Ever wonder what blueprint Warren Buffett uses? Or how he
manages his company or decides what companies to invest in or buy outright?
Well, we are in luck because June 1996 Buffett published
his first “owners manual” for Berkshire Hathaway shareholders. His
manual provided information about the company’s goals, policies, and
expectations. He recently updated the manual, as of the 2017 annual report.
As one of the leaders of the value investing model,
Buffett has long believed that investors should only buy stock in companies
that have solid fundamentals, strong earnings power, and the potential for
continued growth.
These ideas may seem like easy concepts to grasp, but
finding companies that exhibit these characteristics is not always that easy.
I believe this is one of the reasons that Buffett laid
down this foundation with his “owners manual.” To help us understand
how he uses his principles to find companies worth owning.
We can break down Buffett’s investing style into four
categories:
- Business
- Management
- Financial Measures
- Value
We are going to take Buffett’s owner’s manual and break
it down into the four categories and elaborate on how his ideas can translate
to our investing approach.
For a full view of the Berkshire Hathaway Owner’s Manual, go here. There were originally 13 owner-related business principles, and he has since updated the list to include two more. You can also find the manual in every annual report that Berkshire has done since 1983.
Let’s take a look at each category, a word of note, the
items listed on the manual are not necessarily in order of the categories so we
may jump around a bit.
Business Tenets
- “Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.”
Buffett advises investors to view themselves as owners of
the business rather than holding a piece of paper or ticker symbol that we can
sell when the price changes.
The attitude of ownership separates investors from
speculators and is the foundation of value investing. Think of it this way; if
you own something, you are far less likely to sell it if you own it, as opposed
to just borrowing an item. If you paid hard-earned money for that item, you are
less likely to part with it.
Viewing buying a business gives you the same insight as
if you bought an iPhone, and that is how you must think of owning a stock.
Buffett mentions that we should measure the success of
our company’s by long-term progress rather than the month-to-month price
changes.
- “In line with Berkshire’s owner-orientation,
most of our directors have a significant portion of their net worth invested in
the company. We eat our own cooking.”
Eating your cooking is critical when looking for managers
that have shareholders in mind. CEOs or other company officers that don’t
invest in their own company is a HUGE red flag! The same rule applies to
investment advisors who don’t buy what they suggest to their clients.
Charlie and Warren both have an extremely large amount of
their wealth tied up in Berkshire, with Warren’s share stated as over 98%.
Having skin in the game greatly enhances the desire for an operation to succeed,
and both Warren and Charlie understand this idea.
Aligning ourselves with owners that belief in their
company enough to tie their wealth to that company is a great way to sleep
better at night.
- “Our
long-term economic goal (subject to some qualifications mentioned later) is to
maximize Berkshire’s average annual rate of gain in intrinsic business value on
a per-share basis. We do not measure the economic significance or performance
of Berkshire by its size; we measure by per-share progress. We are certain that
the rate of per-share progress will diminish in the future – a greatly enlarged
capital base will see to that. But we will be disappointed if our rate does not
exceed that of the average large American corporation.”
They are not concerned with the overall size of
Berkshire, only that the company performs to their expectations and produces
for the shareholders the returns they deserve. They are finding a company that
is concerned more about performance than growing for growth’s sake is a great
lesson.
In other words, avoid serial acquirers that are more
concerned with being bigger, as opposed to acquiring to create more value for
the company and shareholder. Think Valeant, if you are not familiar with their
story, Google Valeant and read about the history of the company.
Financial Measures
- “Our
preference would be to reach our goal by directly owning a diversified group of
businesses that generate cash and consistently earn above-average returns on
capital. Our second choice is to own parts of similar businesses, attained
primarily through purchases of marketable common stocks by our insurance
subsidiaries. The price and availability of businesses and the need for
insurance capital determine any given year’s capital allocation.”
Buffett comes back to the theme of return on capital over
and over again in his letters to shareholders. This is a very important concept
for all investors to embrace as returns on capital indicate a very strong
company that can grow without borrowing or diluting shares.
He also notates cash flow multiple times in the letters
as well. Free cash is king, and any company that can generate free cash flow
can use that money to reinvest in the company or return value via dividends or
share repurchases.
Two of Buffett’s main tenets are buying companies with
high returns on capital and are generating tons of free cash flow.
