back their earlier gains.
80% of each [portfolio] manager’s performance compensation be dependent on his or her own portfolio and 20% on that of the other manager(s). We want a compensation system that pays off big for individual success but that also fosters cooperation, not competition. [They] will be paid a salary plus a contingent payment based on his performance relative to the S&P. We have arrangements in place for deferrals and carryforwards that will prevent see-saw performance being met by undeserved payments.
Our goal was to find a 2-year-old Secretariat, not a 10-year-old Seabiscuit. (Whoops – that may not be the smartest metaphor for an 80-year-old CEO to use.)
Net income, important though that number may be at most companies, it is almost always meaningless at Berkshire. Regardless of how our businesses might be doing, Charlie and I could – quite legally – cause net income in any given period to be almost any number we would like. We have that flexibility because realized gains or losses on investments go into the net income figure, whereas unrealized gains (and, in most cases, losses) are excluded. […] If we really thought net income important, we could regularly feed realized gains into it simply because we have a huge amount of unrealized gains upon which to draw. […] We have a deep disgust for “game playing” with numbers.
John Kenneth Galbraith once slyly observed that economists were most economical with ideas.
Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it “anomalies.” (I always love explanations of that kind: The Flat Earth Society probably views a ship’s circling of the globe as an annoying, but inconsequential, anomaly.)
When leverage works, it magnifies your gains. […] Once having profited from its wonders, very few people retreat to more conservative practices.
Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job. Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed.
Ray DeVoe’s observation, “More money has been lost reaching for yield than at the point of a gun.”
Not a dime of cash has left Berkshire for dividends or share repurchases during the past 40 years. […] That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.
We can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation. We must continue to measure every act against not only what is legal but also what we would be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.
Sometimes your associates will say “Everybody else is doing it.” This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision. Whenever somebody offers that phrase as a rationale, in effect they are saying that they can’t come up with a good reason. If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them.
If you see anything whose propriety or legality causes you to hesitate, […] it’s very likely that [this course of action is] too close to the line and should be abandoned. There’s plenty of money to be made in the center of the court.
As a corollary, let me know promptly if there’s any significant bad news. I can handle bad news but I don’t like to deal with it after it has festered for awhile.
We now employ more than 250,000 people and the chances of that number getting through the day without any bad behavior occurring is nil.
Culture, more than rule books, determines how an organization behaves.
More than 98% of my net worth is in Berkshire stock [and] being so heavily concentrated in one stock defies conventional wisdom.
The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.
As one of our directors says, it’s like shooting fish in a barrel, after the barrel has been drained and the fish have quit flopping.
Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enough human behavior to know the futility of that.
Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
Charlie would gladly trade me for a second Ajit.
“Buy commodities, sell brands” has long been a formula for business success.
At Berkshire, the managers do the work; I take the bows.
After retiring, [Mrs. B] died the next year [at 103], a sequence I point out to any other Berkshire manager who even thinks of retiring.
When our quarterly filings report relatively small holdings, these are not likely to be buys I made (though the media often overlook that point) but rather holdings denoting purchases by Todd or Ted.
Investing is often described as the process of laying out money now in the expectation of receiving more money in the future.
The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. [Likewise] a non-fluctuating asset can be laden with risk.
Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. […] Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. […] “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.
A wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.” […] Right now bonds should come with a warning label.
[A tulip-like] investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce […] but rather by the belief that others will desire it even more avidly in the future. […] As “bandwagon” investors join any party, they create their own truth – for a while. […] Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices.
The major [non-productive] asset in this category is gold, […] being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B? Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices. A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond. Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.
After all, the reporters’ mantra is: “If your mother says she loves you, check it out.
When the partnership I ran took control of Berkshire in 1965, I could never have dreamed that a year in which we had a gain of $24.1 billion would be subpar.
When I count my blessings, I count GEICO twice.
Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.
Insurance earnings are now benefitting from “legacy” bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years. […] Today’s bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over.
For example, if the insurance industry should experience a $250 billion loss from some mega-catastrophe – a loss about triple anything it has ever experienced – Berkshire as a whole would likely record a significant profit for the year because it has so many streams of earnings. All other major insurers and reinsurers would meanwhile be far in the red, with some facing insolvency.
