Buffett, or the “Sage of Omaha” as he’s become eloquently known, has spent the last 50 years assembling a portfolio of businesses wonderfully diverse and positioning himself firmly in the top ten of the world’s richest people.
Throughout that time, he has written to shareholders every year – analysing his Berkshire Hathaway activity and explaining what might be in store for the future. His 50th effort, aside from providing fascinating insight on the early history of Berkshire Hathaway, provided some pertinent advice and guidance for entrepreneurs young and old.
Buffet books, whether written by the man himself or by other’s about him, are numerous – with people across the world hoping some of his enviable knowledge might brush off onto them.
Like all good businessmen, Buffett is not afraid to admit his mistakes – and that is where it all started in 1960s New England. The coming together of Berkshire Fine Spinning Associates and Hathaway Manufacturing soon “morphed into a suicide pact”, as Buffet remembered it.
So why did Buffett stick with it, persevere, and hope that one day he’d develop a successful way of doing business? After buying stock at a discounted rate, he got his free cigar puff when the business used the proceeds from factory shutdowns to repurchase shares at 50 per cent above the amount Buffett paid.
But the businessman in Buffett wasn’t content with getting that cheap fix and instead started buying up additional stock until it reached takeover level. Ending up with a “terrible business” that he knew little about, he described the situation as like becoming the “dog who caught the car”.
Despite the poor performance of the company, Buffett got lucky and kept it afloat. However, it wasn’t until he crossed paths with his now vice-chairman Charlie Munger that Buffett learnt how to take his cigar-butt investing in small firms and create a scalable strategy. “Cigar-butt investing was scalable only to a point. With large sums, it would never work well,” Buffett recounted in his letter.
Describing Munger as having “wide-ranging brilliance, a prodigious memory, and some firm options”, Buffett declared Munger’s most important architectural feat (he had a passion for design that saw him design and build apartment projects) was the Berkshire Hathaway blueprint. Simply put: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.
Altering his behaviour was not an easy task, Buffett said in his letter. However, fifty years is a long time and by combining his skills with Munger the duo have formed a formidable team. That same time period is also bound to contain some amazing stories of both success and despair.
Entrepreneurs and business owners would be hard-pressed to find a more useful hour than sifting through the contents of Buffet’s 50th shareholder letter. But I’d like to share with you some of my favourite parts.
The “most gruesome” of his mistakes involved a business called Dexter Shoe. Having paid $433m for the company in 1993, its value promptly dropped out in the face of international competition. While a big loss of money, it would have been slightly easier to stomach had Buffett not financed the acquisition using stock of Berkshire Hathaway. The shares he used are now worth about $5.7bn which, as a financial disaster, he predicts “deserves a spot in the Guinness Book of World Records”.
This mis-hap has led to him developing a simple philosophy: “The intrinsic value of the shares you give in an acquisition must not be greater than the intrinsic value of the business you receive.” This is advice he doesn’t believe is heeded enough by the investment banking community, who too often refer to premiums-to-market-price or earnings-per-share. He declared: “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 original projections, are rare in American boardrooms. They should be standard practice.”
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The Berkshire Hathaway of today is an incredible beast. Buffett describes it as a “sprawling conglomerate”. Acknowledging conglomerates have a “terrible reputation” with investors, he believes the Berkshire Hathaway conglomerate brings with it “huge and enduring advantages”.
Conglomerate’s bad reputation, Buffet believes, stems from the perception that they simply drive a company’s share price to 20x earnings, issue shares as fast as possible to acquire another business selling at 10x earnings and then apply “pooling accounting” to the purchased business. This, increasing the per-share earnings, is used as evidence of “managerial genius”, to convince investors of an enhanced price-to-earnings ratio. After this it’s a case of lather, rinse and repeat all over again.
In the time at which conglomerates were at their most popular, Buffet remembered being told that having an accounting “wizard” at the helm of a growing conglomerate was a “huge plus”. “In the late 1960s, I attended a meeting at which an acquisitive CEO bragged of his ‘bold, imaginative accounting’,” Buffet recounted. “Most of the analysts listening responded with approving nods, seeing themselves as having found a manager whose forecasts were certain to be met, whatever the business results might be.”
At Berkshire Hathaway, Buffett declared there has never been a strategy of investing in companies that are “hell-bent” on issuing shares. His justification of the conglomerate model? “If the conglomerate is used judiciously, it is an ideal structure of maximising long-term capital growth.
“A conglomerate such as Berkshire is perfectly positioned to allocate capital rationally and at minimal cost. Our structural advantages […] are formidable.”
The Berkshire Hathaway model means that its management are able to move “huge sums” of money from one business with limited opportunities for incremental investment to sectors with “greater promise”. Not being tied down to a specific industry is also a big help, he explained. His analogy: “If horses had controlled investment decisions, there would have been no motor industry.”
So being a company backed by Berkshire Hathaway is like being supported by an enormous bank, which will only be too happy to move, at an unbeatable low rate, money to help growth. “In effect, the world is Berkshire’s oyster – a world offering us a range of opportunities far beyond those realistically open to most companies,” he boasted in the letter. “We can profitably scale to a far larger size than the many businesses that are constrained by the limited potential of the single industry in which they operate.”
However, he his frank in his admission that he and Munger have no idea what a great many companies will look like in ten years from now.
On the subject of spinning off some of its interests, something pundits frequently suggest, Buffett is firm that the firm’s companies are worth more as a part of Berkshire than as separate entities. On top of moving funds between businesses instantly and without tax, having businesses tied together limits duplicate costs such as paying for a board of directors at every business.
Moving on to the future of Berkshire Hathaway in his letter, Buffett embraced both existing investors and those wondering whether their money would be better with the “Sage of Omaha”.
“For those investors who plan to sell within a year or two after their purchase, I can offer no assurances, whatever the entry price,” he advised. “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 the lunacy.”
My favourite line from the entire of Buffett’s 50th letter centres on whether Berkshire Hathaway would be able to cope with financial problems. “We will always be prepared for the thousand-year flood; in fact, if it occurs we will be selling life jackets for the unprepared,” he joked.
His, and the firm’s, continued conservatism is driven by the saying that though practically all days are relatively uneventful, tomorrow is always uncertain.
He finishes up by revealing that he will be suggesting that his son, Howard, take over the reigns as non-executive chairman. In true Buffett style, Howard will receive no pay and will spend no time at the job other than that required of all directors.
Despite having a razor-sharp mind, at 84 years-old Buffett senior won’t have that many more years of active investing left in him. Could we be about to see the rise of the junior “Sage of Omaha”?
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