- “Because of our two-pronged approach to
business ownership and because of the limitations of conventional accounting,
consolidated reported earnings may reveal relatively little about our true
economic performance. Charlie and I, both as owners and managers, virtually
ignore such consolidated numbers. However, we will also report to you the
earnings of each major business we control, numbers we consider of great
importance. These figures, along with other information we will supply about
the individual businesses, should generally aid you in making judgments about
them.”
Buffett likes to ignore earnings season speculation
because he feels it fuels Mr. Market and all the ups and downs of the market.
He and Charlie prefer to use owner earnings as a way of determining the value
of a company.
Additionally, with the change in accounting rules
recently, Berkshire has seen tremendous swings in its earnings per share. The
new rules state that unrealized gains or losses from investments now must be
considered as revenue. Both Charlie and Warren think this rule is ridiculous,
but, of course, they are following the rule.
Buffett recommends that we consider all factors when
discussing the performance of any business. Using metrics such as profitability
metrics, cash flow metrics, return on assets, return on equity, and so on will
give a better overall barometer of the health of a business than the short-term
idea of earnings.
- “Accounting
consequences do not influence our operating or capital-allocation decisions.
When acquisition costs are similar, we much prefer to purchase $2 of earnings
that is not reportable by us under standard accounting principles than to
purchase $1 of earnings that is reportable. This is precisely the choice that
often faces us since entire businesses (whose earnings will be fully
reportable) frequently sell for double the pro-rata price of small portions
(whose earnings will be largely unreportable). In aggregate and over time, we
expect the unreported earnings to be fully reflected in our intrinsic business
value through capital gains.”
Buffett refers to the use of capital allocations from
retained earnings in this quote. He feels that many outstanding businesses use
their retained earnings to give back value to shareholders in the form of
dividends or share repurchases. Or using those funds to reinvest back into the
business at high levels of return on capital.
Another trademark Buffett investing tenet is to find
great capital allocators. CEOs that use the business proceeds to increase
shareholder value are gold to him. And, frankly, that is one of his best
attributes as the CEO of Berkshire.
He and Charlie both regard look-through earnings as
realistically portraying gains from operations for any business.
For those not familiar with that term. Look-through
earnings are both monies paid out to investors, think dividends, and funds
reinvested by the company, think the return on capital. Look-through earnings
give a much more realistic view of the company’s annual gains, and the value
created for the shareholders.
- “We
use debt sparingly. We will reject interesting opportunities rather than
over-leverage our balance sheet. This conservatism has penalized our results
but it is the only behavior that leaves us comfortable, considering our
fiduciary obligations to policyholders, lenders and the many equity holders who
have committed unusually large portions of their net worth to our care. (As one
of the Indianapolis “500” winners said: “To finish first, you
must first finish.”).”
Both Charlie and Warren believe that debt is the devil
and has lead to more failings on Wall Street than almost anything except, maybe
greed.
Taking on debt to either purchase companies, pay
dividends, or repurchase shares can be dangerous. Many companies use debt as a
way to lever up their returns, and this can lead to a lot of problems. Warren
mentions in the letter that he “would
never permit our trading a good night’s sleep for a shot at a few extra
percentage points of return.”
Berkshire is built upon the two sources of capital that
allow it to own more assets, those being deferred taxes, and float from its
insurance businesses. Not many companies enjoy this benefit, but Buffett has
used this “free” capital to the shareholder’s great advantage.
- “A
managerial “wish list” will not be filled at shareholder expense. We
will not diversify by purchasing entire businesses at control prices that ignore
long-term economic consequences to our shareholders. We will only do with your
money what we would do with our own, weighing fully the values you can obtain
by diversifying your portfolios through direct purchases in the stock market.”
Buffett and Munger only believe in growing the value of
Berkshire through prudent acquisitions. When contemplating buying a company, you
should weigh whether this purchase will improve your portfolio or if it is just
plugging a hole.
Looking for companies that use their earnings to grow shareholder
value is one of the keys to good investing. Bill Gates, during his tenure at
Microsoft, acquired businesses that he felt could grow Microsoft. If he
discovered a technology that he felt would benefit Microsoft and was such that
they couldn’t create it themselves, then he would buy the company to grow
Microsoft.