Our definition of coverage is pre-tax earnings/interest, not EBITDA/interest, a commonly-used measure we view as deeply flawed.
Serious investors should understand the disparate nature of intangible assets: Some truly deplete over time while others never lose value. With software, for example, amortization charges are very real expenses. Charges against other intangibles such as the amortization of customer relationships, however, arise through purchase-accounting rules and are clearly not real expenses. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when calculating earnings – even though from an investor’s viewpoint they could not be more different.
Charlie and I believe in operating with many redundant layers of liquidity, [which] reduces our returns in 99 years out of 100. But we will survive in the 100th while many others fail. And we will sleep well in all 100.
News, to put it simply, is what people don’t know that they want to know. [But] even a valuable product, however, can self-destruct from a faulty business strategy. And that process has been underway during the past decade at almost all papers of size.
[Our] individual papers, however, will be independent in their news coverage and editorial opinions. (I voted for Obama; of our 12 dailies that endorsed a presidential candidate, 10 opted for Romney.)
Sometimes […] managers misfire. The usual cause of failure is that they start with the answer they want and then work backwards to find a supporting rationale. Of course, the process is subconscious; that’s what makes it so dangerous.
Twenty years of management effort and capital improvements in our original textile business were an exercise in futility. I wanted the business to succeed and wished my way into a series of bad decisions. (I even bought another New England textile company.) But wishing makes dreams come true only in Disney movies; it’s poison in business.
You can successfully run a restaurant that serves hamburgers or, alternatively, one that features Chinese food. But you can’t switch capriciously between the two and retain the fans of either.
I must again confess that [Ted & Todd's] investments outperformed mine. (Charlie says I should add “by a lot.”) If such humiliating comparisons continue, I’ll have no choice but to cease talking about them.
Our flexibility in capital allocation [analogous to Woody Allen's comment about bisexuality], our appetite for either operating businesses or passive investments doubles our chances of finding sensible uses for our endless gusher of cash.
Simply put, insurance is the sale of promises. […] Like Noah, who foresaw early on the need for dependable transportation, we know it’s our job to plan ahead.
When Wall Streeters tout EBITDA as a valuation guide, button your wallet.
I knew nothing about operating a farm. But I have a son who loves farming and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out. […] Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm. […] You don’t need to be an expert in order to achieve satisfactory investment returns.
The unsophisticated investor who is realistic about his shortcomings is likely to obtain better longterm results than the knowledgeable professional who is blind to even a single weakness.
Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”
If you instead focus on the prospective price change of a contemplated purchase, you are speculating. […] Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)
Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate. […] After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.
Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.
A “flash crash” or […] tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.
The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal. […] That’s the “what” of investing for the non-professional. The “when” is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur.
Remember the late Barton Biggs’ observation: “A bull market is like sex. It feels best just before it ends.”
Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit.
Charlie and I have always considered a “bet” on ever-rising U.S. prosperity to be very close to a sure thing. […] Indeed, who has ever benefited during the past 238 years by betting against America? […] In my lifetime alone, real per-capita U.S. output has sextupled. [But] gains won’t come in a smooth or uninterrupted manner; they never have.
[In] 1967 […] we acquired National Indemnity and its sister company, National Fire & Marine, for $8.6 million. […] That contract was homemade: Neither side used a lawyer. […] My reasoning: Jack was honest.
If a reinsurer fails to pay a loss, the original insurer is still on the hook for it.
When CEOs tout EBITDA as a valuation guide, wire them up for a polygraph test.
In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.
Stock prices will always be far more volatile than cash-equivalent holdings. […] It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. […] Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.
Borrowed money has no place in the investor’s tool kit.
Market forecasters will fill your ear but will never fill your wallet.
Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship.
Slip out while Charlie’s talking on Saturday and binge on our bargains.
[In 1955,] Berkshire Fine Spinning Associates and Hathaway Manufacturing – both with roots in the 19th Century – joined forces, taking the name we bear today. With its fourteen plants and 10,000 employees, the merged company became the giant of New England textiles. What the two managements viewed as a merger agreement, however, soon morphed into a suicide pact. During the seven years following the consolidation, Berkshire operated at an overall loss, and its net worth shrunk by 37%.