- “We
feel noble intentions should be checked periodically against results. We test
the wisdom of retaining earnings by assessing whether retention, over time,
delivers shareholders at least $1 of market value for each $1 retained. To
date, this test has been met. We will continue to apply it on a five-year
rolling basis. As our net worth grows, it is more difficult to use retained
earnings wisely.”
This from Buffett’s thought, much better than I
can add.
“I should have written the “five-year rolling basis” sentence differently, an error I didn’t realize until I received a question about this subject at the 2009 annual meeting.
When the stock market has declined sharply over five years, our market-price premium to book value has sometimes shrunk. And when that happens, we fail the test as I improperly formulated it. In fact, we fell far short as early as 1971-75, well before I wrote this principle in 1983.
The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense.”
Management
- “We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance – not only mergers or public stock offerings, but stock-for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company – and that is what the issuance of shares amounts to – on a basis inconsistent with the value of the entire enterprise.”
Be fearful of companies that state that they are
undervalued during an IPO; these CEO may be undervaluing their use of the
shareholder cash once they are public. When investigating any company spend
time researching the management as well, the numbers can help tell a story.
Think about a company that is extremely over-levered, and
then they start issuing more shares to create more capital. Are they doing the
shareholders any favors by diluting their shares will not pay down that debt?
These are all questions we must ask ourselves when analyzing any company.
- “You should be fully aware of one attitude Charlie, and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub-par businesses. 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 and the advocates 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 would rather have our overall results penalized a bit than engage in that kind of behavior.”
Beware of companies that are struggling, throwing more
money at the problem is not always the answer, nor is replacing management with
“better” managers. Sometimes it is best just to cut the company that
is struggling, the industry they are in may be going through changes or is on
the way out. Think bookstores, Borders wasn’t able to adapt, neither was Radio
Shack, and this led to their demise.
- “We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less. Moreover, as a company with a major communications business, it would be inexcusable for us to apply lesser standards of accuracy, balance and incisiveness when reporting on ourselves than we would expect our news people to apply when reporting on others. We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private.”
Finding a company that is candid in its communications
will reap benefits in the long run. When reading through any communications
from the CEO, either in the annual letters, 10-ks, or the quarterly earnings
call, pay attention to the wording and tone that the CEO projects. That
attention to detail will help you determine whether they are open and honest,
or if they are just repeating corporate speak. You can smell it a hundred miles
away.
Several CEOs that I have studied who I think is on the
level with their businesses are Jamie Dimon of JP Morgan, Wendell Weeks of
Corning (GLW), Jeff Bezos of Amazon (AMZN), Jeremy Grantham of the asset firm
GMO, Howard Marks of Oaktree Capital, Tom Gaynor of Markel Insurance (MKL).
That is just a shortlist of the letters that I have
either read or currently read for companies that I own or are interested in
owning someday.
Opposites of this would be someone like Elon Musk; his
letters are a smattering of promises, most of which never come true and dreams,
as opposed to laying out the difficulties the company faces and how they plan
to overcome those difficulties.
Not everything is always roses, business is hard, and
running any company is difficult, and you want a leader that is both positive,
but realistic about the challenges ahead.
- “Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we normally will not talk about our investment ideas. This ban extends even to securities we have sold (because we may purchase them again) and to stocks we are incorrectly rumored to be buying. If we deny those reports but say “no comment” on other occasions, the no-comments become confirmation.”
The above idea is an idea that Buffett excels at, he is
more than willing to share his ideas on investing and business. He is like the
parent that teaches us to not only fish but also how to cook the fish. Think of
the phrase, give a man a fish, feed him for the day, teach a man to fish, and
you teach him to feed himself for life.
Buffett gives us all the information we need to invest
for ourselves. He has spent countless hours writing and speaking about his
ideas and methods of investing; it is up to us to decipher those ideas and determine
how to best adapt them to ourselves.
He expresses a ton of gratitude for Ben Graham and his
teachings, and he feels compelled to pass along what he has learned in the
hopes that we pick up the mantle and carry the torch forward even if that
creates more competition for him in the future.