I purchased BPL’s first shares of Berkshire in December 1962 [when] the stock was then selling for $7.50, a wide discount from per-share working capital of $10.25 and book value of $20.20. Buying the stock at that price was like picking up a discarded cigar butt that had one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected.
The most gruesome was Dexter Shoe. When we purchased the company in 1993, it had a terrific record and in no way looked to me like a cigar butt. Its competitive strengths, however, were soon to evaporate because of foreign competition. And I simply didn’t see that coming. Consequently, Berkshire paid $433 million for Dexter and, rather promptly, its value went to zero. […] The shares I used for the purchase are now worth about $5.7 billion. As a financial disaster, this one deserves a spot in the Guinness Book of World Records. […] Trading shares of a wonderful business – which Berkshire most certainly is – for ownership of a so-so business irreparably destroys value.
A panting CEO and his “helpers” will often conjure up fanciful “synergies.” (As a director of 19 companies over the years, I’ve never heard “dis-synergies” mentioned, though I’ve witnessed plenty of these once deals have closed.) Post mortems of acquisitions, in which reality is honestly compared to the original projections, are rare in American boardrooms. They should instead be standard practice.
Conglomerates, it should be acknowledged, have a terrible reputation with investors. And they richly deserve it. […] The drill for conglomerate CEOs then was simple: By personality, promotion or dubious accounting – and often by all three – these managers drove a fledgling conglomerate’s stock to, say, 20 times earnings and then issued shares as fast as possible to acquire another business selling at ten-or-so times earnings. They immediately applied “pooling” accounting to the acquisition, which – with not a dime’s worth of change in the underlying businesses – automatically increased per-share earnings, and used the rise as proof of managerial genius. […] Since the per-share earnings gains of an expanding conglomerate came from exploiting p/e differences, its CEO had to search for businesses selling at low multiples of earnings. These, of course, were characteristically mediocre businesses with poor long-term prospects. This incentive to bottom-fish usually led to a conglomerate’s collection of underlying businesses becoming more and more junky.
The Street’s denizens are always ready to suspend disbelief when dubious maneuvers are used to manufacture rising per-share earnings, particularly if these acrobatics produce mergers that generate huge fees for investment bankers. Auditors willingly sprinkled their holy water on the conglomerates’ accounting and sometimes even made suggestions as to how to further juice the numbers. For many, gushers of easy money washed away ethical sensitivities.
Money flows from the gullible to the fraudster. And with stocks, unlike chain letters, the sums hijacked can be staggering.
We have never invested in companies that are hell-bent on issuing shares. That behavior is one of the surest indicators of a promotion-minded management, weak accounting, a stock that is overpriced and – all too often – outright dishonesty.
There are often obstacles to the rational movement of capital. […] A CEO with capital employed in a declining operation seldom elects to massively redeploy that capital into unrelated activities. A move of that kind would usually require that long-time associates be fired and mistakes be admitted.
A lot of mouths with expensive tastes then clamor to be fed – among them investment bankers, accountants, consultants, lawyers and such capital-reallocators as leveraged buyout operators. Money-shufflers don’t come cheap.
At Berkshire, we can […] move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That’s important: If horses had controlled investment decisions, there would have been no auto industry.
The name may have changed [from LBO to private equity] but that was all: Equity is dramatically reduced and debt is piled on in virtually all private-equity purchases. Indeed, the amount that a private-equity purchaser offers to the seller is in part determined by the buyer assessing the maximum amount of debt that can be placed on the acquired company. […] In truth, “equity” is a dirty word for many private-equity buyers; what they love is debt. And, because debt is currently so inexpensive, these buyers can frequently pay top dollar.
Investment bankers, being paid as they are for action, constantly urge acquirers to pay 20% to 50% premiums over market price for publicly-held businesses. The bankers tell the buyer that the premium is justified for “control value” and for the wonderful things that are going to happen once the acquirer’s CEO takes charge. […] A few years later, bankers – bearing straight faces – again appear and just as earnestly urge spinning off the earlier acquisition in order to “unlock shareholder value.” Spin-offs, of course, strip the owning company of its purported “control value” without any compensating payment. The bankers explain that the spun-off company will flourish because its management will be more entrepreneurial, having been freed from the smothering bureaucracy of the parent company. […] If the divesting company later wishes to reacquire the spun-off operation, it presumably would again be urged by its bankers to pay a hefty “control” premium for the privilege. (Mental “flexibility” of this sort by the banking fraternity has prompted the saying that fees too often lead to transactions rather than transactions leading to fees.)
Through a lot of corporate razzle-dazzle, Ling had taken [the conglomerate] LTV from sales of only $36 million in 1965 to number 14 on the Fortune 500 list just two years later. […] Periodically, financial markets will become divorced from reality – you can count on that. More Jimmy Lings will appear. They will look and sound authoritative. The press will hang on their every word. Bankers will fight for their business. What they are saying will recently have “worked.” Their early followers will be feeling very clever. Our suggestion: Whatever their line, never forget that 2+2 will always equal 4. And when someone tells you how old-fashioned that math is --- zip up your wallet, take a vacation and come back in a few years to buy stocks at cheap prices.
As Ben Graham said many decades ago: “In the short-term the market is a voting machine; in the long-run it acts as a weighing machine.” Occasionally, the voting decisions of investors – amateurs and professionals alike – border on lunacy.
At a healthy business, cash is sometimes thought of as something to be minimized – as an unproductive asset that acts as a drag on such markers as return on equity. […] American business provided a case study of that in 2008. In September of that year, many long-prosperous companies suddenly wondered whether their checks would bounce in the days ahead. […] Indeed, in a three-week period spanning late September and early October, we supplied $15.6 billion of fresh money to American businesses. We could do that because we always maintain at least $20 billion – and usually far more – in cash equivalents. And by that we mean U.S. Treasury bills, not other substitutes for cash that are claimed to deliver liquidity and actually do so, except when it is truly needed. When bills come due, only cash is legal tender.
In our view, it is madness to risk losing what you need in pursuing what you simply desire.
My successor will need one other particular strength: the ability to fight off the ABCs of business decay, which are arrogance, bureaucracy and complacency. When these corporate cancers metastasize, even the strongest of companies can falter. The examples available to prove the point are legion, but to maintain friendships I will exhume only cases from the distant past. In their glory days, General Motors, IBM, Sears Roebuck and U.S. Steel sat atop huge industries. […] Their one-time financial strength and their historical earning power proved no defense.
The extraordinary delegation of authority now existing at Berkshire is the ideal antidote to bureaucracy. […] We don’t have a legal office nor departments that other companies take for granted: human relations, public relations, investor relations, strategy, acquisitions, you name it.
A well-known Mungerism: “If you want to guarantee yourself a lifetime of misery, be sure to marry someone with the intent of changing their behavior.”
Berkshire, however, will join only with partners making friendly acquisitions. […] We, though, will leave these “opportunities” for others. At Berkshire, we go only where we are welcome.
U.S. citizens are not intrinsically more intelligent today, nor do they work harder than did Americans in 1930. Rather, they work far more efficiently and thereby produce far more.
All families in my upper middle-class neighborhood regularly enjoy a living standard better than that achieved by John D. Rockefeller Sr. at the time of my birth.
As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). It is possible, however, to make a sensible estimate.
One of my friends says he is glad that only a few animals can talk, since the ones that do speak seem unable to discuss any subject but insurance.
I suggest that you ignore a portion of GAAP amortization costs. But it is with some trepidation that I do that, knowing that it has become common for managers to tell their owners to ignore certain expense items that are all too real. “Stock-based compensation” is the most egregious example. The very name says it all: “compensation.” If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?
Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring “earnings” figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing “access” to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.
Depreciation charges are a more complicated subject but are almost always true costs. [...] I wish we could keep our businesses competitive while spending less than our depreciation charge, but in 51 years I’ve yet to figure out how to do so. [...] When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.