Value
- “To the extent possible, we would like each Berkshire shareholder to record a gain or loss in market value during his period of ownership that is proportional to the gain or loss in per-share intrinsic value recorded by the company during that holding period. For this to come about, the relationship between the intrinsic value and the market price of a Berkshire share would need to remain constant, and by our preferences at 1-to-1. As that implies, we would rather see Berkshire’s stock price at a fair level than a high level. Obviously, Charlie and I can’t control Berkshire’s price. But by our policies and communications, we can encourage informed, rational behavior by owners that, in turn, will tend to produce a stock price that is also rational. Our it’ s-as-bad-to-be-overvalued-as-to-be-undervalued approach may disappoint some shareholders. We believe, however, that it affords Berkshire the best prospect of attracting long-term investors who seek to profit from the progress of the company rather than from the investment mistakes of their partners.”
Buffett is discussing having a long-term view and
believing in the valuation of the company to be as fair-valued as it can be,
and that we are patient when buying a company. The gains will come from the
long-run, not overnight.
Remember Buffett’s favorite saying, never own a company
for five minutes that you wouldn’t own for five years. If you look at the
short-term of just about any company, you might or not see gains, but if you
look at the longer horizon of a wonderful company, you will see gains.
- “We regularly compare the gain in Berkshire’s per-share book value to the performance of the S&P 500. Over time, we hope to outpace this yardstick. Otherwise, why do our investors need us? The measurement, however, has certain shortcomings that are described in the next section. Moreover, it now is less meaningful on a year-to-year basis than was formerly the case. That is because our equity holdings, whose value tends to move with the S&P 500, are a far smaller portion of our net worth than they were in earlier years. Additionally, gains in the S&P stocks are counted in full in calculating that index, whereas gains in Berkshire’s equity holdings are counted at 79% because of the federal tax we incur. We, therefore, expect to outperform the S&P in lackluster years for the stock market and underperform when the market has a strong year.”
Measuring against a yardstick is a great way to measure
your performance, and the same applies to the stock market. But you need to
understand that yardstick and how your company’s performance will be compared
to the yardstick. A cyclical company will have many ups and downs compared to
that yardstick, which doesn’t mean that it is good or bad, it means you need to
understand that industry and how the company sits in that industry.
Also, different industries are going to go through
periods of being out of favor, such as financials currently. In the past, it
was energy, or oil, and then retail. It will ebb and flow, but it is important
to understand the cycle and the industry, plus doing your analysis of your
company.
INTRINSIC VALUE
“Now let’s focus on a term that I mentioned earlier
and that you will encounter in future annual reports.
Intrinsic value is an all-important concept that offers
the only logical approach to evaluating the relative attractiveness of investments
and businesses. Intrinsic value can be defined simply: It is the discounted
value of the cash that can be taken out of a business during its remaining
life.
The calculation of intrinsic value, though, is not so
simple. As our definition suggests, intrinsic value is an estimate rather than
a precise figure, and it is additionally an estimate that must be changed if
interest rates move or forecasts of future cash flows are revised.
Two people looking at the same set of facts, moreover –
and this would apply even to Charlie and me – will almost inevitably come up
with at least slightly different intrinsic value figures. That is one reason we
never give you our estimates of intrinsic value. What our annual reports do
supply, though, are the facts that we use to calculate this value.”
Buffett meant what he said; he has never revealed how he
and Charlie calculate intrinsic value; they have intimated and discussed
discounted cash flows.
The methods of calculating the intrinsic value for Buffett
have been per-share book value, discounted cash flows, owner earnings, return
on equity. The inputs that he uses are a complete mystery, as well as how he
calculates them.
My opinion is that he has left that up to us to figure
out the clues from his writings and interviews and do our work. I have written
about all of these methods in the past, and my thoughts have evolved as I have
learned more. I think it is a combination of all the above methods, plus his
overall mastery of business and the markets.
Intrinsic value is both an art and a science, using the
tools is the science part, but his knowledge, experience, and wisdom is the art
component.
Final Thoughts
As always, Buffett does such a fantastic job laying out his
thoughts in an easy, understandable way. Part of my attraction to him is his
willingness to share his wisdom and knowledge with me.
The owner’s manual is part of teaching, but it is also a
great start to a checklist to screen for companies. Using the framework that he
lays out in this manual can help you find wonderful companies to analyze.
Nothing he lists in the manual is hard, or complicated. Most of it is simple,
straightforward ideas to follow.
I know that every time I read something from him, I learn
something new. Nothing that we talked about is new territory, but it is always
good to get a refresher.
As always, I hope you enjoyed our discussion on the Berkshire Hathaway Owners’ Manual and that you found something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate
to reach out.
Take care,
Dave