In 1900, America’s civilian work force numbered 28 million. Of these, 11 million, a staggering 40% of the total, worked in farming. The leading crop then, as now, was corn. About 90 million acres were devoted to its production and the yield per acre was 30 bushels, for a total output of 2.7 billion bushels annually. Then came the tractor and one innovation after another that revolutionized such keys to farm productivity as planting, harvesting, irrigation, fertilization and seed quality. Today, we devote about 85 million acres to corn. Productivity, however, has improved yields to more than 150 bushels per acre, for an annual output of 13-14 billion bushels. Farmers have made similar gains with other products. Increased yields, though, are only half the story: The huge increases in physical output have been accompanied by a dramatic reduction in the number of farm laborers (“human input”). Today about three million people work on farms, a tiny 2% of our 158-million-person work force. Thus, improved farming methods have allowed tens of millions of present-day workers to utilize their time and talents in other endeavors, a reallocation of human resources that enables Americans of today to enjoy huge quantities of non-farm goods and services they would otherwise lack. [...] We would not have anything close to the America we now know had we stifled those improvements in productivity. (It was fortunate that horses couldn’t vote.) On a day-to-day basis, however, talk of the “greater good” must have rung hollow to farm hands who lost their jobs to machines that performed routine tasks far more efficiently than humans ever could.
In 1947, shortly after the end of World War II, the American workforce totaled 44 million. About 1.35 million workers were employed in the railroad industry. The revenue ton-miles of freight moved by Class I railroads that year totaled 655 billion. By 2014, Class I railroads carried 1.85 trillion ton-miles, an increase of 182%, while employing only 187,000 workers, a reduction of 86% since 1947. [...] As a result of this staggering improvement in productivity, the inflation-adjusted price for moving a ton-mile of freight has fallen by 55% since 1947. [...] Safety at BNSF has improved as well: Reportable injuries were 2.04 per 200,000 man-hours in 1996 and have since fallen more than 50% to 0.95.
A bit more than a century ago, the auto was invented, and around it formed an industry that insures cars and their drivers. [...] This agency-centric approach included high commissions and other underwriting expenses that consumed about 40¢ of the premium dollar. [After that] both State Farm and Allstate have had underwriting expenses of about 25%. [...] In the early 1930s, another contender, United Services Auto Association (“USAA”), a mutual-like company, was writing auto insurance for military officers on a direct-to-the-customer basis. This marketing innovation rose from a need that military personnel had to buy insurance that would stay with them as they moved from base to base. That was business of little interest to local insurance agencies, which wanted the steady renewals that came from permanent residents. [...] That made Leo and Lillian Goodwin, employees of USAA, dream of broadening the target market for its direct distribution model beyond military officers. In 1936, starting with $100,000 of capital, they incorporated Government Employees Insurance Co. (later compressing this mouthful to GEICO). Their fledgling did $238,000 of auto insurance business in 1937, its first full year. Last year GEICO did $22.6 billion. […] GEICO’s underwriting expenses in 2015 were 14.7% of premiums.
Though the early bird gets the worm, the second mouse gets the cheese.
Historically, the survival of a local electric company did not depend on its efficiency. In fact, a “sloppy” operation could do just fine financially. That’s because utilities were usually the sole supplier of a needed product and were allowed to price at a level that gave them a prescribed return upon the capital they employed. The joke in the industry was that a utility was the only business that would automatically earn more money by redecorating the boss’s office. And some CEOs ran things accordingly.
BHE acquired its Iowa utility in 1999. In the year before, that utility employed 3,700 people and produced 19 million megawatt-hours of electricity. Now we employ 3,500 people and produce 29 million megawatt-hours. That major increase in efficiency allowed us to operate without a rate increase for 16 years, a period during which industry rates increased 44%. [...] The safety record of our Iowa utility is also outstanding. It had .79 injuries per 100 employees in 2015 compared to the rate of 7.0 experienced by the previous owner in the year before we bought the operation.
When innovation and the market system interact to produce efficiencies, many workers may be rendered unnecessary, their talents obsolete. Some can find decent employment elsewhere; for others, that is not an option. When low-cost competition drove shoe production to Asia, our once-prosperous Dexter operation folded, putting 1,600 employees in a small Maine town out of work. Many were past the point in life at which they could learn another trade. We lost our entire investment, which we could afford, but many workers lost a livelihood they could not replace. The same scenario unfolded in slow-motion at our original New England textile operation, which struggled for 20 years before expiring. Many older workers at our New Bedford plant, as a poignant example, spoke Portuguese and knew little, if any, English. They had no Plan B. The answer in such disruptions is not the restraining or outlawing of actions that increase productivity.
We, like all public companies, are required by the SEC to annually catalog “risk factors” in our 10-K. I can’t remember, however, an instance when reading a 10-K’s “risk” section has helped me in evaluating a business. That’s not because the identified risks aren’t real. [...] When we took over the company in 1965, its risks could have been encapsulated in a single sentence: “The northern textile business in which all of our capital resides is destined for recurring losses and will eventually disappear.”
I think, however, that Einstein’s 1949 appraisal remains apt: “I know not with what weapons World War III will be fought, but World War IV will be fought with sticks and stones.”
[I propose] Noah’s Law: If an ark may be essential for survival, begin building it today, no matter how cloudless the skies appear.
The [GAAP] accounting rules [...] that apply to companies we control differ in important ways from those used to value marketable securities. Specifically, the accounting for businesses we own requires that the carrying value of “losers” be written down when their failures become apparent. “Winners,” conversely, are never revalued upwards. [...] We have no quarrel with the asymmetrical accounting that applies here.
From the standpoint of exiting shareholders, repurchases are always a plus, [since] it’s always better for a seller to have an additional buyer in the market. For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. [(with] a spread that is appropriate because calculations of intrinsic value can’t be precise [). Yet], buying out “partners” at a discount is not a particularly gratifying way of making money.
Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent. It is puzzling, therefore, that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed. That certainly wouldn’t be the case if a management was buying an outside business. There, price would always factor into a buy-or-pass decision. When CEOs or boards are buying a small part of their own company, though, they all too often seem oblivious to price.
As Charlie says, it’s great to have a manager with a 160 IQ – unless he thinks it’s 180.
[It's important to have] an ever-widening diversity of earnings streams, which shield BHE from being seriously harmed by any single regulatory body. [...] It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects.
Where current costs for many depreciable items far outstrip historical costs. The inevitable result is that reported earnings throughout the railroad industry are considerably higher than true economic earnings. [...] At BNSF, to get down to particulars, our GAAP depreciation charge last year was $2.1 billion. But were we to spend that sum and no more annually, our railroad would soon deteriorate and become less competitive. The reality is that – simply to hold our own – we need to spend far more than the cost we show for depreciation
Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses, [...] the two favorites of “don’t-count-this” managers. [...] That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well. [...] Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers. [...] Berkshire, I would say, has been restructuring from the first day we took over in 1965. Owning only a northern textile business then gave us no other choice. And today a fair amount of restructuring occurs every year at Berkshire. That’s because there are always things that need to change in our hundreds of businesses. Last year, as I mentioned earlier, we spent significant sums getting Duracell in shape for the decades ahead. [...] But, to tell owners year after year, “Don’t count this,” when management is simply making business adjustments that are necessary, is misleading. And too many analysts and journalists fall for this baloney.
Many cash-rich American companies hold a large portion of their funds in jurisdictions imposing very low taxes. [...] Off-shore cash is simply not worth as much as cash held at home.
I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line? What followed was the sound of silence. [...] Only one man – Ted Seides – stepped up to my challenge. [...] Protégé Partners, my counterparty to the bet, picked five “funds-of-funds” that it expected to overperform the S&P 500. That was not a small sample. Those five funds-of-funds in turn owned interests in more than 200 hedge funds5. [...] The five funds-of-funds got off to a fast start, each beating the index fund in 2008. Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund5.
Finally, there [is one] reality that cause investing success to breed failure[:] a good record quickly attracts a torrent of money.
Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase. Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size. Investment bankers, smelling huge fees, will be applauding as well. (Don’t ask the barber whether you need a haircut.) If the historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint.
During the 2008-2009 crisis, we liked having Treasury Bills – loads of Treasury Bills – that protected us from having to rely on funding sources such as bank lines or commercial paper [which often can't] comfortably withstand economic discontinuities. [...] At yearend [2017] Berkshire held $116.0 billion in cash and U.S. Treasury Bills (whose average maturity was 88 days).
The loss reserves of an insurer are similar to a self-graded exam. Ignorance, wishful thinking or, occasionally, downright fraud can deliver inaccurate figures about an insurer’s financial condition for a very long time.
American investors pay staggering sums annually to advisors, often incurring several layers of consequential costs. [For hedge funds] fixed fees averaging a staggering 21⁄2% of assets or so were paid every year by the fund-of-funds’ investors. [...] Performance comes, performance goes. Fees never falter.
It is likely that – over time – Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down.
“Adjusted EBITDA” [is] a measure that redefines “earnings” to exclude a variety of all-too-real costs.
Over the years, Charlie and I have seen all sorts of bad corporate behavior, both accounting and operational, induced by the desire of management to meet Wall Street expectations. What starts as an “innocent” fudge in order to not disappoint “the Street” – say, trade-loading at quarter-end, turning a blind eye to rising insurance losses, or drawing down a “cookie-jar” reserve – can become the first step toward full-fledged fraud. Playing with the numbers “just this once” may well be the CEO’s intent; it’s seldom the end result. And if it’s okay for the boss to cheat a little, it’s easy for subordinates to rationalize similar behavior.
Like it or not, the U.S. Government “owns” an interest in Berkshire’s earnings of a size determined by Congress. [...] Last year, however, 40% of the government’s “ownership” (14/35ths) was returned to Berkshire – free of charge – when the corporate tax rate was reduced to 21%. [...] This happening materially increased the intrinsic value of the Berkshire shares you and I own.
Many managers, it should be noted, will disagree with this policy, arguing that significant debt juices the returns for equity owners. And these more venturesome CEOs will be right most of the time. At rare and unpredictable intervals, however, credit vanishes and debt becomes financially fatal. A Russian-roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company’s upside but does not share in its downside.
In reviewing my uneven record, I’ve concluded that acquisitions are similar to marriage: They start, of course, with a joyful wedding – but then reality tends to diverge from pre-nuptial expectations. Sometimes, wonderfully, the new union delivers bliss beyond either party’s hopes. In other cases, disillusionment is swift. Applying those images to corporate acquisitions, [...] it’s easy to get dreamy-eyed during corporate courtships. [...] A meaningful number, however, have caused me all too quickly to wonder what I was thinking when I proposed.
Mistakes in assessing insurance risks can be huge and can take many years – even decades – to surface and ripen. (Think asbestos.) A major catastrophe that will dwarf hurricanes Katrina and Michael will occur – perhaps tomorrow, perhaps many decades from now. “The Big One” may come from a traditional source, such as wind or earthquake, or it may be a total surprise involving, say, a cyber attack having disastrous consequences beyond anything insurers now contemplate.
When Berkshire [Hathaway Energy] entered the utility business in 2000, purchasing 76% of BHE, the company’s residential customers in Iowa paid an average of 8.8 cents per kilowatt-hour (kWh). Prices for residential customers have since risen less than 1% a year, and we have promised that there will be no base rate price increases through 2028. In contrast, here’s what is happening at the other large investor-owned Iowa utility: Last year, the rates it charged its residential customers were 61% higher than BHE’s. Recently, that utility received a rate increase that will widen the gap to 70%.
[Audit] committees remain no match for managers who wish to game numbers. […] My direct experience (limited, thankfully) with CEOs who have played with a company’s numbers indicates that they were more often prompted by ego than by a desire for financial gain.
I have yet to see a CEO who craves an acquisition bring in an informed and articulate critic to argue against [the acquisition proposals]. [...] Overall, the deck is stacked in favor of the deal that’s coveted by the CEO and his/her obliging staff.
When seeking directors, CEOs don’t look for pit bulls. It’s the cocker spaniel that gets taken home.
Over the years, board “independence” has become a new area of emphasis. One key point relating to this topic, though, is almost invariably overlooked: Director compensation has now soared to a level that inevitably makes pay a subconscious factor affecting the behavior of many non-wealthy members. Think, for a moment, of the director earning $250,000-300,000 for board meetings consuming a pleasant couple of days six or so times a year. Frequently, the possession of one such directorship bestows on its holder three to four times the annual median income of U.S. households. […] And job security now? It’s fabulous. Board members may get politely ignored, but they seldom get fired. […] Despite the illogic of it all, the director for whom fees are important – indeed, craved – is almost universally classified as “independent” while many directors possessing fortunes very substantially linked to the welfare of the corporation are deemed lacking in independence.
Most of the truly great businesses had no interest in having anyone take them over. Consequently, deal-hungry conglomerateurs had to focus on so-so companies that lacked important and durable competitive strengths. That was not a great pond in which to fish. Beyond that, as conglomerateurs dipped into this universe of mediocre businesses, they often found themselves required to pay staggering “control” premiums to snare their quarry. Aspiring conglomerateurs knew the answer to this “overpayment” problem: They simply needed to manufacture a vastly overvalued stock of their own that could be used as a “currency” for pricey acquisitions. (“I’ll pay you $10,000 for your dog by giving you two of my $5,000 cats.”)
Wall Street loves the fees that deal-making generates, and the press loves the stories that colorful promoters provide. [...] Financial history is replete with the names of famous conglomerateurs who were initially lionized as business geniuses by journalists, analysts and investment bankers, but whose creations ended up as business junkyards.
Owning a non-controlling portion of a wonderful business is more profitable, more enjoyable and far less work than struggling with 100% of a marginal enterprise.
Investors must never forget that their expenses are Wall Street’s income.
Charlie and I are not stock-pickers; we are business-pickers.
In 1955, when Berkshire Fine Spinning and Hathaway Manufacturing agreed to merge their businesses, [the] solicitation [assured] shareholders that “the combination of the resources and managements will result in one of the strongest and most efficient organizations in the textile industry.” That upbeat view was endorsed by the [Hathaway Manufacturing]’s advisor, Lehman Brothers.
Deceptive “adjustments” to earnings – to use a polite description – have become both more frequent and more fanciful as stocks have risen. Speaking less politely, I would say that bull markets breed bloviated bull.
When large enterprises are being managed, both trust and rules are essential. Berkshire emphasizes the former to an unusual – some would say extreme – degree. Disappointments are inevitable. We are understanding about business mistakes; our tolerance for personal misconduct is zero.
Beating “expectations” is heralded as a managerial triumph. [...] It requires no talent to manipulate numbers: Only a deep desire to deceive is required. “Bold imaginative accounting,” as a CEO once described his deception to me, has become one of the shames of capitalism.
Capitalism has two sides: The system creates an ever-growing pile of losers while concurrently delivering a gusher of improved goods and services. Schumpeter called this phenomenon “creative destruction.”
Stocks often trade at truly foolish prices, both high and low. “Efficient” markets exist only in textbooks. [Stock market] behavior [is] usually understandable only in retrospect.
Controlled businesses are a different breed [than publicly-traded companies]. They sometimes command ridiculously higher prices than justified but are almost never available at bargain valuations. Unless under duress, the owner of a controlled business gives no thought to selling at a panic-type valuation.
Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years. [...] The lesson for investors: The weeds wither away in significance as the flowers bloom.
When a company overpays for repurchases, the continuing shareholders lose. At such times, gains flow only to the selling shareholders and to the friendly, but expensive, investment banker who recommended the foolish purchases. [Yet] when you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive).
America would have done fine without Berkshire. The reverse is not true.
Huge and entrenched fiscal deficits have consequences. [...] During the decade ending in 2021, the United States Treasury received about $32.3 trillion in taxes while it spent $43.9 trillion.
[Charlie's best quotes include:]
Early on, write your desired obituary – and then behave accordingly.
Patience can be learned. Having a long attention span and the ability to concentrate on one thing for a long time is a huge advantage.
A great company keeps working after you are not; a mediocre company won’t do that.
If you keep making something more valuable, then some wise person is going to notice it and start buying.
There is no such thing as a 100% sure thing when investing. Thus, the use of leverage is dangerous. A string of wonderful numbers times zero will always equal zero. Don’t count on getting rich twice.
Notes
Notes
1 : This section is from the 1978 letter
2 : This section is from the 1977 letter
3 : This section is from the 1982 letter
4 : This section is from the 1985 letter
5 : This section is from the 2017 letter
6 : This section is from the 2002 letter
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